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Using the Tax Triangle to Save Money and Boost Your Retirement Plan

Most people know they need to save for retirement, but they may not realize they also need to think about spending their retirement savings strategically. If you’re not careful, taking money out of your personal retirement plan can involve taking a big tax hit. Since the amount of taxes you pay on withdrawals has a direct effect on the size of your nest egg, protecting after-tax income is a key goal for many retirees.

The good news is, you can save thousands of dollars with the right financial advice. Tax diversification, also known as the tax triangle or tax protection triangleis a model we use here at Wealth Legacy Institute to make sure you get the most out of your retirement savings plan. 

How Tax Diversification Can Increase Your Retirement Savings

As the infographic below shows, there are three types of taxation when it comes to retirement savings accounts: taxable, tax-free, and tax-deferred. 

  • Taxable accounts are taxed every year, such as savings accounts/money market accounts and brokerage accounts which include stocks and mutual funds.
  • Tax-free accounts are tax-free when withdrawn, so you don’t have to pay any taxes on the growth. Roth IRA, Roth 401(k), and bonds, and cash value life insurance are all examples of tax-free retirement accounts. 
  • Tax-deferred means you pay taxes when you withdraw the money. 401(k), 403(b), and traditional IRAs are all tax-deferred accounts. 

Think of these tax types as three points on a triangle.  We find that most times a 30/30/40 mix of tax-free, taxable, and tax-deferred accounts seems to be the ideal recipe within your retirement plan. Each account type has its advantages (and limitations), which means diversifying gives you the most flexibility. Reference the infographic at the end of this post for details.

How Tax Diversification and Withdrawal Order Go Hand-in-Hand 

At some point in the future, you’ll need to use your retirement savings to live off of. So, it makes sense to protect your money from taxes as much as possible. Before taking retirement income from your investment portfolio it’s important to establish a distribution strategy.

Withdrawal order refers to the sequence in which you withdraw funds from your various retirement accounts. The right withdrawal order can result in more money in your pocket.  Helping you make the most of your retirement assets is just one of the ways a long-term financial planner can help you make the most of your personal retirement plan. 

As with most financial matters, there are exceptions to consider, such as Roth conversions and estate considerations. A financial advisor can help you determine the best course of action based on your tax bracket, your financial goals and plans. In general, we recommend the following withdrawal order from your retirement portfolio:

  1. Any income you receive such as Social Security benefits, required minimum distributions (RMDs) or annuities, if you have them
  2. Taxable accounts
  3. Tax-deferred accounts
  4. Tax-free accounts

This distribution strategy allows your tax-advantaged accounts to grow for a longer period before you start taking money out, helping you achieve a higher potential after-tax income.

A lot goes into optimizing withdrawals in retirement and you do need to plan ahead in order to protect your funds. Tax diversification planning can be a complex process; it requires a firm understanding of current tax codes, your own situation, and how accounts are structured. Fortunately, the solution can be simple when you have a trusted advisor at your side.  

If you want the most flexibility and sustainability for your retirement savings, speak to an advisor at Wealth Legacy Institute today.

Tax Triangle Infographic for Retirement Planning

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