Retirement Income Tax Diversification Strategies

Let’s say you save X million dollars in your combined retirement savings plans—you’ll be all ready for that retirement in the tropics you’ve been planning most of your life. Maybe you’ll even be able to work in an early retirement too. You’re on a roll and everything is working according to plan. Great!

Or maybe not so great, at least not entirely.

To paraphrase a famous superhero movie, with great wealth comes great taxes, as in income taxes. Once you begin withdrawing money out of your retirement accounts you’ll have to pay them.

And maybe a lot of them.

Tax free VS tax deferred

Tax sheltered retirement plans are one of the very best investment vehicles ever conceived—maybe even the best. People of modest means can accumulate great amounts of wealth, and not the least of which because of the tax deferral status they have.

Not only do your contributions lower your taxable income in the year they’re made, giving you a substantial reduction in current income taxes, but the investment earnings grow without regard to income taxes as well. You can have several decades of pure growth, as in growth not reduced by income tax. That’s a major reason how you’re able to grow a high six figure or even a seven figure portfolio in significantly less than a human lifetime.

But there’s a world of difference between tax free and tax deferred, and tax deferred is what your retirement plans are. If they were tax free, you’d never have to worry about income taxes. Ever. But with tax deferral, you will have to worry about it, and at possibly the worst time it could happen.

A large retirement portfolio will mean large distributions, particularly once you reach age 70 ½ when required minimum distributions (RMD’s) kick in. An annual 4% “safe withdrawal rate” on a $2 million retirement portfolio could result in an income that’s higher than the salary that the portfolio funded with. That will mean higher income taxes than you expect.

The object then should be to prepare for this possibility now while you still have time to adjust your strategy. And if you think your retirement portfolio will be in the million dollar plus range, you really want to consider this.

Roth IRA’s to the rescue

One of the best tax diversification strategies to have in retirement is a Roth IRA. You won’t be able to deduct your contributions in the years when you make them, but once you reach 59 1/2, you can begin withdrawing funds both tax-free and penalty free.

If a substantial portion of your retirement portfolio is held in a Roth IRA, then a substantial amount of your income will be also. That’s tax free income, and just what you’ll need to offset the taxable income you’ll withdraw from other, more traditional retirement plans.

But there’s another benefit to a Roth IRA that pertains to early retirement. If you retire at age 59 1/2, but before you’re eligible for Social Security and/or pension benefits, you’ll be able to withdraw as much money as you need to live on without having to worry about the tax consequences.

A Roth IRA is a must if only from a tax diversification standpoint. Fortunately, the Roth IRA contribution limits are increasing again for 2013, rising from $5,000 in 2012 to $5,500. If you’re 50 or older, you can increase that by $1,000 for the “catch-up provision”. That’s $6,500 total if you’re 50 or older.

If you don’t have one of these plans, get one going as soon as your able. The more money you have in one, the more tax free income you’ll have in retirement.

Using non-tax sheltered plans

Still another way to achieve tax diversification in retirement is by building non-tax sheltered investment accounts. This can include interest bearing investments, like certificates of deposit and treasury bills, or broker accounts and managed funds or exchange traded funds. The money you withdraw from them won’t be subject to tax of any kind, because all taxes are paid during the time the accounts build. They’re funded with after tax dollars, and taxes are paid on the investment income in the year earned.

The one disadvantage to regular accounts is that they don’t grow as fast as tax deferred accounts do because you have to pay the tax on the earnings they accumulate each year. Still they’re good to have in addition to actual retirement plans.

There a bonus benefit to these too. If you retire early, like before 59 ½ you can withdraw the money completely tax free. That can help bridge the gap between early retirement at just about any age, and traditional retirement at 65.

Everyone assumes they’ll be in a lower tax bracket at retirement, but if you’re working to build a very large retirement portfolio, that may not be the case. Add some retirement tax diversification to your portfolio, and do it now while there’s plenty of time.

Have you considered the very real possibility that you may actually be in a higher tax bracket when you retire?