At a recent NAPFA conference in Las Vegas, a couple key note speakers said that good financial planning was a key element in retirees having a secure retirement. Obviously they may have been just trying to make all of us advisors feel good about ourselves, but they had some pretty compelling information to support the claim. One of the factors that benefited retirees that used comprehensive financial planners was tax savings. With tax loss harvesting, advanced tax deferral, and other tax strategies, financial planners were able to add value to their clients’ retirement and account values. But many of these strategies aren’t possible unless you are tax diversified.
Tax diversified means that you have money saved in different types of accounts. For example, money in a joint account is taxed at capital gains tax and dividends are taxed at ordinary income. Money invested in a 401k and Traditional IRA account are taxed as ordinary income, while money invested in a Roth IRA isn’t taxed at all.
One of the biggest mistakes I see investors make is putting all their investments in their 401k or 403b because they save money on income taxes now. They don’t have any money outside this account to fall back on in the event of an emergency. When their car breaks down and they have to buy a new one, they have to get a loan. When they have an emergency, they use credit cards. Setting up an automatic monthly investment into a taxable account at a discount brokerage firm like Schwab or TD Ameritrade is easy to do, and important to diversify your tax situation. If you have losses carried over from down markets like 2008, you can use these losses to withdraw money with no capital gains tax due.
For example, I had one client that had losses of over $200,000 in his taxable account. That sounds bad, but it was only abut 28%, similar to what many others lost in 2008. If he needed $40,000 for retirement income one year, he could withdraw it from his taxable account and not have to pay any capital gains tax. This would let his IRA grow.
If you own a Roth IRA, you could even use a different investing strategy. You might consider putting the small cap portion of all your accounts into the Roth, because historically small cap has outperformed other asset classes. This would allow the portion of your investments that should grow the most, get the most tax benefit. Obviously historical performance is not indicative of future performance, and there are no guarantees when investing in the stock market. But this is the sort of planning that one could benefit from if one were tax diversified.
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