Why Tax Diversification Matters in Retirement

Most investors understand the importance of investment diversification. They may own different types of stocks, bonds, funds, and other investments rather than relying on a single investment.

But there is another type of diversification that can become increasingly important as retirement approaches: tax diversification.

Tax diversification generally means having retirement assets held across accounts that receive different tax treatment.

Why can that matter?

Because once you retire, the account you choose to withdraw money from may affect how much taxable income you report that year—and potentially influence other parts of your retirement plan.

The Three Tax Buckets

Retirement assets can generally be thought of as falling into three broad tax categories.

Taxable accounts may include individual or joint brokerage accounts. Interest, dividends, and realized capital gains may create taxable income, but withdrawals themselves aren't necessarily taxed like traditional IRA distributions.

Tax-deferred accounts may include traditional IRAs and many employer-sponsored retirement accounts. These accounts generally allow taxes to be deferred while the money remains invested, but taxable distributions are generally included in income when withdrawn. IRS

Tax-free accounts may include Roth IRAs. Contributions to a Roth IRA aren't deductible, but qualified distributions are generally tax-free. Roth IRAs also generally don't require distributions during the original owner's lifetime. IRS

Having money available in more than one of these categories may provide additional flexibility when creating retirement income.

Why Having Most of Your Money in a Traditional IRA Can Create Challenges

Many retirees spent decades accumulating money in 401(k)s and traditional IRAs.

That can be an effective way to save for retirement, but eventually those tax-deferred dollars generally become taxable when distributed.

Required Minimum Distributions can also force money out of traditional retirement accounts once an individual reaches the applicable RMD age.

Under current law, RMD timing depends on birth year. The IRS currently lists age 73 as the starting age for individuals reaching that age under today's applicable rules; SECURE 2.0 increases the applicable age to 75 for people born in 1960 or later. IRS

Large tax-deferred balances can therefore create taxable income later in retirement even when the retiree doesn't necessarily need all of the distribution for living expenses.

Why Withdrawal Flexibility Can Matter

Imagine a retiree needs an additional $40,000 for a major expense.

If virtually all of the retiree's assets are held in a traditional IRA, obtaining that money could require taking a taxable retirement distribution.

But someone with money spread among a traditional IRA, Roth IRA, taxable brokerage account, and cash reserves may have more choices.

Depending on the circumstances, retirement income could potentially be coordinated among several account types rather than automatically coming from the same place every year.

That flexibility can be valuable because retirement tax planning isn't simply about how much income you need.

It's also about where that income comes from.

Tax Diversification and Medicare

Taxes aren't the only consideration.

Medicare's Income-Related Monthly Adjustment Amount, commonly known as IRMAA, can increase Medicare Part B and Part D costs for higher-income beneficiaries.

Certain retirement income decisions can increase modified adjusted gross income used for IRMAA purposes.

This doesn't mean retirees should make decisions solely to avoid an IRMAA surcharge. But Medicare costs are another reason it can be helpful to have flexibility over the sources of retirement income.

Where Roth Conversions Can Fit

This is one reason Roth conversions are frequently discussed during the years between retirement and Required Minimum Distributions.

A Roth conversion generally involves moving money from a traditional retirement account to a Roth account and recognizing taxable income on the converted amount.

That means voluntarily paying some tax today in exchange for potentially having more assets in a different tax category later.

Whether that makes sense depends on many factors, including current and future tax rates, other income, Medicare premiums, cash flow needs, estate planning goals, and the size of existing retirement accounts.

The objective shouldn't simply be to convert as much as possible.

The question is whether creating additional tax diversification may improve flexibility over the course of retirement.

Tax Diversification Doesn't Mean Equal Buckets

A retiree doesn't necessarily need one-third of their assets in taxable accounts, one-third in traditional retirement accounts, and one-third in Roth accounts.

There is no universal allocation that works for everyone.

The appropriate mix depends on the retiree's financial situation, tax circumstances, income needs, goals, and time horizon.

The important point is recognizing that the tax characteristics of your accounts are another part of retirement planning.

Questions to Consider Before Retirement

As retirement approaches, it may be helpful to ask:

• How much of my retirement savings is tax-deferred?
• What might my future RMDs look like?
• Do I have assets available that can potentially provide tax-free income?
• How might Social Security affect my taxable income?
• Could future withdrawals affect Medicare premiums?
• Are there years when Roth conversions may be worth evaluating?
• If one spouse dies, how could the surviving spouse's tax situation change?

These questions shouldn't be considered independently. They are interconnected pieces of the same retirement income and tax plan.

The Goal Is Flexibility

No one knows exactly what future tax laws will look like.

That's one reason tax diversification can be valuable.

Rather than attempting to predict future tax rates perfectly, retirees may benefit from having different sources of money available with different tax characteristics.

That can provide more choices when deciding how to generate income, manage taxes, address unexpected expenses, and adapt as circumstances change.

Final Thoughts

Retirement planning isn't only about how much you've saved.

Where you've saved it can matter too.

Building retirement assets across taxable, tax-deferred, and potentially tax-free accounts may provide additional flexibility when coordinating income, taxes, RMDs, Medicare premiums, and other retirement decisions.

For retirees approaching retirement, reviewing the tax characteristics of existing accounts can be an important part of developing a broader retirement income strategy.

This article is for educational purposes only and should not be considered tax, legal, or investment advice. Tax laws and individual circumstances vary and may change. Please consult the appropriate professionals regarding your individual situation.