Tax diversification in 3 steps

Key Points

  • Research shows that successful investors prioritize tax treatment when planning for the future
  • Understanding three fundamental tax categories for savings is an important step to planning
  • With new tax laws you may want to consider reallocating some investments

Concerned about the impact new legislation could have on your taxes today and in retirement? Rather than worrying, consider shifting your perspective and looking at the changes as an opportunity to revisit your tax strategy.

Successful investors are more likely to prioritize tax treatment when planning their retirement income, according to the Ameriprise Pay Yourself in Retirement study.*

This means looking for opportunities to create a tax-diversified portfolio that helps to maximize the amount of money that stays in your pocket and helps to minimize what you pay to the government.

A key first step is to understand the tax categories involved in retirement planning. With a clearer picture of how these work, you’ll be armed with the foundational information for a conversation with your advisor and tax professional about tax allocation among investments.

What are the tax categories and how do they work?

From an income tax standpoint, there are three categories you can allocate funds to:

You generally pay no tax on any earnings or growth as money grows, but when money is withdrawn, it’s taxed as ordinary income. This category contains traditional IRAs, pension plans, 401(k) plans and annuities. You can invest in tax-deferred vehicles using either pre- or post-tax dollars, but you’ll pay taxes on withdrawals of untaxed amounts taken during retirement.

Tax-free investment vehicles may include Roth IRAs, municipal bonds and municipal bond funds, 529 savings plans or cash-value life insurance policies. Because after-tax dollars are invested in tax-free vehicles, you generally won’t pay taxes on earnings that can be reinvested. You also generally won’t pay taxes on money taken out if certain requirements are met. 529 savings plans, Roth IRAs and cash-value life insurance policies must be done according to certain specifications or they can be taxed. 

Taxable investment vehicles such as bank accounts, brokerage accounts and mutual funds, which are funded with after-tax dollars, are also referred to as non-qualified assets.8 Generally, any earnings generated in these accounts are subject to current taxes. You may also pay taxes when money is withdrawn from these accounts9 by selling assets (for example, taxable capital gains). Advantages of taxable vehicles include preferential tax treatment on long-term capital gains and qualified dividends, and full liquidity with no strings attached.

Why diversify?

While there’s no one-size-fits-all tax planning strategy, stockpiling most of your savings in one category could be problematic.

For instance, if you keep the lion’s share of retirement assets in the tax-deferred bucket, you may be vulnerable to future increases in income tax rates and capital gains tax rates. In contrast, Roth distributions are tax-free in retirement if conditions are met.

By distributing investments among all three categories, you can withdraw money from various accounts in ways that can help reduce your tax burden.

As you approach your peak earning years and begin to gain more clarity about income needs after leaving the workforce, you may want to get even more dialed in with tax planning strategies.

It’s also vital to keep abreast of tax law changes and work with your advisor and tax professional to recalibrate your retirement tax planning strategies accordingly.

No matter what your income tax rate, crafting smart tax strategies today can help provide you with flexibility, control and tax efficiency now and in the future.

We can help

Your financial advisor — working in concert with a tax professional — can help bring the big-picture view of your tax allocation into sharper focus. 

 

The Pay Yourself in Retirement study was created by Ameriprise Financial, Inc. and conducted online by Artemis Strategy Group. 1,350 interviews with U.S. adults were completed November 16-22, 2015. The respondents are between the ages of 55 to 75 and have at least $100,000 in investable assets. The margin of error is +/- 2.7 percent at the 95 percent confidence level. For further information and details about the Pay Yourself in Retirement study, including verification of data that may not be published as part of this report, please contact Ameriprise Financial or go to Ameriprise.com/payyourself.

Withdrawal before age 59 ½ may result in a 10% IRS penalty on taxable earnings.
Special rules apply to appreciated employer securities in qualified retirement plans.
Necessary requirements must be met. Consult with your tax advisor.
Certain tax-exempt income may be subject to the alternative minimum tax, or state or local taxes. Taxable capital gains or losses may be incurred. 
When used for qualified higher education expenses; otherwise, you may have to pay income tax plus a 10% penalty to the extent of earnings. 
Death proceeds generally are not subject to income tax. Loans from a non-Modified Endowment Contract (MEC) policy are not subject to income tax unless the contract lapses or is surrendered. Loans from a MEC policy are subject to income tax to the extent that there is gain in the policy. Partial or full surrenders from a life insurance contract may be subject to income tax to the extent of earnings.
Bank deposits are FDIC insured up to $250,000 per depositor

8 Held in nonqualified brokerage accounts or managed accounts
9 Dividends and long-term capital gains may be taxed at a lower rate. Interest may be taxable even if not received, for example, if from a CD or OID. For certain short-term debt instruments, interest is taxed at maturity.

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