Why tax diversification matters in retirement

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Drawing income from different tax buckets can help you manage taxes in retirement.

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Diversification is one of the oldest principles in investing. Rather than concentrating your money in a single company, industry, or asset class, you spread your savings across a wide range of stocks, bonds, and other investments to reduce the impact if some assets perform poorly. The same idea can apply to taxes. Instead of accumulating all of your retirement savings in one type of account, you can spread them across accounts with different tax treatments—a strategy known as tax diversification.

The type of account you use to save for retirement, whether it’s a traditional IRA or 401(k), a Roth account, or a taxable brokerage account, can affect how much flexibility you have throughout your financial life. During your working years, different accounts offer different tax advantages. After you stop working, drawing income from accounts with different tax treatments gives you more control over when income is recognized, how much tax you pay in a given year, and how different retirement decisions affect the rest of your financial picture.

Building tax diversification into your retirement strategy can provide options to help you optimize and manage tax efficiency, required minimum distributions (RMDs), Medicare premiums, and Social Security benefits.

It’s common for retirement savers to accumulate money in whichever account is available through work, often a traditional 401(k). Others contribute to Roth IRAs, taxable investment accounts, health savings accounts (HSAs), or a combination of account types.

Traditional retirement accounts generally provide a tax deduction up front, allowing your investments to grow tax-deferred. You pay ordinary income tax later when you withdraw the money in retirement. For many workers, especially those in higher tax brackets, the upfront tax deduction can be a significant benefit during their earning years. Roth accounts work in the opposite way: Contributions are made with after-tax dollars, but qualified withdrawals in retirement are generally tax-free. Taxable brokerage accounts receive neither benefit.

Rather than concentrating retirement savings in one type of account, tax diversification spreads savings across multiple tax “buckets.” No one knows what future tax rates—or their own retirement income needs—will look like. Tax diversification preserves flexibility as factors change. 

Retirement income needs aren’t always predictable. Some years you might need more income for travel, home renovations, or health care expenses. Other years, you may simply want to keep your taxable income lower. Multiple account types allow you to choose where your withdrawals come from. For example:

Instead of taking every dollar from a tax-deferred account, you can combine withdrawals from different buckets to better manage your taxable income. That flexibility can be especially valuable when other parts of the tax code—such as the rules governing Social Security taxation, Medicare premiums, and RMDs—come into play.

Tax diversification can provide flexibility in a variety of retirement scenarios, helping you manage taxes and keep more of your retirement income. 

Many workers retire before claiming Social Security benefits. Those years may temporarily place them in a lower tax bracket because they no longer receive wages and haven’t begun collecting Social Security benefits. 

If you can access your retirement savings without triggering an early withdrawal penalty, those lower-income years may provide an opportunity to withdraw money from traditional retirement accounts while remaining in a relatively low tax bracket. You may also choose to supplement your income with qualified Roth withdrawals, which generally aren’t included in taxable income, or convert some traditional retirement savings to a Roth account.

If you can’t yet access your retirement accounts without penalty, you may still be able to draw on taxable investment accounts to help bridge the gap until penalty-free withdrawals become available. In some cases, careful management of capital gains can also help limit taxable income. 

In general, you must begin taking required minimum distributions (RMDs) from traditional retirement accounts by age 73—whether you need the money or not—and those withdrawals increase your taxable income. If most of your retirement savings are in tax-deferred accounts, mandatory withdrawals can push you into a higher tax bracket. Roth IRAs, by contrast, aren’t subject to RMDs during your lifetime. 

If you have tax diversification buckets, you can draw down some of your traditional accounts while using a combination of Roth, HSA, and taxable accounts to supplement some of your income. Over time, reducing the balance in traditional retirement accounts can reduce future RMDs and the taxes that come with them. 

Depending on your income, up to 85% of your Social Security benefits may become taxable. Qualified Roth IRA withdrawals, however, generally aren’t included in the calculation. As a result, drawing retirement income from Roth accounts may reduce the portion of your Social Security benefits that is subject to tax.

HSA withdrawals used for qualified health care costs aren’t usually considered taxable income, either. Focus on using HSA money for your medical costs instead of withdrawing from other accounts to avoid higher taxation.

Similarly, carefully managing withdrawals from taxable accounts and traditional retirement accounts may help you avoid crossing important income thresholds that can trigger higher taxes on Social Security benefits.

Higher-income Medicare beneficiaries may pay income-related monthly adjustment amount (IRMAA) surcharges on Medicare Part B and Part D premiums. IRMAA surcharges are based on modified adjusted gross income (MAGI) from two years earlier, so even a one-time large traditional account withdrawal can increase Medicare premiums later.

Having access to Roth accounts or taxable assets may provide alternatives for generating cash while limiting increases in MAGI. With careful planning and coordination, you can increase your chances of staying below the IRMAA threshold.

Let’s compare two retirees, each with $1.5 million saved for retirement. Each one wants $80,000 of annual retirement income.

Retiree A has no tax diversification and almost all of that $80,000 a year is considered taxable income. Because nearly all of that $80,000 is taxable income, Retiree A could be pushed into a higher tax bracket. While in that higher tax bracket, there’s less room for tax planning, such as a Roth conversion. Later, RMDs are likely to be higher, continuing the taxation issue.

On top of that, once Retiree A begins collecting Social Security, up to 85% of those benefits could become taxable. The higher taxable income could also push Retiree A above the IRMAA threshold, resulting in Medicare surcharges.

Meanwhile, Retiree B can withdraw from different tax diversification buckets to manage their taxable income. For example, Retiree B could take:

With this strategy, $30,000 of withdrawals aren’t included in taxable income. Retiree B has a lower taxable income and can stay in a lower bracket. If it makes sense, Retiree B can decide to convert some traditional assets into a Roth account at favorable rates. Those lower-income years can be especially favorable for Roth conversions, which may reduce future RMDs. The overall strategy may also limit taxes on Social Security benefits and help Retiree B avoid Medicare IRMAA surcharges.

The two retirees accumulated the same wealth, but have different tax outcomes based on their account flexibility.

Tax diversification often develops over time. As you move through your career, consider these strategies to create tax diversification buckets that can benefit you in retirement:

The right mix depends on your current tax bracket, expected retirement income, estate planning goals, and other financial priorities. There’s no single formula—or ideal percentage—for each tax bucket. The value comes from having options when it’s time to turn your savings into retirement income.

Investment diversification helps manage market risk, while tax diversification helps manage tax risk. By building savings across traditional retirement accounts, Roth accounts, HSAs, and taxable investments, it’s possible to gain more flexibility over how retirement income is generated.

That flexibility, in turn, can create opportunities to manage taxes, reduce potential Medicare premium surcharges, reduce taxes on Social Security benefits, and keep RMDs from pushing you into a higher tax bracket later.