Tax Diversification and Retirement Flexibility

When you separate from federal service, your retirement benefits are income diversified thanks to the Federal Employees Retirement System and its three “stool legs” of the Basic Benefit, Thrift Savings Plan (TSP), and Social Security distributions.

You can also benefit from tax diversification.

Such an approach can help minimize costly liabilities and protect you from tax shifts or income hikes during your retirement years.

Spreading the Burden

A tax diversification plan encourages you to allocate financial contributions to three “buckets” that contain different funds, savings accounts, and retirement plans. Spreading out the wealth helps you manage what taxes you might owe.

Tax diversification can also help mitigate the following:

• Social Security tax thresholds: These can be as high as 85%, depending on your income
• Income-Related Monthly Adjusted Amount (IRMAA): If you have a high income, you’ll pay this surcharge on Medicare premiums; IRMAA is based on tax returns from two years prior.
• Required minimum distributions (RMDs): These are the smallest amounts that you must withdrawannually from tax-deferred retirement accounts after reaching a certain age. Failure to take this action could result in severe penalties from the IRS.

The Three-Tax-Bucket Retirement Strategy

Now that you understand the concept, let’s take an in-depth look at the tax diversification buckets.

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Bucket #1: Taxable

This holds pensions, bank accounts, Social Security distributions, brokerage accounts, and anything else that generates taxable income, interest, or dividends. Withdrawals can be used for daily living essentials, including groceries, gas, clothing, and entertainment.

Bucket #2: Tax-Deferred

Here’s where your Thrift Savings Account (TSP) or Individual Retirement Account (IRA) lives. You don’t pay taxes on initial contributions or gains, but withdrawals are taxed as ordinary income. Use these investments for planned baseline withdrawals or if you are in a lower income bracket during retirement.

Bucket #3: Tax-Free

This bucket includes Roth TSPs, Roth IRAs, and Health Savings Accounts (HSAs). “Tax-free” means you pay taxes when you make the contributions but pay nothing on the withdrawals. Use these accounts for large purchases or emergencies and to handle tax bracket changes.

Considerations for Your Tax Diversification Strategy

Here’s how you can get the most out of your three-bucket tax approach:

• Maximize contributions to each bucket, based on financial ability and account limitations
• Be flexible in withdrawing from each bucket to help minimize tax liability
• Prepare for issues including Social Security taxes, Medicare IRMAA, or required tax planning withdrawals (including RMDs)
• Regularly review accounts to change strategies based on income changes, tax bracket shifts, and other factors

Reducing Your Tax Liability

A well-thought-out tax diversification strategy helps ensure you get the financial support you need without incurring costly taxes. You can end up with the best options that support your long-term retirement plan.

If you need help with setting up or maintaining an effective tax planning approach, reach out to the expert CERTIFIED FINANCIAL PLANNERS® at Serving Those Who Serve. These Fed-focused professionals can provide guidance on all aspects of retirement planning, including tax burden reductions.

Email the team at [email protected] or visit the website to schedule a no-obligation appointment.

The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Serving Those Who Serve writers and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **