Diversified Tax Character in Retirement Planning: Ensuring Tax Efficiency and Flexibility

By Andi McNamara, CFP®
Vice President, Director of Financial Planning
Washington Trust Wealth Management

As you approach retirement, the strategy behind your portfolio shifts from primarily growing wealth to maximizing and preserving income. A key aspect of this shift is the tax character of your accounts. By holding a diversified mix of tax-deferred, tax-free, and tax-advantaged accounts, you give yourself flexibility and control over your retirement income and keep your tax burden manageable.

Understanding Your Tax Character

Each account type you hold in retirement—Traditional IRAs, Roth IRAs, Health Savings Accounts (HSAs), and taxable accounts—comes with distinct tax advantages, giving you options as you draw down your assets. 

• Tax-Deferred Accounts (e.g., Traditional IRA, 401(k)): Contributions are tax-deductible, but withdrawals are taxed as ordinary income. These accounts grow tax-free until you start withdrawing, typically in retirement.
• Tax-Free Accounts (e.g., Roth IRA): Contributions are made with after-tax dollars, but withdrawals in retirement are tax-free, providing you with a source of income that doesn’t push you into a higher tax bracket.
• Tax-Advantaged Accounts (e.g., HSA): Contributions are pre-tax, grow tax-free, and qualified withdrawals for healthcare expenses are also tax-free, offering another layer of tax efficiency.
• Taxable Accounts: While they lack tax-deferral benefits, investments in taxable accounts (such as brokerage accounts) can generate dividends or capital gains that may be taxed at lower rates, offering flexibility when other accounts might increase your taxable income.

Diversifying Your Tax Character  

If you find yourself with a high concentration in tax-deferred assets like Traditional IRAs or 401(k)s, diversifying your portfolio's tax character can provide significant flexibility and tax benefits as you approach and enter retirement. Here are a few strategies to discuss with your wealth advisor:

1. Roth Conversions. By converting a portion of your Traditional IRA or 401(k) assets to a Roth IRA, your converted assets grow tax-free, and qualified withdrawals in retirement won’t be taxed. By converting in lower-tax years you minimize the tax impact of the conversion itself.  Once in a Roth, these assets won’t be subject to Required Minimum Distributions (RMDs) during your lifetime, allowing you to keep them growing tax-free, which adds flexibility to your future income streams.
2. Maxing Out Roth Contributions. If your income allows, consider contributing the maximum amount to a Roth IRA each year, or if you’re over the income limit for direct Roth contributions, consider a backdoor Roth IRA contribution (contributing to a Traditional IRA and then converting those funds to a Roth IRA). Roth contributions give you a tax-free source of income in retirement, offering a strategic counterbalance to your taxable, tax-deferred accounts. A Roth conversion may be an option within your 401(k) plan as well.
3. Health Savings Account (HSA). If you are eligible, an HSA can serve as a tax-free account for healthcare expenses, and after age 65, you can use HSA funds for non-medical expenses, although you will be taxed similar to a Traditional IRA withdrawal.
4. Taxable Accounts for Long-Term Flexibility. Taxable accounts, such as brokerage accounts, don’t have the tax deferral benefits of IRAs, but capital gains and qualified dividends are typically taxed at lower rates than ordinary income. Plus, these accounts have no RMDs, offering flexibility in retirement income planning. The step-up in basis at death can also make these assets beneficial from an estate planning perspective.

Discussing Tax Character Diversification with Your Wealth Advisor   

At Washington Trust Wealth Management, we understand that tax character in retirement isn’t a one-time decision; it’s an ongoing strategy addressing your needs and the evolving tax landscape. Your Washington Trust wealth advisor can help you develop a plan that considers the current balance of your tax-deferred, tax-free, and taxable assets, considering questions like:

• Am I taking full advantage of Roth conversions in lower-tax years?
• Is there an opportunity to strategically use my HSA for qualified medical expenses in retirement?
• How can I approach RMDs from tax-deferred accounts to avoid a big tax hit?

Whether you’re several years from retirement or already there, we can discuss your asset allocation across your portfolio accounts and diversity as needed to avoid unexpected tax consequences that could derail your retirement goals.