Jacob: Hey, everybody, and welcome back to the Retirement Answers podcast. My name is Jacob Duke. And today, I wanted to talk about a topic of diversification, but not so much in the way that maybe you're expecting. I wanna talk about tax diversification. So most of us, when we hear that word, we often think of our investments.
You know, we don't wanna be invested in only one stock or even just a small group of stocks. We wanna be diversified across the full market so that we don't have any risk of picking the wrong thing. So that applies to, hey. We need to actually invest in international markets as well as US markets. We need to invest in the large cap stocks and the small cap stocks.
So that's diversification from an investment perspective, but I wanted to talk about tax diversification and specifically how it can be a benefit to you in retirement. So what does it mean to be tax diversified? Well, if you can have money in different tax buckets, meaning how that money is taxed, then you can ultimately lower your overall taxable income because you can pull money from sources that are either tax free, tax deferred, or taxable. And so we're gonna walk through exactly what that means and how you can achieve what we call tax verifications. So let's say, for example, Jim has a million dollars of retirement assets in his traditional IRA, and all of that money is tax deferred.
Right? Because any dollar he takes from that, he will pay tax upon that whenever he withdraws. And then Bob also has a million dollars, but 500,000 of that is in the traditional IRA, then 250,000 of that is in his raw, and then 250,000 of that is in his taxable investment or or brokerage account. So who is in a better spot? They both have a million dollars, but I would argue that Bob is in a better spot because he is more tax diversified than Jim.
So by having money in those different places to pull from, Bob will have a lower tax rate throughout his entire retirement than Jim, who will always be distributing taxable income that will be taxed at ordinary, income rates. So by having these different sources of income throughout, your retirement, what you can do is you can say, hey. I wanna pull a little bit of money from my tax deferred account. I wanna pull a little bit of money from my Roth, and then I wanna pull a little bit of money from my taxable investment account. And you can do that in such a way, you know, by doing the math on it and and planning ahead in such a way that you can ultimately either pay no income tax on that, or you can pay minimal income taxes on that compared to if you were pulling money all out of that traditional IRA, which is always gonna be taxed as income.
So how can we achieve this thing called tax diversification? Well, if you're still working, you can start now. Right? If you're still earning an income and you're saving money for retirement, you can build out that tax diversification now while you're still working. So perhaps that might mean, hey.
You're already contributing 10 or 15% to your tax deferred four zero one k account. Well, what if we pulled that back to where you only you're contributing up to your match, and then everything else is gonna be contributing to a Roth account, whether it be your your Roth four zero one k, your Roth IRA, maybe you have to do a backdoor Roth if you're earning above the income limits. But then also, I wanna start building out that taxable or brokerage account by saying, hey. I'm gonna pay the tax now. I get that.
But that gives me benefit in the future because now I'm gonna have another source of income that's gonna be perhaps not taxable or will be taxed at a long term capital gain rate. So you can do that now if you're still working. Now let's say you're already retired, and you're in retirement. You're no longer earning an income from a job or something like that, and you're living off of your assets. What can you do to get more tax diversified for both now, but also in the future?
You can do, Roth conversions. So if you're before age 72 or age 73, depending on when you started or when you how old you are, your, RMDs will start at a different time. But if you are still below 73, your RMDs will not start until that point, which means you have what I call gap years. You have the opportunity to convert money from a tax deferred source, like your IRA, to a tax free source, like your Roth IRA. So, yes, you would be choosing to pay the tax now, but it would be all for the benefit of not having to pay more taxes later.
So when we look at how we can be tax diversified and how to accomplish that, what this is not saying is we're not lowering your taxes right now. We're most likely gonna be increasing your taxes this year and the next year or whatever years we plan to do these different strategies. But we're ultimately doing is lowering your lifetime tax bill, which could be hundreds of thousands of dollars. So if we can lower that lifetime tax bill by a 100,000 or $200,000 of taxes, I think it'd be well worth it to consider that. Right?
So if you're in retirement, what you could do is you could do Roth conversions. If you're not yet taking Social Security and then you're not yet taking your RMDs, you can do those Roth conversions before you get to that RMD age or before you start your Social Security that will ultimately say, hey. I'm gonna pay the tax now, and then I'm going to pay less tax in the future. Now I won't talk about how to do, Roth conversions optimally because that's perhaps a different subject. But as you can probably see, having multiple sources of income throughout your retirement by having what's called tax diversification, having money in the tax free bucket, having money in the tax deferred bucket, and then having money in the taxable bucket, you have different sources to pull from.
You can say, hey, I wanna pull a little bit from the Roth, a little bit from the IRA, and a little bit from my brokerage account, which ultimately lowers your overall tax bill. So whenever someone says, hey, I got a million dollars. I've got $2,000,000, and it's all in a tax deferred account. The reality is they really don't have $2,000,000. They might only have 1 and a half or even less depending on, you know, how much, income and and how much tax they're gonna pay on that.
So the main thing is how can we get as much after tax money as possible, you know, into your overall portfolio by doing that while you're working, saving into Roth, saving into after tax brokerage accounts, or, you know, how can we do that after retirement by saying, hey. How can we do Roth conversions, get money from the tax deferred status to the tax free status, which will ultimately lower your tax bill throughout the rest of your life for both you and then your spouse? Because whenever you can lower the amount that is in your tax deferred account, whenever your RMDs kick around, there's something that I call a widow's tax trap, which basically says whenever you pass away, your wife or your husband is going to have to begin taking those RMDs as a single tax filer as opposed to a married filing jointly tax filer. So what that does is that compresses those tax brackets down, but the issue is not necessarily in the tax brackets. The issue is the fact that if you have a million dollars or $2,000,000 and you're taking RMDs on that amount of money, now you're taking the same dollar amount in terms of the RMD, but you're taking it at a lower, more compressed tax bracket, which is what I call the widow's tax trap.
So, getting as much out of the tax deferred status before your RMD start or before you pass away is gonna be important for your spouse, but then also it's gonna be important for your kids one day or whoever inherits your account because they will have to begin taking those distributions from your tax deferred accounts like a four zero one k or an IRA over a ten year period. And so if you got $2,000,000 sitting there and you've got one child, they're gonna have to take $2,000,000 out of that IRA over the next ten years at around 200,000 a year, which means they're gonna pay upwards of 30 plus percent at the federal level and who knows at the state. So by getting as much out of a tax deferred status into the tax free status allows you to lower your tax bills both now for you and your spouse, but also for your heirs one day after you pass away. So I hope this has been helpful in terms of thinking about, you know, tax diversification and some of the ways that you can do that and why it's perhaps important. I think it just gives you flexibility to have money in three different, you know, tax buckets, tax free, taxable, and tax deferred.
Gives you the options that you want before retirement, but then also gives you options in retirement to lower your tax bill as well. So thank you so much for tuning in to this, episode of the Retirement Answers Show. My name is Jacob Duke, and I look forward to speaking with you again next week.