Ask a CFP® – Foundational Questions Edition: What Is Tax Diversification (and How Can It Help)?
As we wrap up our Account Types Series, we want to bring everything together by exploring tax diversification — how different types of accounts can work together to create long-term flexibility.
When most people think about diversification, they picture spreading investments across asset classes like stocks, bonds, or alternative assets to help manage investment risk.
But tax diversification is arguably just as important, especially as you approach or enter retirement. It helps you manage tax risk — the risk that future tax laws or changes in your income could affect how much of your retirement income you get to keep. Just as investment diversification provides flexibility in different market environments, tax diversification gives you flexibility in different tax and income environments.
What Is Tax Diversification?
In simple terms, tax diversification means spreading your savings across different account types that are taxed in different ways.
That mix usually includes:
Tax-deferred accounts: like Traditional IRAs and 401(k)s
Tax-free accounts: like Roth IRAs and Roth 401(k)s
Taxable (non-qualified) accounts: like a regular brokerage account
Having funds spread out among these gives you options when you start drawing income in retirement. With the exception of Required Minimum Distributions (RMDs) from pre-tax retirement accounts (generally starting at age 73 under current law and rising to 75 for those born in 1960 or later), you can often choose which bucket to pull from based on what makes the most sense for your tax situation that year. Roth IRAs have no RMDs for the original owner.
Each type of account serves a purpose. The key is using them together strategically. If you’d like to learn more about the differences between Traditional and Roth accounts or about how taxable brokerage accounts are taxed, I’d encourage you to check out our other posts on these:
Traditional vs. Roth Account: Key Tax & RMD Differences — Sanders Retirement Planning
What Is a Taxable Brokerage Account? Potential Benefits & Tax Basics — Sanders Retirement Planning
The Goal: Minimize Taxes Over Your Lifetime, Not Just This Year
It’s easy to focus on paying as little tax as possible right now. But in retirement, a better goal is usually to minimize your total taxes over your lifetime.
That means looking at your long-term picture, not just this year’s tax return, and managing your income so you avoid unnecessary spikes into higher tax brackets or future Required Minimum Distributions (RMDs) that could push you into higher rates later.
Depending on your priorities, it can also make sense to think beyond your own lifetime tax bill — for example, minimizing taxes for a surviving spouse or other beneficiaries.
A Quick Refresher: How Tax Brackets Work
The U.S. tax system is progressive, which means you don’t pay the same rate on every dollar of income. Think of it like filling a series of buckets:
The first bucket effectively fills at 0% (thanks to the standard deduction)
The next at 10%
Then 12%, and so on
When you fill one bucket, the next dollar of income “spills” into the next bucket, which gets taxed at a higher rate. That’s why retirees often try to “fill” their lower brackets intentionally — for example, by taking enough income to stay within the 12% bracket, but not so much that they spill into 22%.
Ultimately, what counts as a “low” or “high” bracket is all relative and depends on your overall plan. This is where creating a long-term retirement income and tax projection can be so helpful. It helps you see which brackets you might fill later, so you can make smart use of the ones available to you today.
How Tax Diversification Helps You Manage Those Buckets
Having multiple account types gives you more control over which “tax buckets” you fill each year.
In low-income years, you might:
Take more from a Traditional IRA or 401(k) to fill lower brackets efficiently, or
Realize long-term capital gains from your taxable account while staying in a low bracket.
In higher-income years, you might:
Pull from Roth accounts, which don’t increase taxable income, or
Hold off on realizing gains or conversions until a future year with a lower effective rate.
It’s like having a toolkit — different tools for different tax situations that can help you keep more of your hard-earned savings over time.
Opportunities During Low-Income Years
Lower-income years can also open doors for strategies such as:
· Roth Conversions — moving funds from a Traditional IRA to a Roth IRA to pay tax now and potentially avoid higher rates later.
· Capital-Gain Harvesting — realizing gains from a taxable account while in the lower capital gains brackets (potentially 0% or 15%).
