Insurance Insights: The Cleary Insurance Blog

Presented by: Matthew Clayson, Financial Advisor at Commonwealth Financial Group

If you’re saving and investing for retirement, you’re probably familiar with the concept of investment diversification: Combining different types of assets to balance your overall investment risk and return. This same principle can and should be applied to income tax diversification.

Why? Income tax diversification may allow you to structure withdrawals in retirement to potentially increase the amount of after-tax spendable income.

To achieve a diversified tax base, you want financial assets that offer different types of income tax advantages as you:

• Save for retirement (Contribution).
• Grow your savings (Accumulation).
• Use them for retirement income (Distribution).

There are particular income tax advantages offered by different financial instruments at each of these stages.

Choosing options that offer tax advantages during these different stages may help you accumulate more for retirement and reduce your income tax liability during retirement.

Retirement savings plans (pretax contributions, tax-deferred accumulation, taxable withdrawals)

As you earn money, you pay income tax. But certain retirement savings programs — 401(k) plans, IRA’s, and some types of pension and profit-sharing plans allow you to contribute on a pretax basis. This effectively lowers your gross pay and, as a result, the taxes on that income.

Additionally, many employers offering these types of plans offer some kind of match of funds to a certain limit. For example, your employer may contribute 50 cents for every dollar you contribute up to 6 percent of your pay. So, if you contribute 6 percent of your pay, then add your employer’s match, your contribution amount is effectively increased to 9 percent.

The pretax income you invested in these types of qualified retirement accounts grow on a tax-deferred basis, meaning the money doesn’t get taxed until you take it out.

These kinds of plans are typically subject to a 10 percent penalty for distributions prior to age 59½, and may also have annual required minimum distributions (RMDs) starting at age 73. Failure to take full RMDs will result in a penalty tax equal to 50 percent of the shortfall.

Roth plans (after tax, tax deferred, tax advantaged)

Roth IRAs and Roth 401(k)s are built with after-tax dollars. Both earnings and withdrawals are income tax free if the owner is 59½ and has had the account for five years or longer.

Contributions are limited, however. Those making more than a specific income level cannot contribute a Roth IRA. And those do qualify can only contribute a set amount. Roth 401(k)s don’t have income thresholds, but have limits on how much can be contributed.

Roth account values may also pass tax deferred to the account beneficiary at death.

Annuities (tax deferred, tax advantaged)

An annuity is a contract with an insurance company that can protect you from the risk of outliving your savings in retirement. It is purchased in a lump sum or series of payments and guarantees a stream of payments at some time in the future.

There aren’t any statutory limits on how much after-tax money can be used to fund an annuity, although the annuity itself may have contractual limits.

Earnings in annuities accumulate tax-deferred. When you start receiving payments, you’ll be taxed. If the annuity was bought with pretax funds, the payments will be taxed as ordinary income. If purchased with after-tax funds, you would only pay tax on the earnings.

Life insurance (after tax, tax deferred, tax advantaged)

Life insurance provides a death benefit to help your loved ones carry on in the event of your passing, and life insurance death benefit proceeds are generally income tax free.

Some types of life insurance build cash value. This cash value grows on a tax-deferred basis.

The cash value can be accessed on a tax-advantaged basis. Money taken from the cash value of a life insurance policy is not subject to taxes up to the “cost basis.” That’s the amount paid into the policy through out-of-pocket premiums.

Policyowners can withdraw or borrow against their cash value for any need, like paying a college bill or coming up with a down payment on a house. Retirees can use the cash value as a ready reserve of funds for inevitable market pullbacks, allowing time for invested funds to recover.

Municipal bonds

Those looking to diversity their tax base also sometimes look at municipal bonds.

The attraction of municipal bonds is the interest earnings are not subject to federal taxes. They may also avoid state and local taxes if the investor lives in the state that issued the bond.

Conclusion

The kind of income tax diversification mix using the various options will be different from individual to individual, depending on age, income, and other circumstances. Many people turn to a financial professional to help them understand the choices and possible outcomes.

Provided by Matthew Clayson, courtesy of Massachusetts Mutual Life Insurance Company (MassMutual). CA Insurance License # 0I01304

©2023 Massachusetts Mutual Life Insurance Company, Springfield, MA 01111-0001 

MM202611-307408

About the Author

Matthew Clayson is a Financial Advisor at Commonwealth Financial Group. He is a registered principal of, and offers investment advisory and financial planning services through, MML Investors Services, LLC, Member SIPC (www.sipc.org).