How to Manage Investment Volatility and Maximize Your Retirement Income with a Diversified Tax Strategy
Managing the ups and downs of your investments is a fundamental principle of smart investing. But beyond just spreading out your assets to reduce risk, have you considered how your retirement income might be impacted by taxes? The way you allocate your investments across different types of accounts can play a crucial role in how much you get to keep once you start relying on your savings in retirement.
Let me walk you through how a diversified tax strategy can not only protect your income but also help you enjoy the retirement lifestyle you’ve worked so hard for.
Balancing Risk and Return for a Comfortable Retirement
Creating a portfolio that balances risk and return is key to ensuring that your retirement income is not only sustainable but also lets you sleep soundly at night. The goal is to craft a mix of investments that provides you with the returns you need without exposing you to unnecessary risk. But managing a portfolio isn’t a one-time task. It requires regular monitoring and adjustments to keep it aligned with market changes and your evolving needs. Review our last post that has a checklist about considerations when reviewing your investment allocation here: What Should I Consider When Reviewing My Investments? (brookswealthmanagement.com)
One thing often overlooked in this process is the impact of taxes on your withdrawals. You might have carefully chosen your investments, but if you’re not strategic about how and when you withdraw funds, taxes could take a big bite out of your returns.
The Building Blocks of a Tax Diversification Plan
As you save for retirement, you generally have three main types of accounts to contribute to: tax-deferred accounts, taxable accounts, and tax-free accounts. Each of these accounts has unique tax advantages, and by strategically dividing your investments among them, you can maximize your benefits both while working and in retirement.
- Tax-Deferred Accounts – These include traditional 401(k), 403(b), and IRA accounts. Contributions are made with pre-tax dollars, which lowers your taxable income in the year you contribute. The money grows tax-deferred, but you’ll pay ordinary income tax on both contributions and earnings when you withdraw them in retirement. If you expect to be in a lower tax bracket during retirement, this can be a beneficial strategy.
- Taxable Accounts – These are brokerage accounts funded with after-tax dollars. The big advantage here is flexibility. You’ve already paid taxes on the funds before investing, so when you withdraw, you’re only taxed on the gains, which are taxed at either short-term or long-term capital gains rates. This gives you more control over when and how much tax you pay.
- Tax-Free Accounts – Roth IRAs and Roth 401(k)s fall into this category. You contribute after-tax dollars, but the money grows tax-free, and withdrawals in retirement are also tax-free. This can be a powerful tool, especially if you expect to be in a higher tax bracket later in life.
By incorporating all three types of accounts into your retirement strategy, you can create a diversified tax plan that helps you manage your tax liability in retirement.
Creating a Dynamic Retirement Income Plan
Imagine you’re in retirement and want to withdraw $150,000 from your investments. If your tax rate is 25%, how you structure these withdrawals can make a big difference.
Option 1: All from a Tax-Deferred 401(k)
- After-tax income: $112,500 (25% tax on $150,000).
Option 2: Spread Across All Three Account Types
- Withdraw $75,000 from your tax-deferred account, resulting in $56,250 after taxes.
- Take $50,000 from your taxable account, where you pay a 15% capital gains tax, leaving you with $42,500.
- Withdraw $25,000 from your tax-free Roth account, with no taxes due.
In this scenario, your total after-tax income would be $123,750—a significant increase of $11,250 compared to the first option.
This is a simplified income plan and everyone’s personal situation needs to be carefully considered before implementing a strategy.
Additional Tax Planning Benefits
Diversifying your accounts doesn’t just reduce taxes on withdrawals. It can also open up other tax-saving opportunities. For example, you could use tax-loss harvesting in your taxable account to offset capital gains. Additionally, the types of assets you place in each account can further minimize your tax burden—such as holding municipal bonds in a taxable account or placing taxable bonds in a tax-deferred account.
The Bottom Line
Creating a diversified tax strategy, paired with a thoughtfully allocated investment plan, can make a substantial difference in your retirement income. By being proactive and strategic, you can protect your savings from unnecessary taxes and focus on enjoying the retirement lifestyle you’ve always envisioned.
As you approach or enjoy retirement, consider reaching out for a personalized strategy that aligns with your goals. At Brooks Wealth Management, I’m here to help you navigate the complexities of investment management and tax planning to ensure you’re set up for success.
Disclaimer:
The information provided in this financial planning post is intended for general informational purposes only and should not be construed as personalized financial, investment, tax, or legal advice.
Financial planning is a complex and highly individualized process that takes into account your unique financial situation, goals, and risk tolerance. While this post aims to provide useful insights and guidance, it is not a substitute for professional advice tailored to your specific circumstances. We strongly recommend that you consult with a qualified financial advisor, tax professional, or legal expert before making any financial decisions or implementing any financial strategies. Any decisions made based on the information in this post are solely at your own risk.