These moves can help reduce future taxable income and increase flexibility. That said, each comes with nuances and potential ripple effects, which is why we suggest working closely with your qualified tax or financial professional before deciding if they make sense for you.
Other Real-World Considerations
Taxes aren’t the only thing to watch. Higher income can also raise other costs, such as:
· IRMAA, which increases Medicare premiums,
· ACA premium credit phase-outs for those under 65, and
· Social Security taxation or other income-based programs like college aid.
A well-diversified tax strategy helps you manage these thresholds intentionally.
A Quick Note on Beneficiaries
Tax diversification can also help with legacy planning.
For example:
Traditional accounts are generally taxable to beneficiaries and, under current law, most non-spouse heirs must withdraw the funds within 10 years.
Roth accounts can typically be inherited tax-free to beneficiaries (if qualified), though non-spouse heirs are also subject to the 10-year withdrawal rule.
Taxable accounts often receive a step-up in cost basis, meaning unrealized gains can disappear at death.
If your goal is to maximize the after-tax value of what you leave behind, it can sometimes make sense to draw from Traditional accounts during your lifetime while allowing taxable (non-qualified) assets to continue benefiting from that potential step-up in basis, especially if those investments have grown significantly since you purchased them.
Alternatively, if part of your plan involves leaving assets to a qualified charity, you might focus on spending taxable (non-qualified) and Roth assets during your lifetime, leaving more Traditional assets to the charity. A charity won’t mind the taxable nature of Traditional accounts since it doesn’t pay income tax.
The best approach depends on your broader plan, current tax brackets, and estate goals, so coordinating with your tax and financial professionals is key.
It’s About Control, Not Guesswork
The future of tax law is uncertain — but your ability to respond to it doesn’t have to be.
Tax diversification gives you some sense of control:
Control over which accounts you draw from when markets or tax laws shift.
And subsequently:
Control over when you pay taxes,
And control over how much you pay.
That flexibility is what allows you to adapt, rather than react, as your financial life and the tax landscape evolve.
Putting It All in Perspective
Tax diversification can be an important tool in a well-rounded retirement plan — but diversification at any cost isn’t the goal either. Like most financial strategies, its value depends on your situation, your income sources, and how tax laws evolve over time.
There are certain situations where having multiple account types can make a big difference. For example:
When you need to make a large one-time withdrawal that would otherwise push Traditional IRA distributions into a much higher tax bracket.
During low-income years when you can strategically realize long-term capital gains or complete Roth conversions at favorable rates.
If you’re under age 65 and want to keep income low enough to qualify for ACA premium credits or other income-based benefits.
Ultimately, while flexibility is valuable, it’s equally important to achieve it in a reasonable way. For example, prioritizing Roth contributions or conversions during high-tax-rate years purely for the sake of tax diversification rarely leads to the best outcome.
Your specific tax rates — both current and expected future rates — are what matter most. Understanding where you stand today and modeling how that could change over time is the best way to decide how much tax diversification is right for you.
TL;DR
Here’s a quick summary if you just want the highlights.
Tax diversification means having a mix of Traditional, Roth, and taxable accounts to help you control how and when you pay taxes.
It can help you:
Smooth out taxes over time instead of facing spikes,
Take advantage of lower tax years,
Avoid unnecessary RMD or IRMAA surprises, and
Pass assets to beneficiaries more efficiently.
It’s not about predicting future tax law, it’s about preparing for it.
With tax diversification, you gain flexibility, control, and peace of mind throughout retirement.
Final Thoughts
Your investments may grow and your income needs may change, but tax diversification gives you some power to adapt no matter what the future holds.
All content is for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. Sanders Retirement Planning LLC does not provide legal or tax advice. Please consult your financial advisor, tax professional, or attorney regarding your specific situation. The information provided is believed to be from reliable sources, but its accuracy and completeness cannot be guaranteed. Links to third-party sites are for informational use only and do not constitute an endorsement. Past performance is not indicative of future results. All investments carry risk, including the potential loss of principal. Advisory services offered through Sanders Retirement Planning LLC, a Registered Investment Adviser. Services may not be available in all jurisdictions.