Tax Diversification in Retirement Planning

    Financial planners have always stressed the importance of diversification among asset classes, but how many are preaching tax diversification? With taxation becoming the issue of the hour from the halls of Capitol Hill to Main Street America, tax diversification may be as important as asset allocation.

    Three Taxes to Avoid with Tax Diversification

    There are three different taxes estate planners seek to avoid. The first is income tax, the second is capital gains tax, and the third, for wealthy individuals, is the estate tax. Combined, these three taxes can put a dent in your retirement savings, and in many cases, completely wipe out the last decade of growth.

    Avoiding these taxes, however, is far easier said than done. Take, for example, the capital gains tax, which has risen from 25% to 39.875% from 1954 to the mid-1970s before falling down to 15% during the last decade. Income taxes, on the other hand, not only shift due to political changes, but also to changes in income and tax brackets. Finally, the estate tax has been the most volatile, with the upper bound of the estate tax peaking at nearly 80% in the 1940s and 1950s before falling throughout much of the last half century to 35% of a total estate.

    Are death and taxes the only certain things in life? Alas, there are no certain tax rates or tax burdens, nor is it easy to plan today for the tax structure of the future.

    A 40-year old planning to retire within the next 25 years will have to plan for policy shifts from at least three more presidents, as many as four senators, and at least 12 House election cycles. With so much volatility, tax diversification starts to look like a safe bet.

    The goal of tax diversification is not to base your entire portfolio around the current tax structure, but to spread out the risk of a portfolio amongst many different policy and tax code changes. With proper tax diversification, your portfolio will be worth roughly the same, regardless of a policy change. This will allow you the security and safety of knowing that you will have enough to retire, regardless of what happens in Washington DC.

    A Reversal of Tax Trends

    Most financial planners now agree that while the top brackets for income, capital gains and the estate taxes may have been on a general decline for more than 50 years, overall tax burdens will be going up in the future, not down. Much of this thinking centers around social programs like Social Security and Medicare, which were underfunded for much of their existence (as tax rates fell) and will now have to derive more revenues in the future.

    From an investor’s perspective, this should be seen as lost money, as any net increase in taxes will not be offset by increases in Social Security. In fact, with talk of austerity quickly growing around the world, some are expecting income taxes for those making more than six figures to rise another 6.2% per year in the United States to help pay off the great burden of Social Security, Medicare, and Medicaid. Alongside that adjustment, some expect, will be a “means test,” where only the very poor and underfunded will qualify for Social Security.

    What does that mean for you? Well, without tax diversification, it means higher taxes and less retirement income from no Social Security payments.

    Retirement Accounts and Tax Diversification

    There are two different types of savings vehicles: pre-tax and post-tax retirement accounts. A pre-tax retirement account would be a classic 401k or IRA, while a post-tax account is a Roth IRA or Roth 401k. Both of these accounts have certain tax benefits, which aid in the tax diversification process.

    If one were to contribute equally to a Roth 401k or Roth IRA and a regular 401k or IRA, they would maintain perfect tax diversification at the surface. Since a Roth IRA is paid with post-tax dollars, the eventual payouts would be untaxed. On the other hand, a regular IRA or 401k would be funded with pre-tax dollars, with the taxes due upon withdrawal. The important thing to realize, however, is that the tax diversification is only at the surface, as a very important part of tax planning has been ignored: the tax bracket.

    If you're like most, you expect that your days in retirement will be less expensive than your days as a working person. Generally, planners assume a reduction in spending of anywhere from 25-40% per year, most of which comes as a result of losing a mortgage payment as your home is paid off. On the low end of a 25% reduction in costs, few changes need be made to your standard of living. On the high end, you'll probably have to skip out on a few nights on the town.

    Either way, any reduction in income at retirement is a boon, since you'll likely fill a much smaller tax bracket. In 2010, a family earning $200,000 per year as a head of household would pay some $60,000 in income taxes. That same family drawing only $120,000 on a retirement account, or a full-blown retirement plan, would pay just $32,000 per year in taxes. As income falls, so does the tax burden, especially since pre-tax plans like a traditional 401k are not FICA exempt during the building phase.

    Thus, to maintain proper tax diversification requires that investors not only balance between pre- and post-tax retirement accounts, but that these accounts are weighted proportionally to their future tax burden. This requires an adjustment for FICA, which for people earning under $109,000 per year, makes up a very sizable chunk of total tax burdens.

    There is no perfect tax diversification, just as there are no perfect investments; however, with proper planning and arithmetic, you should be able to face any major policy change coming toward your portfolio. Of course, the ultimate safety net is always the one least followed: save more than you think you'll need.
    Tim Ord
    Ord Oracle

    Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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