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Smart diversification includes account types, not just the assets within

“Death, taxes, and childbirth!  There’s never any convenient time for any of them.”

– Margaret Mitchell, Gone with the Wind

There are so many things we would tell the younger version of ourselves; eat better, exercise more, spend more time with family, and of course, save more.  Over the years, I have encountered many retirees ready to embark on their journey to financial freedom, beginning distributions from their portfolio, which consists entirely of 401(k) and IRA dollars.  The newly retired have done a great job of funding their 401(k) plans over the years, which can lead to a nice nest egg as they cross the finish line.  Assuming a thirty-year-old saved $1,000 per month at 7% over a thirty-year career, they would have $1.2 million at retirement!  Monthly distributions from their IRA begin (the new paycheck), and every dollar that leaves the account is taxable at ordinary income tax rates.  Consequently, if this newly retired couple needs $100,000 per year deposited into their bank account for living expenses, they might need to distribute as much as $150,000 from the IRA so that the IRS and state can receive their share, depending upon where they live.  Ouch!  Wouldn’t it be nice to have more control over taxes in retirement?  Younger self: save more to different types of accounts with different tax treatment as you contribute and, more importantly, as you distribute in retirement.

Essentially, there are three types of accounts that you can save to: taxable, tax-deferred, and tax-free (Roth).

Taxable

When saving and investing, you might consider opening a taxable account in either your individual name, in the name of your trust, or jointly with a spouse.  This type of account is funded with after-tax dollars, often from the proceeds from a sale of a business or rental property, a bonus, or simply through monthly contributions.  Each year, the realized gains or losses as well as any income from the account are reported on an IRS Form 1099.  Unlike qualified retirement plans, the taxable account has no penalty for withdrawals prior to age 59 ½; therefore, this type of account can be useful when saving for other, non-retirement goals.  A taxable account can also be quite beneficial in retirement since gains on the sale of any shares are taxed at long-term capital gains rates, which are currently much lower than ordinary income tax rates.   In addition, this account can be extremely tax-efficient by allowing the losses on any investments to be harvested for tax purposes, as these tax losses offset gains in the future, creating a nice bucket to distribute from in retirement.

Tax-deferred –

Tax Savings Today

Probably the most commonly used account for retirement savings is a 401(k) plan, which is often rolled over to an IRA at retirement for investment flexibility.  Contributions to the plan are made through payroll deductions, which reduces your taxable income today, and the growth on the contributions is tax-free.  Sometimes, there is even a company match (free money!)  Tax-deferred growth and free money are incredible components to wealth accumulation; however, as mentioned previously, every dollar that is distributed is taxed as ordinary income.  In addition, once you are 70 ½ there are required mandatory distributions, even if you don’t need the funds!  Wouldn’t it be nice to supplement this account with the aforementioned taxable account, as well as the “holy grail” of retirement accounts: the Roth?

The Roth –

Tax Savings in Retirement

A Roth IRA is an individual retirement plan that bears many similarities to a traditional IRA. The biggest distinction between the two is how they’re taxed.  Contributions to a Roth IRA do not reduce your taxable income, but they still grow tax-free, and distributions are tax-free.  Tax-free growth and distributions in retirement sound fantastic; so, how do you get dollars into this type of account?  There are essentially five ways:

  1. Roth IRA Contribution

If your income meets certain thresholds, you