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The Power of Tax Diversification in Retirement
Tax diversification is one of the most overlooked yet powerful strategies for creating reliable and tax-efficient income in retirement. It’s not just about lowering taxes. It's about giving yourself more control, more flexibility, and fewer financial regrets down the road.
As more retirees reflect on their financial decisions, a growing number are saying the same thing: “I wish I’d diversified my tax exposure.” In fact, this trend is highlighted in a recent Business Insider article, where retirees admitted they didn’t fully understand the consequences of having too much of their savings in tax-deferred accounts. The result? Higher taxes in retirement and fewer options when they need them most.
If you’re approaching retirement with a sizable portfolio, now is the time to take a hard look at your current savings strategy and ask: Am I setting myself up for tax flexibility or a future tax trap?
What Is Tax Diversification?
Tax diversification means spreading your retirement savings across different types of accounts, each with its own tax treatment. It’s similar to investment diversification, but instead of managing market risk, you're managing tax risk.
At its core, tax diversification involves three main account types:
- Tax-deferred accounts (like traditional IRAs and 401(k)s)
- Tax-free accounts (such as Roth IRAs or Roth 401(k)s)
- Taxable accounts (individual or joint brokerage accounts)
By combining these, you create more options for how and when you withdraw money in retirement. That means you can keep more of what you’ve earned.
Why Tax Diversification Matters More in Retirement Than You Think
Tax diversification gives you the flexibility to pull income from different sources depending on what’s happening with your income level, tax brackets, market performance, and changes in tax law. Here's why that flexibility matters:
Tax-deferred accounts give you an upfront tax break, but every dollar you withdraw later is taxed as ordinary income. That can push you into a higher tax bracket in retirement, especially when Required Minimum Distributions (RMDs) kick in at age 73.
Roth accounts, on the other hand, offer no tax deduction now. But withdrawals in retirement are tax-free. That can help reduce your taxable income in key years, like when you’re selling a property, receiving Social Security, or managing RMDs from other accounts.
Taxable accounts don’t offer special tax breaks upfront or on withdrawal, but they come with advantages, too. For example, long-term capital gains are taxed at lower rates, and you can access funds at any time without age restrictions or penalties.
Tax diversification gives you the freedom to choose from all three, depending on your goals and what the tax landscape looks like each year. And that can add real dollars back into your retirement plan.
How Tax Diversification Supports Smarter Withdrawal Strategies
Most retirees focus on how much to withdraw. But where you withdraw from each year can make just as much of a difference. Tax diversification allows for flexible withdrawal strategies, which can be adjusted year by year to help:
- Stay in lower tax brackets
- Manage Medicare premium surcharges (IRMAA)
- Reduce RMDs
- Lower taxable Social Security income
- Control exposure to future tax rate changes
For example, in a year when your taxable income is low, maybe you delay Social Security or have large deductions, you might take more from your tax-deferred accounts at a lower rate. In a high-income year, you could switch to Roth or taxable accounts to stay under important tax thresholds.
Common Retirement Accounts and Their Tax Impacts
Let’s take a closer look at each type of account, how it works, and how it fits into a tax diversification strategy.
Tax-Deferred Accounts
Examples: Traditional IRA, 401(k), 403(b)
Tax treatment: Contributions are typically pre-tax. Growth is tax-deferred. Withdrawals are fully taxable as ordinary income.
Pros: You get an immediate tax deduction when contributing.
Cons: All income is taxable later. RMDs are required. Higher income can trigger additional taxes or Medicare costs.
Tax diversification helps reduce over-reliance on these accounts and avoids large, unexpected tax bills later in life.
Roth Accounts
Examples: Roth IRA, Roth 401(k)
Tax treatment: Contributions are after-tax. Growth and qualified withdrawals are tax-free.
Pros: Withdrawals do not count toward taxable income in retirement. No RMDs for Roth IRAs.
Cons: You pay taxes on contributions upfront. Income limits may apply for direct Roth IRA contributions.
Including Roth assets in your overall plan increases flexibility, especially during high-income years or for legacy planning.
Taxable Accounts
Examples: Individual or joint brokerage accounts
Tax treatment: No tax break for contributions. Dividends and capital gains are taxed, but at favorable long-term rates.
Pros: No age-based restrictions. Capital gains taxes can be managed with smart timing.
Cons: Less tax sheltering than other account types.
Tax diversification gives these accounts an important supporting role in cash flow planning and in bridging income gaps before RMDs or Social Security begin.
When Should You Start Planning for Tax Diversification?
Ideally, tax diversification starts years before retirement. But it’s never too late to improve your position.
If you’re within 5 to 10 years of retirement, now is the time to:
- Evaluate your current mix of tax-deferred, Roth, and taxable accounts
- Consider Roth conversions during lower-income years
- Harvest capital gains or losses in taxable accounts strategically
- Coordinate tax diversification with your broader retirement tax planning
If you’re already retired, it’s still worth revisiting your withdrawal strategy to minimize taxes over time. Every year presents new opportunities to make smarter choices.
Tax Diversification in Action: A Real-World Scenario
Imagine a couple in their early 60s who have $3 million saved. About 90% is in traditional IRAs and 401(k)s. They plan to delay Social Security and retire in three years.
They meet with a fiduciary advisor who helps them project their future tax situation. They discover that once RMDs start, their taxable income will push them into a higher bracket and increase Medicare premiums. Instead of waiting, they use the next few lower-income years to make partial Roth conversions. They also start shifting some spending to their taxable account.
Now, in retirement, they can draw from Roth, taxable, and tax-deferred sources. This allows them to keep their income level in check, reduce RMDs, and make their money last longer, all because they built in flexibility through tax diversification.
Getting Started with a Personalized Tax Diversification Plan
There’s no one-size-fits-all solution for tax diversification. The right strategy depends on your income, savings, retirement timing, and long-term goals.
At Haywood Wealth Management, we help clients create personalized retirement tax planning strategies that are built for the long haul. Our fiduciary approach puts your best interests first, and we work alongside your CPA to make sure all parts of your financial picture are working together.
Final Thoughts
Tax diversification is not just about saving money on taxes. It's about building a retirement income plan that gives you options. It helps reduce future surprises, supports smarter withdrawal strategies, and creates more stability in a changing tax landscape.
If you're within a decade of retirement, or already there, now is the time to take a serious look at how your savings are structured. A little planning today can help you avoid big regrets later.
Ready to explore how tax diversification can strengthen your retirement plan? Schedule a consultation with our team and take the next step with confidence.
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