Understanding Taxes as a Financial Risk

When you think about building a financial plan that will help you meet your goals at every stage of your financial journey, saving and investing are usually the first things that come to mind. Starting early, saving as much as possible, and being thoughtful about how you allocate your portfolio to balance risk and return potential are the basics for most investors.

But the traditional way of thinking about taxes is that they often take a backseat to investing. There is a good basis for an argument that taxes should always be considered alongside investing—they are both at the core of maximizing income, just different sides of the same coin.

When it comes to retirement, tax planning is even more important, because you are no longer making an income. Taking a more comprehensive approach to tax planning that borrows from two key investing concepts—tax allocation and tax diversification—can yield a better result.

Updating Some Retirement Tax Assumptions

It used to be commonly assumed that because you are not making a salary in retirement and are living on investments, taxes will be lower than in your working years. If you have been diligently saving in a 401(k) or other tax-advantaged vehicle, that might not be the case. Depending on what you have saved, required minimum distributions may be high enough to create a significant tax liability. Planning your retirement strategy so that you understand your income and how much of it will be taxed is critical.

Minimizing Tax Risk Through Diversification

Tax risk takes into account how much you are taxed in retirement. Just like diversifying your investments to create an income stream, diversifying your tax treatment can help. These could be tax-free accounts where contributions are made with after-tax dollars—Roth accounts are an example. Setting up a strategy that places the right assets in the right tax treatment can minimize tax risk and help ensure a sustainable level of income.

Tax Legislation Risk Requires Foresight and Planning

There is also the reality that over time, taxes may increase. Our aging population, unavoidable infrastructure spending, and increased spending on climate-related disasters are all increasing costs that need to be funded. This is a tax legislation risk. As the government looks to increase funding, there may be changes to the whole taxation picture. This is an ongoing reality that needs to be planned for in a solid retirement plan.

The Bottom Line

Taxes, particularly in retirement, are a meaningful part of the risk that you should plan for. There are strategies you can undertake that can help you diversify your tax allocation and set you up to handle whatever tax environment the future brings.