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This may be one of the most important articles we’ve ever written. That’s because when it comes to retirement, your distribution strategy is every bit as important as your contribution and investment strategy…
You might say, "But I'm 20 years from retirement". We understand. However, your distribution plan is what determines the type of accounts you contribute to during the accumulation phase, as well as how much you allocate to the different types of accounts. As a result, planning your distribution strategy is critical during your contribution years, primarily due to the impact your contribution decisions can have on the income tax side of things.
Most think of diversification in terms of the different types of investments, like stocks vs. bonds, and large cap vs. emerging markets, etc. But there’s another diversification strategy that’s critical to consider, and that’s the tax classification of your investments.
For instance, if you withdraw $50,000 from your 401k in retirement, that $50,000 distribution is fully taxable. Whereas a $50,000 distribution from a Roth IRA is entirely tax-free.
Because we’re in a progressive income tax system, higher levels of income are taxed at higher rates. So it behooves taxpayers to limit the amount of taxable income being reported on their tax return. It follows that having some non-taxable income in retirement pairs well with taxable income, in order to avoid paying crazy tax rates on retirement income, which could severely impact the net available funds from distributions.
Also, the taxation of your social security is based on your other taxable income figures. So if you’re able to stay under certain limits with distribution income, it may limit your social security income taxation.
There are numerous different types of accounts and income sources for retirement (social security, pension, 401k’s, IRA’s, HSA’s, etc., etc.), and each have different taxation implications. Not only can that affect your contribution strategy, but it may bring in to play strategies such as a Roth IRA conversion.
As always, we don’t suggest taking any financial decisions lightly, and highly recommend affiliating with a qualified financial advisor to help you in making these all-important choices.