Best Advice? Tax Diversification

While sitting family style at dinner on the Amtrak train with my two new friends this past New Year’s Eve, I was asked:  “What’s your best financial advice these days?”

Yes, Amtrak.  The train cars are totally stuck in the 90s – one outlet in our room, no wifi, no interior upgrades.  It’s more fun than it sounds.

Yes, new friends.  Didn’t even know how much they paid for their train ticket, let alone how much they had in assets. 

I know nothing about them, and they want advice.  Welcome to my world.

I contemplated punting and telling them I couldn’t give advice without knowing them, but then I thought, What answer applies to most people?

That answer?

Tax diversification.

More Money for Milk

Most folks who are moving into Phase 3 (otherwise known as retirement) have a big-ticket spending item called “income taxes” – federal and likely state income taxes. 

If these folks have been W2 employees for most of their Phase 2 life (their working years), they often haven’t had their eyes on how much they pay in taxes, even at tax time.  They look at their net take-home pay and create a spending plan from there. 

Nothing wrong with that strategy.  It works when trying to live within one’s means. 

The problem is it does not take into account the full picture of income and expenses, and it’s hard to fix a problem when you don’t know you have one.

When Phase 3 arrives and money is withdrawn from retirement accounts, clients are often shocked at how much is withheld from the withdrawal for taxes.

And taxes are probably the biggest line item in their spending plan.

When clients reduce the size of that spending item, they have more money for other things.  Like milk.  Or travel or gifts or whatever. 

Have Accounts with Differing Tax Treatment

One of the “tricks” of managing taxes is to have accounts with varying tax treatments.

“Earned income” tax treatment taxes income as if you had gone to work and earned it.  The vast majority of retirement accounts (401k, 403b, IRAs) have this treatment.  Most people enter Phase 3 with at least one of these accounts.

“Long-term capital gains” tax treatment taxes only the gain on an asset sold and typically at a lower rate than earned income, especially in low-income years.   The people who can take advantage of these types of accounts usually have a brokerage account filled with stocks and bonds.

“Tax-free” tax treatment is just that:  free of taxes.  There are a variety of ways to get tax-free income, the most common of these being the Roth version of traditional retirement accounts – the Roth IRA, the Roth 401k and the Roth 403b.

Use that Variety of Accounts to Your Advantage

When you have a variety of accounts from which to pull money, you now have the ability to play what I call a “tax margin game.”  This game allows you get the amount of money you need and pay the least in taxes.

This best understood by example.  I’m going to oversimplify to make it easy.  I’m also only going to talk about federal taxes and not state taxes, which can vary widely in tax rates.

Let’s say a couple needs $100K in spending money after they pay taxes.

Option 1:  This couple could withdraw all this money from an IRA.  That’s taxed at an earned-income rate.  Let’s say that rate is 20% on the first $100K and 30% on the next $100K.

They take out $100K and pay $20K in taxes, leaving $80K to spend.

They need $20K more, but at a 30% tax rate, they have to liquidate almost $29K to yield $20K in spending money.

Their total withdrawal?  $129K.

Total tax bill?  $29K.

Option 2:  This couple could withdraw money from an IRA and a brokerage account. 

As in the first example, this couple could withdraw the first $100K from an IRA account.  After paying 20% in taxes, they now have $80K.

Then they could liquidate some stock, where they would only be charged 15% in taxes.  They would only have to liquidate about $24K to get an additional $20K to spend.

Their total withdrawal?  $124K.

Total tax bill?  $24K.

Option 3:  Withdraw money from an IRA and a Roth IRA.

As in the first two options, this couple could withdraw the first $100K from an IRA account.  After paying 20% in taxes, they now have $80K.

Then they could take out $20k from a Roth IRA and pay no taxes to get the additional $20K they need for spending money.

Their total withdrawal?  $120K.

Total tax bill?  $20K.

Option 4:  This couple could withdraw money from an IRA, a brokerage account and a Roth IRA. Let’s say this couple liquidates:

• $80K from an IRA, pays $16K in taxes, gets $64K to spend;
• $20K from a brokerage account, pays $3K in taxes, gets $17K to spend;
• $19K from a Roth IRA, pays $0 in taxes, gets $19K to spend.

Their total withdrawal?  $119K.

Total tax bill?  $19K.

The configurations here are endless and of course other considerations need to be taken into account like required minimum distributions, estate planning considerations, tax-loss harvesting opportunities, any carryforward losses, etc.

Result?  More Flexibility and Options … and Milk

Regardless of other considerations, you can see how having money in a variety of places can improve your financial situation.

Generally, people like to have more money than less to spend. 

Generally, people like to pay less in taxes.

Generally, people want to keep as much money working for them as possible.

If you take some time to allocate assets in a variety of accounts that have differing tax consequences, you can improve your overall financial situation. 

We don’t know what Congress will do about taxes or how it will impact your situation, but if you have a variety of accounts, you are giving yourself the flexibility and options to meet whatever situation might present to you.

If you want to talk about how to tax-diversify your accounts, please reach out.