Tax Diversification for Retirement Accounts

Avoid tax surprises in retirement by putting savings into several "buckets," including a 401(k) and home equity. But know your life goals first

I recently asked a dozen financial planners to name the principal tax issues that can affect one's retirement finances.

Some planners responded with specific tips that might not apply to all taxpayers, such as setting up some type of corporation for a part-time retirement business, or a spousal IRA for your non-working spouse.

But almost all planners put the most emphasis on two basic messages. First, keep in mind that tax laws can change at any time—the continuing debate over when and whether to extend the Bush tax cuts is a case in point. Second, as financial planner Gayle Buff of Newton Highlands, Mass., says, your best bet for protecting your savings from tax law changes over the decades is "hedging; using a variety of retirement savings vehicles" that are subject to different tax rates.

Maximizing Retirement Income

When you're younger and retirement is many years away, it's easy to just let all your contributions accumulate in a 401(k) or other tax-deferred retirement account, and benefit from the tax break while you have a good income. But if you use this strategy your whole working life it could result in lower retirement income than if you'd diversified into different types of accounts. That's because, at least under current law, when you're ready to start using the money to pay your retirement expenses, withdrawals from these tax-deferred accounts will incur ordinary income tax, which for most BusinessWeek readers will be higher than paying capital gains tax.

In 2008, if you are an individual taxpayer and your taxable retirement income is $78,850 or more, the marginal tax rate will be 25%. If your taxable income is higher, all those thousands or millions you've nurtured and accumulated with wise investment decisions over the years, in effect, could be subject to that rate or as much as 35%. (To see the 2008 income tax rate tables click here.)

In contrast, if you claimed the same amount of long-term capital gains from a taxable investment account with exactly the same funds or stocks, held for at least a year and a day, under current law in most cases you would only pay capital gains tax of 15%. (For details on capital gains taxes click here.

Diversify: Roth to Mortgage

One easy way to avoid this "tax trap," as Bradley Bofford, a financial planner in Fairfield, N.J., calls it, is to put as much money as possible into a Roth 401(k). But not only would this violate the principle of tax diversification of your investments, it would also hike your tax bills, something you probably don't want to risk while you're already paying taxes on a full-time salary. Instead, Bofford suggests the following to divvy up savings as you work toward retirement: Make 401(k) contributions up to the level of the employer match and, if you meet the income requirements (modified adjusted gross income of $159,000 for joint filers; $101,000 for individual taxpayers), put the rest into a Roth IRA, so there will be no income tax on withdrawals during your golden years.

Susan Elser, a planner in Indianapolis, suggests further diversifying your pre-retirement assets into as many as five "buckets": A 401(k)-type tax-deferred plan, a Roth IRA, a personal investment account, liquid cash reserves, and home equity. In the home-equity bucket, Elser says, for many people, not having to worry about paying a mortgage is worth losing their mortgage interest deduction. The catch here is that the value of the deduction depends on how much you owe on your mortgage and the type of loan you have. Retirees who have had their house for many years may be paying off mostly principal, and only a small amount of tax-deductible interest.

Retirees who have a substantial income, who could profit from offsetting deductions, could benefit most from keeping a mortgage. This could apply, for example, if you're buying a new home for your retirement. Shawn Sandoval, a financial planner in Irvine, Calif., suggests another way to get around the problem of having mostly principal to pay off: have an interest-only mortgage. If this idea tempts you, keep in mind that interest-only mortgages come with risks—you will not be building any home equity and at some point, the bill for the principal will come due.

Vision Quest

Successful retirement planning, of course, requires developing a vision of the retirement lifestyle you want, coming up with a multifaceted plan, and then taking specific steps to implement it.

So before you allow yourself to get too embroiled in the fine points of the tax code, you should also follow the advice of financial planner F. Dennis De Stefano of Maui, Hawaii, who reminds us that "tax reduction is a means to an end, your life goals, not an end in itself."

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