The benefits of practicing tax diversification with your savings
Most investors practice investment diversification, but far fewer practice tax diversification with their savings. The lack of tax planning, especially for retirement, can result in tax inflexibility at best and at worst, a ticking time bomb.
Most save for retirement in pretax 401(k) accounts, and make no mistake — the traditional 401(k)s should be the first and primary retirement vehicle for almost everyone. The logic is simple: Your income is likely higher during your working years than your retirement years; reduce taxes now and pay them later.
Yet savers should prepare for higher future tax rates. The Treasury Department announced U.S. debt hit a record $34 trillion at the end of 2023, nearly doubling in 10 years. Servicing that debt will likely include higher taxes.
Even if your tax rate will be lower in retirement, diversifying your tax savings strategy has advantages. If your investments consist entirely of traditional 401(k)s/IRAs, those large, one-time withdrawals added to your normal living expenses will increase your taxable income, possibly launch you into a higher bracket and might even increase your Medicare costs.
Roth IRAs are a great tax diversifier. Contributions do not lower your taxable income like traditional 401(k)s and IRAs, but withdrawals in retirement (post-59 ½) are tax-free. The Roth (and traditional IRA) annual contribution limit increased in 2024 to $7,000, $8,000 for those 50 or older. Roth IRAs are such a good deal, though, that the government excludes high-income earners from saving into them. Yet the IRS did raise the income thresholds in 2024. Individuals with modified adjusted gross income of $161,000 or less in 2024 can contribute. If you are married filing jointly, the income threshold is now $240,000.
But anyone, regardless of how much they make, can contribute to Roth 401(k)s. The 401(k) annual savings limit also rose in 2024 to $23,000. If you’re 50 or older, your limit is $30,500.
Investors who are worried about future taxes may also consider Roth conversions. This is the practice of converting pretax IRA dollars to Roth IRAs. The conversion amount counts as income in the year the conversion occurred. The strategy is particularly attractive to those currently in a low tax bracket but see a high tax bracket in their future, whether through increased wages, a sale of a business, an inheritance or decades of large pretax savings.
Another wonderful option is a health savings account (HSA). HSAs, only available to those on a high-deductible health plan, are the crown jewel of tax-advantaged vehicles: Contributions lower taxable income, growth is tax-deferred and withdrawals for medical expenses are tax-free. If you have the means, use other savings for current health expenses and allow the HSA to grow for retirement health expenses, including Medicare premiums.
Investors with the means should also consider nonretirement stock investments. For many, the capital gains tax rate applied to them might be lower than their retirement income taxes. Be smart, though, about investing in low turnover investments, and place your high dividend paying investments inside your tax-deferred accounts.
The bottom line is saving for retirement — in any way — is the most important, yet those with the means to diversify their savings strategy have the flexibility to help create their tax bracket in retirement.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Authors
Ben Marks & Matt Arnold
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