When people hear the word diversification, they usually think about investments. They think about owning different types of assets like stocks and bonds or spreading investments across U.S. and international markets. While investment diversification is important, there’s another strategy that’s often overlooked: tax diversification.
Tax diversification means having retirement assets in different tax categories instead of keeping all of your money in one type of account. This can be especially important in retirement because taxes may become one of your largest expenses. Having multiple tax buckets can provide more flexibility when it’s time to generate income and adapt to changing financial needs.
Understanding the Three Tax Buckets
The first bucket is taxable accounts. These include brokerage accounts, bank accounts, and other non-retirement investments. These accounts are generally accessible at any age and may benefit from favorable long-term capital gains tax treatment. However, interest, dividends, and realized gains can create ongoing tax consequences.
The second bucket is tax-deferred accounts. Think of your Traditional IRAs and 401(k)s. These accounts often provide a tax deduction when contributions are made, and investments grow tax-deferred over time. The tradeoff is that withdrawals are generally taxed as ordinary income, and required minimum distributions may apply later in retirement.
The third bucket is tax-free accounts, like Roth IRAs and Roth 401(k)s. Contributions are typically made with after-tax dollars, but qualified withdrawals can be tax-free. Roth IRAs can also offer additional flexibility because they aren’t subject to required minimum distributions during the owner’s lifetime.
Why Tax Diversification Matters
Retirement planning isn’t static. Tax laws, income needs, and personal circumstances can change. That’s why flexibility can be so valuable.
Consider two retirees. Retiree A has all their retirement savings in a Traditional IRA. Every withdrawal increases taxable income. Retiree B has assets spread across taxable, tax-deferred, and tax-free accounts. When income is needed, Retiree B may have more choices when deciding where those withdrawals should come from.
This flexibility can help retirees better manage taxable income from year to year. It may also provide more options during periods of market volatility or when unexpected financial needs arise. Simply put, having multiple tax buckets can create more control over how retirement income is generated.
Planning Opportunities Created by Tax Diversification
One consideration is Medicare premiums. Certain Medicare costs are tied to taxable income through a surcharge known as IRMAA. Because income levels can affect these premiums, having flexibility over where retirement income comes from may help retirees better navigate those thresholds.
Tax diversification doesn’t eliminate taxes, and it isn’t a guarantee of lower taxes in retirement. However, it can provide greater flexibility when making income and withdrawal decisions. And in retirement, flexibility can be one of the most valuable planning tools available.
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Because retirement planning isn’t just about accumulating assets. It’s about creating options.