Tax Diversification: Smart Ways to Preserve Your Nest Egg

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Remember when you first started saving for retirement with a tax-deferred investment plan? Back then, the idea of putting your savings into a traditional IRA, 401(k) or similar retirement plan probably seemed almost too good to be true.

An account that reduces your taxable income upfront while also offering tax-deferred investment growth? Who wouldn’t see the appeal?

Especially if you thought your income tax rate would be lower in retirement — when your kids were grown, your mortgage was paid off and your income needs were reduced.

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Unfortunately, for many people, this just isn’t true. Though studies show that many people do pay a lower tax rate in retirement, the widely held belief that life will be less expensive than when you were working doesn’t apply to everyone.

Reasons for higher taxes in retirement

Today’s retirees want a more active — and, therefore, more costly — lifestyle than past generations. That might include travel, a golf club membership or the purchase of a second home. To meet this living standard, those retirees often need the same or even more income than when they were working.

Today’s retirees also live longer, which can mean higher medical and long-term care costs later in life. And if they’re pulling a major chunk of those funds from a tax-deferred account every year, it may keep them in a much higher tax bracket than they ever expected or planned for. Here’s why:

Every distribution you make from a tax-deferred account is taxed as ordinary income.

Savers sometimes forget that Uncle Sam is a silent partner in their 401(k) or IRA — and he’s been waiting a long time to get his share of that money. Depending on the tax bracket you’re in when you withdraw your funds each year, you could find yourself handing over a sizable portion of your nest egg to the IRS.

Distributions from tax-deferred accounts can trigger other taxes in retirement.

Until it became a topic of interest in the recent presidential campaign, many soon-to-be retirees were unaware that they could pay taxes on a percentage of their Social Security benefits.

Benefits aren’t subject to taxes unless your provisional income (your gross income plus 50% of your Social Security benefits plus any tax-exempt interest you’ve received that tax year) exceeds IRS thresholds.

But a large distribution from a tax-deferred account could easily push your income over those limits, which may have been set decades ago and haven’t been adjusted for inflation.

You also could end up paying the income-related monthly adjusted amount (IRMAA), a surcharge that high-income beneficiaries may be required to pay for Medicare parts B and D. The amount you owe in state taxes could be affected as well.

The IRS won’t allow you to keep the funds in your account indefinitely.

Even if you avoid tapping your tax-deferred accounts early in retirement, the start of required minimum distributions (RMDs) at age 73 can lead to a sudden and unwanted surge in taxable income for diligent savers.

The more you have stashed away in tax-deferred accounts, the more you can expect to pay.

Tax diversification can give you options

There’s a common saying in finance that it’s not how much you make that counts, it’s how much you keep. In other words, when it comes to your investment portfolio, it’s important to balance risk and reward with a diverse mix of stocks, bonds, cash and other assets.

What retirement savers don’t always understand is that the same principle applies to taxes. Using an appropriate mix of fully taxable, tax-advantaged and tax-free accounts could help provide you with strategies that are more tax-efficient than decades of deferral.

By strategically building your savings in, and withdrawing from, these different accounts, you could have more opportunities to help reduce your tax burden. This can help you achieve your retirement goals while also helping allow your retirement savings to last longer.

Where to start

If you’re looking for a good starting point, talk to your financial adviser or tax professional about the benefits of contributing to a Roth IRA. Or, if it’s an option that’s available through your employer, you may also wish to consider a Roth 401(k).

If you earn too much to contribute directly to a Roth, or you’ve already accumulated savings in a 401(k) or traditional IRA, you can ask your adviser about the benefits of converting some or all of that money into a Roth.

Yes, you’ll pay more in taxes upfront when you transfer the money to your Roth IRA or Roth 401(k). But you may rid yourself of the ticking tax time bomb that’s waiting for you in retirement.

If you’ve been carefully tending to and growing your nest egg for years, don’t let taxes eat up more of what you’ve earned than is necessary.

Take steps now to transition to a diversified tax plan that can help you enjoy the retirement lifestyle you’ve worked so hard for.

Kim Franke-Folstad contributed to this article.

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.

Insurance products are offered through the insurance business Financial Services of America (FSA). Financial Services of American (FSA) is also a Financial Services practice that offers securities products and services through AE Financial Services, LLC (AEFS), member FINRA/SIPC. Financial Services of America (FSA) is also an Investment Advisory practice that offers investment advisory products and services through FSA Advisors (FSAA), a Registered Investment Advisor. AEFS and FSAA do not offer insurance products. The insurance products offered by Financial Services of America (FSA) are not subject to regulatory requirements and standards of care applicable to registered representatives and are not subject to investment advisory requirements. AEFS, FSAA and FSA are not affiliated companies. 4692502-3/25

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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As supervisor of the Investment Advisory Division at Michigan-based Financial Services of America, Nick Shaheen helps ensure his firm’s clients receive tailored, high-quality advice to help them reach their financial goals. He is dedicated to helping others achieve a clear and confident retirement, and he takes pride in helping to simplify the planning process.