The other kind of diversification

A well-thought-out plan that takes into account tax-efficient withdrawals can be key for retirees

Apr 8, 2015 @ 11:58 am

By Gavin Morrissey

Financial advisers have long touted the benefits of appropriate asset allocation as a way to provide clients with portfolio diversification while defending against market volatility. While portfolio diversification is certainly a central tenet of successful retirement planning, tax diversification can also play a primary role in achieving a client's retirement goals.

Just as a well-diversified portfolio includes a mix of asset classes, such as equities, fixed income, alternatives and cash, a tax-diversified portfolio holds assets in accounts with different tax characteristics (taxable, tax-deferred and tax-free).

(More: "Untimely IRA rollover leads to trouble")

Many retirement income plans are based on two common guidelines: the 4% withdrawal rule and the standard sequence of withdrawals, with taxable assets used first. Although these are appropriate starting points for many clients, scrutinizing a retirement income plan with an eye to tax-efficient withdrawals may better protect it against the inherent risks of market action, inflation, taxation and longevity.

The 4% rule aims to provide clients with reliable, sustainable retirement income for the remainder of their lives, and it's generally a sound guideline. But because no two clients or their portfolios are the same, it's important to take a proactive approach. You can't just put a retirement income plan on autopilot when using a 4% withdrawal strategy.

For example, a client with mostly tax-deferred assets will likely require a larger percentage withdrawal to meet his or her after-tax income needs than a client whose portfolio is held in various accounts with varied tax characteristics.


Further, the traditionally accepted sequence of withdrawals may not lead to maximum tax efficiency for all clients.

Using the standard guideline, assets would be withdrawn from retirement portfolios in the following order: taxable assets, tax-deferred assets and tax-free assets.

The idea is to grow the tax-deferred and tax-free assets as long as possible, under the assumption that the client's marginal tax rate will fall in retirement. While this is possibly a worthwhile starting point, it may not be the most beneficial strategy for every client.

Under the current tax code, withdrawals may be subject to various levels of tax treatment. Withdrawn funds, or portions thereof, can be characterized as ordinary income, short- or long-term capital gains, tax-exempt or return of principal. Plus, some clients may be subject to an additional 3.8% Medicare surtax on certain net investment income.

Given the potential complexity of determining a tax-efficient withdrawal strategy, it's easy to see the appeal of the straightforward ordering of withdrawals approach. Unfortunately, ease of implementation may come at the expense of a truly sustainable retirement income plan.

(More: "How to best minimize taxes during retirement")

A significant benefit of tax diversification is the adviser's ability to control bracket creep.

For example, a married couple is taxed at 15% until their income exceeds $74,900. If their portfolio is held in various accounts with different tax characteristics, the adviser could elect to take funds from retirement accounts until they reach $74,900 while preserving other assets subject to preferential long-term capital gains tax or no tax, reducing the amount of retirement assets subject to required minimum distributions at age 70.

Any income need above the retirement account distributions to that point could come from the more preferentially taxed portion of the portfolio, helping to ensure that the couple's marginal rate remains as low as possible.

Although this example is simplistic, creating a tax-efficient retirement income plan is not. Many clients tend to retire with large qualified plan and IRA balances, which make tax diversification challenging to achieve.

Strategies such as partial Roth conversions in lower-income years, after-tax savings in nonqualified accounts and municipal bonds are well worth looking into for advisers who wish to offer their clients the most tax-efficient plans possible.

Gavin Morrissey is senior vice president of wealth management at Commonwealth Financial Network.


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