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Diversify the Tax Impact of Your Retirement Income

Jessica Lanning

There’s an industry rag I read weekly called Investment News.  Recently the “Retirement Watch” column reminded planners not to overlook tax efficiency in retirement income planning.  My first reaction:  “Ah, a man after my own heart.”  My second reaction:  “Ohmigod, planners have to be reminded about this?!”

Choose a planner that put his/her attention on tax planning

Remember my beliefs.  The first one is that retirement savings and planning depends on you, you, and you (as opposed to the government, your employer, and you).  The second one is that you’ve got to keep your eye on market volatility, inflation/deflation (even if only medical expenses inflation), and TAXES.  Taxes could potentially be your biggest expense in retirement.  If you’re not diversifying your investments to provide tax-free income in retirement, you’re missing out on an opportunity to save on that expense and therefore have more money to spend in retirement.

Here are the Cliff Notes (remember Cliff Notes?):

  1. As investors accumulate retirement assets, they should put money in three buckets: one that’s tax-deferred, one that is tax-free, and one that is taxable for savings and investments outside tax-advantaged accounts.
  2. Investors often can stretch their retirement dollars further if they have the flexibility to manage distributions in a tax-efficient way.  This is a process that must begin in the accumulation phase.
  3. Directing money to tax-free accounts can be the most challenging and needs to start early.
  4. In the example given, because the couple was able to draw money from a variety of sources, the couple had $120K in retirement income and was able to keep an effective 7.7% tax rate and also realized these potential benefits: they will qualify for lower Medicare Part B premiums, potentially qualify for the lower capital gains tax, and improve their ability to deduct health insurance and/or long-term care premiums.
  5. If cash is king, flexibility is queen:  A tax-diversified retirement portfolio gives investors more flexibility to deal with unknowns like changing tax rates and the potential means testing for Social Security and Medicare benefits. 

See, I’m not the only one who says these things.