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  • 4-Minute Article
  • |
  • Mar 15, 2018

Planning Retirement Income Taxes with a Diversified Income Plan

Understanding how different types of income are taxed can help reduce income taxes in retirement.

Diversification is an important part of retirement planning. Choosing the right mix of investments and financial products can be key in providing growth potential, managing risk, and minimizing the impact of taxes during retirement.

Not all retirement income is taxed the same way. Understanding these differences can help you work with a financial professional to ensure a diversified mix of assets that spans these various tax treatments. Here’s a look at how different types of retirement income sources are taxed, along with hypothetical examples illustrating how taking income from different sources might help reduce taxes in retirement.

Assembling a Tax-Diverse Mix of Income Sources

When considering investments and products for a retirement financial plan, some financial professionals use a concept called the “tax control triangle,” which consists of three asset categories that receive different tax treatments:

Tax Control Triangle

Retirement income sources can be diversified across three different tax treatments:

1. Tax-deferred income sources

Includes: Traditional IRAs, 401(k)s, 403(b)s, traditional pension plans, and non-qualifed annuities.1

Benefits: Generally, contributions to qualified plans can help reduce current taxable income. Taxes on the growth of savings in the tax-deferred category of accounts, including non-qualified annuities, are generally deferred until the account holder begins making withdrawals. When withdrawals begin, the account holder must pay ordinary income taxes on the full amount withdrawn.

Considerations: Liquidity is limited. Generally, account holders can’t access their money before age 59½ without paying a 10% penalty. Withdrawals made after age 59½ are taxable at ordinary income tax rates. In the case of IRAs and tax-qualified plans, such as 401(k)s, account holders may need to take required minimum distributions (RMDs) beginning at age 70½ (or upon retirement, in the case of qualified plans). Failing to take RMDs results in a penalty equal to 50% of the required withdrawal amount.

2. Tax-favored income sources

Includes: Roth IRAs and Roth 401(k)s and permanent life insurance policies.2

Benefits: Because these sources are funded with after-tax money, withdrawals are generally tax-free. Withdrawals from the cash value of permanent life insurance are also tax-free, provided the amount doesn’t exceed the original purchase payments.3 Withdrawing contributions from Roth accounts generally is tax-free, and withdrawals of earnings are tax-free if the account owner is at least age 59½ and has owned the account for at least five years. Roth accounts also do not have the same RMD requirements of traditional IRAs, meaning there’s more flexibility in choosing when to begin taking income.

Considerations: Liquidity may be limited. In addition, funds put into these products don’t help reduce current taxable income. Loans from permanent life insurance policies carry interest rates, and loans and withdrawals from these policies will reduce their cash value and death benefit and may cause the policy to lapse, which could result in tax consequences.

3. Taxable sources

Includes: Stocks, corporate bonds, savings accounts, money market, mutual funds, and wages.2

Benefits: Assets are liquid, meaning account holders can access their money at any age. Certain types of withdrawals may be taxed at a lower rate than the individual’s ordinary income tax bracket.

Considerations: Income generated from taxable sources is subject to income tax, either at the individual’s income tax rate or the capital gains tax rate. For example, proceeds from the sale of investments held for at least a year in a brokerage account, such as mutual funds and stocks, as well as qualified dividends from stocks are taxable at the capital gains tax rate of 0%, 15% or 20% (depending on total income level).4 Interest payments from corporate bonds typically are taxable at the bond holder’s ordinary income tax rate. Wages from full- or part-time work are taxed as ordinary income.

The right blend of income sources will depend on each person’s unique circumstances, including total income level and tax deductions/exemptions. To develop a customized plan that accounts for the right mix of income sources, talk to a financial professional.

How Income Diversification Works

Here are two hypothetical examples that illustrate how different tax sources could be managed during retirement.

Scenario 1:

A retired couple, age 70, wants to supplement its Social Security benefits with $100,000 in annual income drawn from their retirement savings.

Option 1
Withdraw $100,000 from a 401(k) plan; the entire amount would be taxable at the couple’s income tax rate:Result: A potentially larger tax bill because all funds are fully taxable at the couple’s income tax rate.

Option 2
Make withdrawals totaling $100,000 from three accounts that have different tax treatments: a 401(k) plan, a brokerage account holding investments purchased with after-tax money, and a Roth IRA that they have owned for more than five years: Result: A potentially smaller overall tax bill, due to different tax treatments.

Scenario 2:

A retiree needs to draw additional income to cover an unexpected expense, such as a large medical bill.

Option 1
Withdraw more money than planned from a 401(k):

Option 2
Make planned 401(k) withdrawal and cover the unexpected bill with a distribution from a permanent life insurance policy:

The Right Income Mix Depends on Individual Circumstances

Working with a financial professional and a tax attorney or specialist can help ensure that a retirement plan includes a mix of assets across the tax control triangle that fits your individual needs. This diversification can help reduce the risk of paying higher taxes than needed in retirement — and help keep more income to support your desired lifestyle.

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