Imagine yourself on the day before you become financially independent. As you cross the line, you begin to look at your various accounts and the tax status of each. Have you made sure that those accounts include money that is not subject to the same uniform tax effects? Tax diversification means having access to some tax-free money, some tax-deferred money and some taxable money. This allows you to protect against changes in the tax brackets and gives you a certain amount of control over the amount of tax you pay in retirement. Consider the following two lawyers, both financially independent and both looking to spend $100,000 this year. To keep things simple, both portfolios are assumed to be the same size after taking into consideration taxes.
Lawyer A has a portfolio that is entirely tax-deferred, consisting of a rollover IRA created after he moved his 401(k) into a traditional IRA.
Lawyer B has a portfolio consisting of a mix of accounts. He started a Roth IRA in law school, made some backdoor Roth IRA contributions during his career, contributed to his 401(k), an HSA and also put some money into a taxable account.
If both want to spend $100K, how would they do it?
Lawyer A pulls $100K out of his rollover IRA. There’s no penalties if he’s over 59 1/2 and there’s no required minimum distribution if he’s not yet 70. The money is tax-deferred, so he will have to pay income taxes on the amount withdrawn. His adjusted gross income is $100K. He takes the married standard deduction of $12,600 and personal exemptions of $8,100 to arrive at $79,300 of taxable income of which he’s going to pay approximately $11,368 of taxes at an effective rate of 11.4%.
Lawyer B has options to achieve his $100K income. Maybe he withdraws $10K from his HSA to cover healthcare expenses, all tax-free. He could use appreciated stock in his taxable account for any charitable contributions, again all tax-free. Assuming no charitable giving, he’d still need $90K in my example. He could pull $50K from his Roth IRA which would not be taxed. He’d need another $40K from his Traditional IRA to bridge the gap, which would generate $40K in taxable income. Because he had a taxable investment account, he may have been able to do a little tax-loss harvesting throughout the years and thus have a $3K loss he can deduct from his income, knocking it down to $37K. After taking the standard deduction and personal exemption, his taxable income drops to $16,300 for a tax bill of $1,630.
The first lawyer pays an effective tax rate of 11.4% but the second lawyer only pays an effective rate of 4.4%. That’s the magic of tax diversification at work.
Tax diversification lessons
1. Options are Valuable. The first lesson is quite clear. It pays to have options when you retire since you can aggregate money from different accounts to cover your expenses and trigger lower taxes as a result. Most interesting is how the second lawyer only paid tax in the lowest income bracket at 10%.
2. You Need to Max Your Retirement Accounts. Even the lawyer with 100% tax-deferred portfolio only paid an effective tax rate of 11.4%. For a lawyer in NYC, every dollar you contribute to a 401(k) may save you taxes in the circa 40% range. Saving taxes at a 40% tax rate and paying them at an 11.4% rate is a winning proposition every time.
3. Maximizing Your Roth IRA as a Law Student. Getting started with a Roth IRA as a law student is a great way to get the Roth IRA contributions going, particularly during a period of your life when you likely have low income and so are not paying much taxes on the income anyway. After you start working, you’ll be able to do backdoor Roth IRA contributions to boost the account. At only $5,500 a year, this account may never be a huge portion of your portfolio but even if it’s 10-20% you’ll be able to use the tax-free withdrawals to top up your income and save from being forced to withdraw tax-deferred money at higher income tax brackets.
4. Use Low-Income Years to Do Roth IRA Conversions. If you retire early, take a year off, become a stay-at-home parent or otherwise have a lower income one year, take advantage of the lower income by doing Roth IRA conversions. You can convert tax-deferred Traditional IRA money to tax-free Roth IRA money by paying income taxes on the conversion. If you have no income one year, you could convert the tax-deferred money by paying taxes at the low 0, 10 or 15% tax brackets. Additionally, this will reduce the required minimum distributions you have to take after age 70 (a requirement of Traditional IRAs). Finally, consider doing the Roth IRA conversions while a resident of a state with no income taxes. A lawyer working in NYC may save around 40% for every dollar contributed to a 401(k). During a transition period in Florida, that same lawyer could do Roth IRA contributions, pay 10-15% federal tax and no state income taxes. That same lawyer could later retire to California and spend the money from his Roth IRA both federal and state tax free.
5. Tax Benefits of Taxable Accounts. Taxable Accounts have a lot of tax benefits, although they should be funded after maxing out all retirement accounts, including backdoor Roth IRAs and HSAs. In a taxable account, you pay the lower capital gains tax rates on any gains in the account. You also get a step-up to your cost basis at death, have the ability to tax-loss harvest and can donate appreciated stock to charity without triggering any taxes.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.
