How Retirees Use Tax Diversification to Slash Income Taxes

Tax diversification is a key to minimizing income taxes during the retirement years, especially when it comes to avoiding or reducing the Stealth Taxes directed at retirees.

During the working years, many people use deductions and tax deferral to manage their tax brackets and tax burden.

But during retirement, tax diversification provides a unique ability to manage your tax bracket by planning and controlling distributions. When properly done, many middle-income retirees can use tax diversification to stay in a very low federal income tax bracket for most of retirement. Retirees with higher incomes are able to avoid being pushed into higher tax brackets by tax traps.

Tax diversification is achieved by having parts of your retirement nest egg in the different types of accounts.

There are tax-deferred accounts, which primarily are traditional IRAs and 401(k)s, as well as employer pensions. Annuities also are tax-deferred accounts.

Taxable accounts are the regular investment accounts at brokers, mutual funds, and other financial services firms.

Finally, there are tax-free accounts, which primarily are Roth IRAs and health savings accounts (HSAs). Cash-value accounts of permanent life insurance also can be tax-free accounts.

Once you have money in each of these different types of accounts, your knowledge of the tax law, and especially the tax brackets, allows you to determine what your tax rate will be by managing how money is taken from the different accounts.

A retiree with tax diversification is in a powerful position.

Let’s take a look at the hypothetical case of Max and Rosie Profits.

In 2024, Max and Rosie have income from various sources totaling $120,000. After the standard deduction (including the additional amount for being older than 65), they’ll be in the 12% tax bracket and pay $9,964 in federal income taxes.

Now suppose they need an additional $5,000 of cash. If they take that from a traditional IRA, they’ll owe $600 of additional income taxes.

But they’ll also have to include more Social Security benefits in gross income and pay about $510 of income taxes on that. They’ll owe $1,110 of taxes on the $5,000 distribution. They’ll need to take more than $5,000 from the IRA to have the after-tax money they need, and that will increase taxes more.

The Profits also need to keep in mind that if their income increases $7,150 from the initial level, their capital gains tax bracket will move from 0% to 15%.

Instead of a traditional IRA distribution, they would be better off taking tax-free money from a Roth IRA or HSA.

An alternative is to sell some investments from a taxable account and recognize long-term capital gain at its lower tax rate. Even better, if some of the investments in the taxable account are below their purchase prices, the Profits could sell $5,000 worth and deduct the loss against the year’s capital gains.

By having tax diversification and managing their sources of retirement spending, the Profits can reduce taxes substantially and make their nest egg last longer.

Retirees with lower incomes and spending than the Profits and who have tax diversification find themselves in an enviable position. In many cases, they’ll be able to manage their distributions to stay in the 0% tax bracket or close to it.

Even if your taxable income pushes you into the 10% bracket, remember 10% is the tax rate only on the additional income above the 0% bracket. When you determine the average tax rate on your total income, it will be in the single digits until you move very high in the 10% bracket.

This strategy requires more planning than traditional spending strategies. You need to know the break points for the income and capital gains tax brackets.

At higher incomes, you also need to be aware of the tax brackets for the Stealth Taxes, such as the taxation of Social Security benefits, Medicare premium surtax and 3.8% net investment income tax.

But the savings can be dramatic and worth the work.