Just as there are benefits to investment diversification, there are benefits to having tax diversification, said Chad S. Hamilton, CFP and vice president of practice management with Mariner Wealth Advisors.
He listed several broad categories of income in terms of tax treatment:
- Tax-free: Roth individual retirement accounts, municipal bonds, or return of basis.
- Fully taxable: Withdrawals from traditional IRAs, 401(k) and 403(b) accounts.
- Partially taxable: Social Security.
- Tax-favored: Long-term capital gains, qualified dividends.
- Other Income: Earned income, rental income, monthly pension.
"You can think of these as different 'buckets' of money, and the idea is that prior to starting to draw down from your assets, you spread money across a variety of investment vehicles," said Hamilton. "By doing so, you will provide a hedge against the inevitable future changes to the tax laws.
"The objective is to monitor the source of your withdrawals each year so that you can max out lower marginal tax brackets but avoid creeping into a higher tax bracket."
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According to Douglas Kobak, CFP, principal of Main Line Group Wealth Management, employees of public companies who overlook the Net Unrealized Appreciation could pay "tens of thousands of dollars in additional taxes." To explain, he used the example of an employee with a 401(k) plan with $1,000,000 of company stock with a cost basis of $100,000.
If the employee were to withdraw directly from it, or roll over the entire amount into an IRA, the withdrawals would be taxed as ordinary income, as high as 39.6 percent federally.
Checklist for preparing client portfolios for retirement
● Define their retirement lifestyle.
● Determine how much income they need annually.
● Review their current investment allocation to prevent against a market downturn.
● Take money out of the market and put it in a safe place.
● Set money aside for any beneficiaries.
● Ensure their investments keep up with inflation.
● Reduce their tax liability.
● Set up an estate plan.
● Put a long-term care plan in place.
Source: Alexander G. Koury, CFP and investment manager at Householder Group Estate & Retirement Specialists
Employing the NUA strategy, the employee does a qualified lump-sum distribution, transferring all shares of company stock from the 401(k) into a taxable account and rolling over all remaining assets to an IRA account.
"As a result, tax owed at transfer is only on the cost basis ($100,000) and taxed as ordinary income," Kobak said. "When shares are sold, long-term capital gains (currently a maximum of 20 percent) are paid on the difference between the cost basis ($100,000) and the sale proceeds.
"This could save the employee as much as 20 percent on taxes," he added.