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Tax Diversification In Your Financial Planning

By Aaron Peck and John Norman

There are many areas to consider when building and reviewing a financial plan for retirement. We often hear a lot about stock diversification and diversifying your investment portfolio. One stands out to me as very important but often overlooked... tax diversification is so important when considering where money comes from in retirement.


The simplest way to address this is to break it down into three areas or buckets. The first bucket is taxable and commonly includes vehicles like checking, savings, CDs, retail investments, and money market accounts. These items are usually taxed in the year interest or growth is credited to the investment. The second bucket is tax deferred. This area usually consists of Traditional IRAs, Traditional 401K, pension plans, deferred compensation accounts, and unless you plan on your income being under $44,000 (AGI based on married filing joint) in retirement, Social Security. These first two are the most common I come across and are used often to save for retirement. The third and becoming more prevalent, is a tax-free upon withdrawal bucket including accounts such as ROTH 401K (more common with employers now), cash value life insurance, municipal bonds, and the individual ROTH IRA. Keep an eye on those municipal bonds as they will have a direct effect on Social Security taxation through the MAGI (Modified Adjusted Gross Income).


It is common for Middle America to have a checking, saving, Rollover IRA, and a Tradition 401K. Two taxable and two tax-deferred accounts. This greatly reduces withdrawal options in retirement and increases risk as tax law changes are becoming more common and increasingly less advantageous as time goes on. An example would be needing a lump sum to pay a deductible for a new roof. Pulling extra from a Traditional IRA can have negative effects on Social Security taxation and increase that person’s tax bracket. Having the option to withdraw from a ROTH, retail investment account, or life insurance can help avoid that problem.


We have used many tools in the past but the one I have found most useful is LEAP. This tool puts the individual or couple on a model with 27 financial drawers, allowing an advisor and client to see a snapshot of all their assets in one place. They can easily determine not only asset diversification but also tax diversification. Using a financial model allows a person to test and verify various approaches to distributing assets in retirement. Which assets are most efficient to use first? What if you only have one or two “buckets” vs. all three? What strategy produces the largest net after-tax income? 


By working with an advisor who understands tax diversification as well as the other kinds of diversification, one’s net after-tax income could be improved, the risk of tax law changes could be minimized, and the number of various income streams a person could access in retirement could be increased. In the end, a person could end up with more liquidity, use, and control over their wealth, which would lead to more certainty of outcome.



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