This will be coming at a time when, I believe, the IRS will be even more aggressive in taxing these assets. Aggressive taxation goes against what we were originally told — IRA and 401(k) accounts were created so we could defer income now until we retire and enter a lower tax bracket! It’s likely just the opposite will happen: we may be seeing the lowest tax brackets now. The growing national debt and retiring baby boomers will probably put a greater strain on government finances in the future.

By determining your R/D Factor now, you can ensure you don’t end up like the countless retirees who didn’t balance their savings and pay the price in taxes. The R/D Factor (R/D = retirement distribution) is a measure of how well you’ve done with reducing your taxable retirement income by building a balanced three-leg stool. The scale runs from 0, the point at which all of your income is taxable, to 100, where all of your retirement income is tax-free. After you determine your R/D Factor, you can use it to create a balanced retirement plan if you don’t already have one, or to rebalance your existing plan to ensure it’ll be tax-efficient upon your retirement.

The example to the right of my clients John and Mary Pritchard will give you an idea of how the R/D Factor works.

The R/D Factor for the Pritchards is 42 in this example, since 42% of their retirement income will be non-taxable. When they retire, they can adjust this factor if they want by changing the amount they’ll distribute from the three accounts. They’ll have a lot of flexibility with this until they reach the age of 70½ and have to start taking minimum distributions from the tax-deferred accounts. A realistic objective is to aim for an R/D Factor™ of 50. This would provide a balance between tax planning for today and saving for retirement.

You should work with a knowledgeable tax advisor to develop strategies to use the R/D Factor to your advantage. In the example above, the Pritchards may want to withdraw more from the tax-deferred accounts when they retire, in order to maximize the 15% bracket. (The 2008 threshold for married filing jointly is $65,100 in taxable income.) And once they start drawing Social Security, they may want to increase their R/D Factor by taking more from the after-tax and tax-free accounts to minimize the amount of their Social Security benefits that are taxed. I explain this strategy in more detail in the forthcoming section on Social Security.

We may be seeing the lowest tax brackets now.

The growing national debt and retiring baby boomers will probably put a greater strain on government finances in the future.

Why Not 100?

My approach to retirement planning is all about balance. Whenever I explain the strategy to audiences, someone usually asks me why we don’t try to save everything in the tax-free accounts. Good question! True, saving everything in tax-free accounts would give you an R/D Factor of 100, and you wouldn’t have to worry about retirement taxes. But there’s a two-fold problem with making 100% tax-free savings your goal:

1. There are immediate tax benefits to using IRA and 401(k) accounts you don’t want to ignore. Your annual tax planning should take into consideration the level of pre-tax savings that will keep you in a lower tax bracket. Itemized deductions are reduced on your total adjusted gross income (AGI). Alternative Minimum Tax (AMT) calculations are also based on your AGI. Pre-tax savings accounts are often the only tool we have to minimize the AMT burden.

2. There are limits to putting money into a Roth IRA. Unless you have a Roth 401(k) offered through your employer, you may not even be able to contribute to a Roth if your income is too high. Even using these strategies, it would still be difficult to put 100% of retirement savings into a Roth without ignoring some significant tax issues.

Recommendations for the R/D Factor

• The R/D Factor is the percentage of your retirement income that won’t be taxable.

• Ideally, you should shoot for an R/D Factor of 50.

• When you retire, you should manipulate your R/D Factor to take maximum advantage of your tax situation each year, accelerating taxable income in low tax years and minimizing taxable income when needed to stay in a lower tax bracket.

• Balance is the goal — don’t neglect to do tax planning today for a tax-free retirement later. Because tax laws change frequently, you want to take advantage of tax incentives now, since they may not be there down the road.