Taxes & Retirement – Give Yourself Some Flexibility

By Scott Thoma February 15, 2017

Taxes are a fact of life – and they don’t retire when you do. With today’s unpredictable tax codes, how can you better prepare for your income needs in retirement? Investment Strategist Scott Thoma explains how tax diversification works.

What is tax diversification?

You simply invest in accounts that are taxed differently. A good example is how taxes are handled with traditional and Roth Individual Retirement Accounts.

When you contribute to a traditional IRA, you may be eligible for a pretax deduction, and you delay paying taxes on that money until you withdraw it in retirement. With a Roth IRA, there is no current tax deduction on your contribution, but you can generally withdraw funds tax free in retirement, provided you meet certain criteria.

One consideration is what you expect your tax rate to be in retirement:

  • If you expect it to be higher, you may want to contribute more to a Roth IRA now.
  • If you expect it to be lower, you may want to contribute more to a traditional IRA now.

Importantly, contributing to either type of IRA doesn’t have to be an “either/or” decision – if you’re eligible, you can own and potentially contribute to both Roth and traditional retirement accounts. Talk with your tax professional and financial advisor before deciding whether to invest in a traditional or a Roth IRA.

What if you’re already retired or close to it?

The amount you withdraw from your investments may be the most influential factor in how long your money will last – but you should also pay attention to the order in which you withdraw this money. By using tax diversification, you can structure your withdrawals to potentially reduce taxes and increase your amount of after-tax spendable income.

As a general rule, we suggest the following order:

  1. Required minimum distributions
  2. Dividends and interest from taxable accounts
  3. Taxable accounts themselves – especially those that may have experienced losses
  4. Tax-deferred accounts, such as a traditional IRA
  5. Tax-free accounts, such as a Roth IRA

Keep in mind that this sequence is just a guide. The account you withdraw from may vary from year to year depending on your tax situation. For example, you may decide to withdraw from a Roth account earlier if this would prevent you from moving into a higher tax bracket. And it’s always important to ensure you maintain proper balance between your stocks and bonds. Therefore, we recommend discussing this with your financial advisor and tax professional.

Important information:

Investors should understand the risks involved of owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal. Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

Edward Jones, its employees and financial advisors cannot provide tax or legal advice. You should consult your attorney or qualified tax advisor regarding your situation.

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