In the world of finance, simplification is often advised. Whether it be consolidation of accounts or alignment of goals, reducing complexities within a financial plan can help you stay on track and lower the anxieties that so often accompany personal finances. Despite a desire for simplification, there is one aspect of a financial plan where it could pay to complicate things: your savings strategy. Most Americans do an excellent job of saving in two ways - building equity in their home, and contributing to 401(k), 403(b), 457(b), and other retirement accounts. While those saving strategies may work, there are advantages to implementing a strategy that incorporates saving outside your 401(k). Owning a combination of tax-deferred IRAs, tax-free Roth IRAs, and post-tax Brokerage accounts (also referred to as taxable accounts) gives you and your portfolio four distinct benefits.
Tax deferral is great, but unfortunately, it doesn't last forever. Investing your savings heavily into a tax-deferred account typically comes with the belief that income taxes will be lower in retirement. While you’ll often have less income, it's possible tax rates will increase in future years. Paying some of your tax liability now, through Roth and Brokerage savings accounts, can help you avoid placing too large a bet on future tax rates.
Changes to tax laws can be substantial and abrupt. Look at the passing of the CARES Act in 2020. In just over a week, the President signed into law a 300-page bill that impacted a vast majority of Americans. Tax law is always under threat of change. So how does diversification help? The passing of the CARES Act allowed retirees an opportunity to drastically reduce their tax liability, so long as they had non-retirement assets to draw from. In scenarios when tax laws abruptly change, having savings spread across different account types can give you more flexibility to quickly take advantage of these changes.
Not all your savings will go towards your retirement. Home improvement, travel, and starting a business are just a few examples of costly events that you may face before you become eligible for penalty-free withdrawals from retirement accounts when you turn 59.5. Additionally, if you’re exploring the possibilities of an early retirement, early withdrawals from retirement accounts and accessing home equity can be costly. If you’re hoping to retire early or simply access savings, it's important to save in accounts meant to be utilized for more than retirement alone. While brokerage accounts may not offer the same tax-deferral benefits as retirement accounts, they give you the flexibility to make withdrawals well before you reach the golden age of 59.5.
In your retirement years, your income can be manipulated to provide sufficient cash flow while simultaneously taking advantage of low tax brackets. For example, say you were to retire at 60 and plan to live off $120,000 per year. There are a few avenues you could take to withdraw that $120,000. Let’s look at 2 of them.
Option 1: Take $40,000 from your Traditional IRAs and $80,000 from brokerage accounts or Roth IRAs.
Option 2: Take all $120,000 from a Traditional IRA.
It’s important to note that withdrawals from Traditional IRAs are taxed as regular income. Option 1 allows you to pull much less from your traditional IRA keeping you within the 12% tax bracket. Conversely, option 2 requires you to take the full amount from your Traditional IRA. In doing so, you would need to increase your $120,000 withdrawal to nearly $150,000, allowing for $30,000 to be withheld for taxes. This would land you dangerously close to the 32% tax bracket.
This example is an extreme simplification, but it outlines an important benefit of account diversification. Having your savings in accounts with different tax treatments gives you multiple withdrawal options, allowing you to optimize your strategy, rather than being stuck with only one avenue.
While simplification is usually a good thing, when it comes to savings accounts, you could benefit from taking on some added complexity. Tax diversification can help make your portfolio more adaptable and help shield from the unknown. Remember that while retirement may be what you’re working towards, there will always be new goals and obstacles along the way. A tailored financial plan will incorporate diversification where needed and help you set your point on the horizon while allowing you the leeway to adjust and shift to your changing circumstances.
Joe Crowley, CFP® is an Investment Advisor at Exchange Capital Management. The opinions expressed in this article are his own.