Our Thoughts

Beware of Policy Changes: One Way to Holistically be Prepared is Tax Diversification!

By: Kati Krause

When discussing investments you often hear that diversification is key. It’s important to have a portfolio that owns stocks, bonds, and even a little real estate. There are other types of diversification too!

Vehicles you own these investments in is also important, and can have a large impact on your tax bill both before and during retirement. It also has the potential to affect the tax bill of your heirs. Here’s the skinny on tax diversification:

Taxable Accounts

i.e. Brokerage accounts, checking & savings accounts
  • Funded with after tax dollars, you receive tax preferential treatment on the growth (capital gains rates), but don’t owe any tax on the withdrawals like tax-deferred accounts (see below).
  • Build this bucket up, so that you have money to spend prior to age 59 ½. This bucket is also helpful to have when you have more intermediate terms goals of want to softly earmark dollars towards a potential achievement.

Tax-Deferred Accounts

i.e. Traditional IRAs, 401(k)s, etc.
  • Funded with pretax dollars, grow tax free, you pay taxes on the withdrawals.
  • If you take a distribution prior to age 59 ½, you’re hit with a 10% penalty unless you meet certain criteria.
  • By building up this bucket, you’ve hopefully lowered your taxable income during your working years and can withdrawal this money when you’re potentially at a lower tax bracket in retirement.
  • Thanks to the Secure Act, RMDs are required at age 72 rather than age 70 ½.

Tax Free Accounts

i.e. Roth IRAs, Roth 401(k)s, Health Savings Accounts
  • Funding with after tax dollars, grow tax free, you do not pay taxes on withdraws.
  • Build up this bucket early in your career when earnings are low, or now in periods of lower tax rates, allows you to pay lower taxes now and gives you tax free dollars to use during retirement.

Since none of us have a crystal ball or full control over public policy, tax diversification gives you options and flexibility when it comes to your financial future. Here’s a primer on how two recent changes in public policy drastically affect your retirement and potential legacy plans.

Cares Act (Read full blog here)

  • 2020 RMDs waived for IRA, 401k, 403b and other defined contribution plan owners
  • Retirees that delayed their 2019 RMD to the April 1, 2020 deadline now no longer have to take either 2019 or 2020 RMDs.
    • Only waives 2019 RMDs of individuals who turned 70 ½ in 2019 if they did not take their RMD. IF they took the 2019 RMD, it’s still treated as such and is not eligible to be rolled over to another retirement account.
    • If the once-per-year rollover rule is a problem, another option is to make a Roth IRA Conversion. These are not subject to the once-per-year rollover rule. The distribution is taxable (but you were going to pay the taxes anyway!) and now the future growth on this amount is tax-free.

SECURE Act (Read full blog here)

  • Eliminates the ‘stretch’ provision for most non-spouse designated beneficiaries. Beneficiaries now have to distribute funds from their inherited account(s) within 10 years after the year of the owner’s death. Prior to this act, beneficiaries could utilize the “stretch” provision, which let them spread distributions out based on their own lifetimes.
  • SECURE Act split beneficiaries into 3 categories, Eligible Designated Beneficiaries, Non-Eligible Designated Beneficiaries and Non-Designated Beneficiaries
    • Eligible Designated Beneficiaries: keep the stretch.
      • Minor children* applicable until they reach age of majority
      • Disabled persons
      • Chronically ill
      • Not more than 10 years younger
      • Spouses
      • Certain trusts
    • Designated Beneficiary: lose the stretch and have to deplete account in 10 years
      • Non-Spouses
      • Certain Trusts
    • Non-Designated Beneficiary: lose the stretch and have to deplete account in 10 years
      • Charities
      • Your Estate
      • Certain Trusts

There are strategies to consider that will further address your financial future besides tax diversification especially in light of public policy changes. Contact us today to see how our advisors can help you prepare for the future.