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Tax Planning for Retirement

Like the weather, the financial future is often difficult to predict. That’s one reason it’s so valuable to diversify your portfolio. By holding a mix of assets, you’re better positioned to ride out a rough patch for any one investment.

But diversification isn’t just for your investment portfolio. It’s also possible to diversify your tax exposure. In fact, diversifying both how and when you pay taxes on your savings can help you successfully navigate two unknowns in retirement:

1. How much taxable income will you have? You need to consider not just your retirement savings but also Social Security, pensions, nonretirement investments and other potential sources of income.

2. What will your future tax rate be? Today’s rates are relatively low by historical standards, and it’s conceivable they could rise before or during your golden years.

Given these unknowns, what’s a saver to do? “One approach,” says Rob Williams, CFP® and vice president of financial planning at the Schwab Center for Financial Research, “is to use accounts with a variety of tax treatments so you can better control your taxable income in retirement.”

The big four

Broadly speaking, you have four account types at your disposal, each with its own unique tax advantages:

1. Tax-deferred: Contributions to these accounts—which include 401(k)s, 403(b)s and traditional individual retirement accounts (IRAs)—generally reduce your taxable income dollar for dollar in the year you make the contribution (see “2019 Contribution and Deduction Limits”). What’s more, pretax contributions and gains typically aren’t taxed until retirement,1 at which point withdrawals are subject to ordinary income tax rates. You can’t leave your savings in these accounts forever, though: The IRS mandates annual required minimum distributions (RMDs) from your tax-deferred savings accounts beginning at age 70½.”

2. Roth: Unlike tax-deferred accounts, contributions to Roth 401(k)s and IRAs are made with after-tax dollars, meaning contributions won’t reduce your current taxable income. However, you won’t owe taxes on appreciation, income or withdrawals in retirement.2 A Roth IRAs is exempt from RMDs, but a Roth 401(k) is not—though you can still avoid RMDs by rolling it into a Roth IRA when you retire.

3. Taxable: These traditional bank and brokerage accounts are also funded with after-tax dollars. You can sell securities and contribute or withdraw money at any time and for any reason without penalty; any taxable investment income is taxed in the year it’s earned; and investments sold for a profit are subject to capital gains taxes. If you sell an investment for a loss, on the other hand, you may be able to use it to offset any gains—and/or up to $3,000 of ordinary income. These accounts are also exempt from RMDs.

4. Health savings: Although not traditionally considered retirement accounts, health savings accounts (HSAs) can be an effective savings vehicle (assuming your employer offers one and you’re covered by a high-deductible health plan). Contributions reduce your taxable income up to annual limits; investments grow tax-free; and you pay no tax on withdrawals used for qualified medical expenses. Once you reach age 65, withdrawals made for nonmedical purposes will be taxed as ordinary income.3 HSAs are also exempt from RMDs.

Tax diversification in action

So, what’s the right mix of retirement accounts for you? That depends on several factors, including your current marginal tax rate, your projected tax rate in retirement and how much flexibility you’d like when making withdrawals in retirement,” says Hayden Adams, CPA, CFP® and director of tax planning at the Schwab Center for Financial Research. Nevertheless, there are some basic guidelines you can consider when deciding which retirement accounts to fund first:

1. Capture your match: If your employer offers matching contributions to your retirement account, your first priority should be to save enough to get the full match. “That’s free money, and you’d be ill-advised to leave it on the table,” Rob says.

2. Consider an HSA: “We’re all likely to have increased medical expenses in retirement,” Hayden says. “So why not pay for them with tax-free dollars?” In 2019, individuals can contribute up to $3,500, families can contribute up to $7,000, and account holders age 55 or older can contribute an additional $1,000. Employers sometimes provide matching contributions, though they’ll count against the annual limits.

3. Maximize your tax-advantaged savings: Next, consider an appropriate combination of tax-deferred and Roth accounts, depending in large part on your current tax bracket:

  • If you’re in a lower tax bracket (0%, 10% or 12%), consider maxing out your Roth accounts. “There’s a chance your tax bracket in retirement will be equal to or higher than it is today, particularly when you consider that tax rates are at the lowest levels we’ve seen in decades,” Rob says. “Workers early in their careers, in particular, may start out in a lower tax bracket than those later in life.”

  • If you’re in a middle tax bracket (22% or 24%), consider splitting your retirement savings between tax-deferred and Roth accounts. “It can be especially difficult for people in the middle tax brackets to predict their future tax rates, but if you contribute to both types of tax-advantaged accounts you may alleviate some of that uncertainty,” Hayden says. If the majority of your workplace savings are in a traditional 401(k), for example, you might opt to diversify with a Roth 401(k), if offered by your employer.

  • If you’re in a higher tax bracket (32%, 35% or 37%), there’s a good possibility that your tax rate in retirement will be the same as or lower than it is today, so maximizing your tax-deferred accounts might make the most sense.

4. Invest tax efficiently in a brokerage account: If you still have more left to save after you’ve taken the steps above, consider investing in a traditional brokerage account. True, income generated in these accounts is generally taxable, but there are strategies you can employ to improve their tax efficiency, such as:

  • Holding appreciated investments for more than a year so you can take advantage of long-term capital gains rates, which range from 0% to 20%, depending on your income.
  • Considering tax-efficient investments, such as exchange-traded funds, index mutual funds and tax-managed funds, which by and large don’t create as many taxable distributions as actively managed funds.
  • Opting for tax-advantaged municipal bonds, especially if you’re in a high tax bracket. The interest paid on such bonds is typically free from federal taxes and, if issued in your home state, is generally free from state and local taxes, as well.

5. Consider a Roth conversion: If your income precludes you from contributing to a Roth IRA,4 one potential option is a Roth conversion. With this strategy, you convert all or a portion of funds from a traditional IRA to a Roth IRA and pay ordinary income taxes on the converted amount in the year of the conversion. “Despite the additional taxes, a Roth conversion can help diversify a mostly tax-deferred portfolio,” Rob says. However, “the conversion amount is considered income, which could nudge you into a higher bracket if you’re not careful,” Hayden warns. “That’s why many people opt to perform several Roth conversions over multiple tax years.” If you’re unsure how much to convert in a given year, a tax professional can help you decide.

The bottom line

No matter your tax bracket or personal situation, it’s always a good idea to consult with a tax or financial-planning professional.

“Anticipating future tax rates is always a bit of a guessing game,” Rob says. “But with a number of account types at their disposal, today’s retirement savers can build in flexibility and a surprising level of control over their future tax bills.”

1Withdrawals are subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty.
2Provided the account holder is over age 59½ and has held the account for five years or more.

3Withdrawals used for nonmedical purposes before age 65 may be subject to ordinary income tax plus a 20% penalty.

4To contribute to a Roth IRA, single filers must have a modified adjusted gross income of less than $137,000, and contributions are reduced starting at $122,000; for those married and filing jointly, the figures are $203,000 and $193,000.

What You Can Do Next

  • Read more insights on taxes and retirement.
  • Estimate your future RMDs.
  • Need help thinking through your retirement savings plan? Call 800-355-2162 to speak with a Schwab investment professional.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

Investing involves risk including loss of principal.

Fixed-income securities are subject to increased loss of principal during periods of rising interest rates. Fixed‐income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Tax‐exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax‐exempt status (federal and in‐state) is obtained from third‐parties and Schwab does not guarantee its accuracy. Tax‐exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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