The Retirement Strategy Most People Miss
Most people enter retirement expecting their tax burden to decrease. After all, you’re no longer earning a paycheck, right?
The reality often proves quite different.
Many retirees discover they’re paying the same – or even higher – tax rates than during their working years.
The culprit? Putting all their retirement eggs in one tax basket. When we talk about retirement planning, we focus on how much you’ve saved and when you plan to stop working.
But there’s one piece that doesn’t get nearly enough attention, even though it can dramatically impact how long your money lasts: tax diversification.
Understanding the Three Tax Buckets
Tax diversification means spreading your retirement savings across accounts that are taxed in different ways. Think of it like a three-legged stool – if all your money sits in just one “leg” and tax rates change unfavorably, you’re stuck. But with diversification, you have more control over how much tax you pay and when you pay it.
Bucket 1: Taxable Accounts
Your taxable accounts include regular brokerage accounts, savings accounts, CDs, and mutual funds held outside retirement wrappers. The money going into these accounts has already been taxed, so you only pay taxes on dividends, interest, and capital gains.
The advantage here is significant. Long-term capital gains and qualified dividends are taxed at lower rates than ordinary income – often 0%, 15%, or 20% depending on your income level. In retirement, if you can keep your ordinary income modest, you might pay very little tax on withdrawals from these accounts.
Bucket 2: Tax-Deferred Accounts
This is where most retirees have the bulk of their savings – traditional 401(k)s, 403(b)s, and IRAs. You received a tax break when you contributed, but you’ll pay ordinary income tax when you withdraw.
Starting at age 73 for most people, the IRS requires you to begin taking required minimum distributions (RMDs). These withdrawals can trigger higher taxes, increase Medicare premiums, and push you into higher tax brackets. While tax-deferred growth is valuable during your working years, too much concentration here can create what I call a “tax time bomb” in retirement.
Bucket 3: Tax-Free Accounts
Tax-free accounts include Roth IRAs, Roth 401(k)s, and Health Savings Accounts (when used for qualified medical expenses). You contribute after-tax dollars, but the money grows tax-free and comes out tax-free in retirement. No RMDs, no ordinary income tax, and no concerns about rising tax rates.
The challenge is building this bucket during your working years, because once you’re retired, contributing to a Roth often triggers a significant tax bill.
The Power of Choice
Here’s where tax diversification becomes powerful. Imagine you need $100,000 annually from your investments during retirement. If all your money sits in a traditional IRA, that entire $100,000 gets taxed as ordinary income.
But with diversification, you might withdraw $40,000 from a Roth, $30,000 from your traditional IRA, and $30,000 from your taxable account. This approach could keep you in a lower ordinary income tax bracket and reduce your overall tax burden.
Tax diversification isn’t just about minimizing taxes in any single year – it’s about smoothing your tax burden across your entire retirement.
Strategic Implementation
You might have low-income years right after retirement, before Social Security begins or RMDs kick in. These present prime opportunities for Roth conversions – moving money from a traditional IRA to a Roth IRA, paying taxes now while your rate is lower, then locking in tax-free growth going forward.
For high earners still in their peak earning years, the decision between traditional and Roth contributions requires careful consideration. If you believe taxes will rise in the future, paying taxes now and securing tax-free income later could prove wise. Many people split their contributions between traditional and Roth accounts to hedge against uncertainty.
Even if you’re approaching retirement with most of your savings in tax-deferred accounts, you still have options. Small Roth conversions, strategic RMD management, or using taxable income for spending while delaying Social Security can all help improve your tax diversification.
Estate Planning Benefits
Tax diversification also impacts your legacy planning. Different accounts are taxed differently when passed to heirs. Roth IRAs are among the best assets to leave beneficiaries because they can stretch tax-free growth for up to 10 years. Traditional IRAs, however, pass along a tax liability.
Building your Roth bucket benefits both your retirement and your family’s financial future.
Getting Started
Begin by reviewing your current retirement savings distribution across the three tax buckets. If you’re heavily concentrated in tax-deferred accounts, consider exploring Roth conversions, increasing taxable savings, or adjusting future contributions.
Think ahead to your projected retirement income. Will you have a pension? When will you claim Social Security? What will your RMDs look like? Understanding these factors helps you design a withdrawal strategy that minimizes taxes and maximizes flexibility.
Tax diversification represents a core component of smart retirement planning. It provides options in a world where tax policy changes, helps you avoid unnecessary taxes, and gives you control over your financial future.
You’ve spent years building your wealth. A thoughtful tax diversification strategy helps ensure you keep more of what you’ve worked so hard to save.
Take the Next Step
Ready to evaluate your tax diversification strategy? I can help you analyze your current savings distribution, identify opportunities for improvement, and create a plan that minimizes your lifetime tax burden.
Click here to get started.
