How Tax Diversification Can Increase Your Retirement Savings
We all want to save for retirement but many fail to realize that planning how you are going to spend your retirement savings is almost as important as saving for it. If you're not careful, taking money out of your retirement plan can involve taking a big tax hit. The more you take out in a year the more income tax you pay, especially if that withdrawal bumps you into a higher tax bracket. Because of this, protecting after-tax income should be a primary goal for retirees.
The good news is that you can save thousands of dollars with the right financial advice. Tax diversification, also known as the tax control triangle, is a model you can use to ensure you get the most out of your retirement savings planning.
As shown below, there are three types of retirement savings categories, each having different taxation consequences.
Point 1 - Tax-Free Accounts
At the pinnacle of the triangle is the tax-free category. These are the most ideal. Who doesn't love tax-free money? The idea is that you place money into these accounts and it grows, and it does so tax-free. In the future when withdrawals are needed for living expenses, they are tax free. These accounts are:
- Roth IRA
- Roth 401k
- Health Savings Accounts
- 529 Plans/Educational Savings Accounts
- Cash Value Life Insurance
Point 2 - Tax-Deferred Accounts
The next point on the triangle is tax deferred. These are accounts where you invest money and it grows tax deferred. In other words, you do not pay taxes on the money until you use it. The accounts that fall into this category are:
- Real Estate
Point 3 - Taxable Accounts
The final point of the triangle is present taxable. Meaning, these accounts are taxable every year. Examples of these accounts are:
- Savings Accounts
- Money Na
- Brokerage Account
At some time in the future, you are going to use your net worth for income. It makes sense to protect your money from taxes as much as possible especially during retirement. The tax triangle shows where you are, and what your future income is going to look like later in life. The table below illustrates how tax rates have changed throughout history. Could tax rates go higher in the future? Potentially. Since we can't know for certain, why not create a strategy to have more control of how much and when you pay taxes. By diversifying where you save your money, you may be able to keep more of it.