Taxes are the largest single expense for retirees. You can lose anywhere from 0% to 50% of your retirement assets to taxes. This post explains how to pay lower taxes in retirement.
What is tax diversification
There are multiple different types of accounts that emergency physicians can use to save for retirement. Each account is taxed in a certain way and can fall into one of three categories: Pre-tax, Roth, or Taxable. Tax diversification is the process of filling each of these three buckets.
How can tax diversification lower your taxes in retirement
With taxes having such a large impact on one’s ability to meet their goals in retirement, it’s important to develop a strategy that keeps your taxes manageable. While it is important to keep your taxes low in any given single year, many people fail to take a step back and ensure they have a long term strategy to minimize taxes over their lifetime. Below are three examples of how tax diversification can lower your taxes in retirement.
Managing your tax bracket
If all your assets are in pre-tax retirement accounts, every dollar you withdraw will be taxed as ordinary income. If, however, you also have money in Roth or taxable accounts, you can draw on your assets much more tax-efficiently. For example, withdraw from pre-tax retirement accounts only to the top of a low tax bracket each year (say, 12% or 22%). Then withdraw from Roth or taxable accounts that are taxed more favorably to pay the rest of your living expenses.
Protecting against surprises
From unexpected medical expenses, to a new car, at some point we all have larger one time expenses that we may not have planned for. These unexpected larger withdrawals can cause a lot of additional tax if they’re taken from pre-tax accounts. Having Roth and taxable accounts gives you the flexibility to withdraw from those accounts and take less of a tax hit on your withdrawal.
Flexibility to retire early
Most retirement accounts have a 10% penalty for withdrawals prior to age 59 1/2. 401(k)s and 403(b)s allow for withdrawals as soon as age 55, if you leave your job during or after the year you turn 55. To avoid the 10% penalty for early withdrawals, you need to fund your living expenses in early retirement from a taxable account. There are no penalties for withdrawals from a taxable account at any age. You’ll be subject capital gains taxes on any sales.
How to build tax diversification
Now that we’ve discussed the importance of tax diversification and how it can lower your taxes in retirement, it’s time we talk about how to build it.
Contribute to a taxable account
One of the easiest ways to build tax diversification is to contribute regularly to a taxable account. Even small amounts contributed to a taxable account each month can compound and build to a large taxable bucket when you retire.
Backdoor Roth IRAs
Roth IRAs are a great account to save in for retirement. The maximum contribution to a Roth IRA for 2021 is $6,000 ($7,000 if age 50+). The challenge faced by emergency physicians is that direct contributions to a Roth IRA are not allowed for high income earners (2021 phaseout starts at $198k of AGI). The Backdoor Roth IRA is the process of contributing to a Traditional IRA (which have no income limits on contributions) and then converting the money from the Traditional IRA to a Roth IRA. This allows you to get money into a Roth IRA even if you are above the income limits. A financial advisor can do this for you. If you’re not working with a financial advisor, use this guide to help you through making a Backdoor Roth IRA contribution.
Roth contributions to 401(k) or 403(b)
Most 401(k)s and 403(b)s have a Roth option. Consider making part of your 401(k) or 403(b) contribution Roth. This should be balanced with the benefit of getting a current income tax deduction for pre-tax contributions. If you’re in private practice and can make a full $58,000 (2021) contribution to your 401(k) because of profit sharing, you should lean toward Roth with the employee deferral potion of your contribution. You should also lean towards Roth in your 401(k) if you can make large pre-tax contributions to a Cash Balance Plan.
Roth conversions
A Roth conversion is when you move money from a pre-tax account to a Roth account. This is usually done in IRAs, but can be done with 401(k)s or 403(b)s if the plan allows it. You need to pay ordinary income tax on the money you convert from pre-tax to Roth. You taxable income may spike when you hit age 72 and have to begin required minimum distributions (RMDs) from pre-tax retirement accounts. Evaluate converting money from pre-tax to Roth between retirement and age 72.
Conclusion
Tax diversification is the process of saving for retirement by filling all three tax buckets: Traditional, Roth, and Taxable. The benefits of tax diversification include lowering the amount of taxes you pay in retirement, protecting against surprise expenses, and having the flexibility to retire early. Build tax diversification by contribution to taxable accounts and making Backdoor Roth IRA contributions. You should also consider making Roth contributions to your 401(k) or 403(b), and evaluate Roth conversions between retirement and age 72.
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