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For most of your career, saving pretax dollars in such accounts as a 401(k) or IRA has been a smart move. You got the upfront tax deduction, your money grew tax-deferred, and it felt like the right play year after year.
But once retirement hits, that same strategy can become a double-edged sword. Suddenly, every dollar you withdraw is taxable income.
If most of your nest egg is sitting in pretax accounts, you’ve effectively made an unspoken deal with your “silent partner,” Uncle Sam, to decide how much of your retirement he’ll own.
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The hidden risk of a one-bucket strategy
Many preretirees approach retirement with 80% to 90% of their savings in pretax accounts such as 401(k)s and IRAs. That concentration limits flexibility and can create costly ripples once withdrawals begin.
Every time you take money out, your taxable income rises, and that affects:
Those are just the obvious effects. A lack of tax diversification also creates deeper planning challenges, such as:
- Leaving a surviving spouse paying higher taxes on less income, since they move to single-filer brackets and lose one Social Security benefit
- Forcing you to sell more in down markets to generate the same income — each dollar fully taxable
- Creating challenges for heirs, who must drain inherited retirement accounts within 10 years under current rules
That’s why spreading your savings across different “tax buckets” — pretax, Roth and taxable — can be one of the most valuable strategies in retirement planning. It’s not about avoiding taxes; it’s about gaining flexibility to choose when and how you pay them.
You can’t control markets, tax laws or Washington’s next move. But with a well-diversified tax strategy, you can give yourself more options and fewer surprises.
What tax diversification really means
Think of tax diversification like crop rotation for your retirement income. Instead of relying on one field for every season, spread your resources so something is always ready for harvest.
Here’s a quick breakdown of the three main “tax buckets”:
- Pretax accounts (401(k), traditional IRA). Contributions are deductible, but every dollar withdrawn is taxed as income
- Tax-free accounts (Roth IRA, Roth 401(k)): You pay the taxes upfront, so qualified withdrawals are tax-free
- Taxable accounts (brokerage, savings, CDs): You pay ongoing taxes on dividends and capital gains, but you have more control over when gains are realized
The right mix of all three gives you the ability to choose which bucket to pull from each year, depending on what the tax landscape and your life look like.
How to build tax diversification over time
Tax diversification doesn’t happen overnight. Here are a few practical ways to build it up over time:
Consider strategic Roth conversions. Roth conversions allow you to move money from pre-tax to Roth accounts and pay taxes now instead of later.
Done thoughtfully, especially in down markets or lower-income years, they can help reduce future taxable income and build a pool of tax-free assets.
Use taxable accounts intentionally. If you’re already retired or transitioning out of work, consider funding taxable accounts with investments that generate qualified dividends or long-term capital gains.
These are often taxed at lower rates and give you another layer of flexibility.
Manage withdrawals across buckets. Each year, review the source of your income. Maybe that means pulling part of your cash flow from your IRA and part from your Roth or brokerage account.
Blending sources can help you stay in a lower tax bracket and minimize unwanted tax triggers.
Watch for opportunity windows. Big life transitions, retiring, selling a business or the years before Social Security and required minimum distributions (RMDs), often create windows in which your income dips temporarily.
Those years can be prime opportunities to convert to a Roth or rebalance your accounts without pushing yourself into a higher bracket.
The payoff: Control and confidence
When your savings are spread across multiple tax buckets, you gain flexibility. You can adjust withdrawals based on markets, tax policy or personal goals. It’s not about trying to predict what Congress will do next; it’s about giving yourself options no matter what happens.
A tax-diversified plan also helps soften the blow of future tax changes. If rates rise, you can lean on your Roth or taxable accounts. If rates fall, you can tap more from pretax dollars. The point isn’t to outguess the IRS; it’s to take control of your lifetime tax bill.
Let’s consider a simple example: two retirees, each with $2 million saved.
- Retiree A has everything in a traditional 401(k). Every $1 withdrawn is taxed as income.
- Retiree B has a mix — $1.2 million pretax, $500,000 Roth and $300,000 taxable.
Both need $100,000 a year in income. Retiree A might need to withdraw the full $100,000 from the IRA and pay income tax on all of it. Retiree B can take $60,000 from pretax, $20,000 from Roth and $20,000 from taxable, lowering taxable income, avoiding IRMAA surcharges and keeping more money.
That’s the difference tax diversification makes. It’s not about chasing higher returns; it’s about smarter withdrawals and fewer surprises.
Turning savings into strategy
A strong retirement plan isn’t just about saving enough; it’s about knowing how to access those savings efficiently. If all your retirement wealth is sitting in one tax bucket, now’s the time to start shifting.
Tax diversification gives you flexibility, control and confidence, three things every retiree deserves.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
