When most people think about retirement planning, they focus on one big question: “Have I saved enough?” That question matters, but it is only part of the story. The next question may be just as important: “How will my retirement income be taxed?” A retiree with a large account balance may still feel disappointed if too much of each withdrawal is reduced by taxes. That is why tax diversification deserves a place in every serious retirement income conversation.
Tax diversification means building retirement assets in different tax categories, so you have choices later. Instead of relying only on pre-tax retirement accounts, a well-designed plan may include pre-tax money, Roth money that can potentially be withdrawn tax-free, and taxable nonretirement accounts where long-term gains may receive a potentially more favorable capital gains treatment. The goal is not to avoid taxes entirely. The goal is to create flexibility, manage taxable income year by year, and help preserve more spendable income in retirement.
Today’s Tax Rates in Historical Perspective
Current tax rates can feel permanent because they are familiar, but history shows otherwise. The U.S. tax system has changed many times since the modern income tax began in 1913, with the highest recorded tax rate at 94% during World War II. Historical tax-rate charts can be helpful because they make one point visible: tax rates are not fixed. They are the result of legislation, economic conditions, and political priorities. Ask yourself, if future tax rates are higher than today’s, would you rather have all your retirement income exposed to ordinary income tax rates, or would you prefer to have choices?
Why Tax Diversification Matters
Many savers accumulate most of their retirement assets in traditional IRAs, 401(k)s, 403(b)s, TSP’s or similar employer plans. These accounts can be excellent tools during working years because contributions may reduce current taxable income or grow tax-deferred. But the tax bill is not eliminated; it is postponed. When money comes out of a traditional IRA or other pre-tax account, distributions are generally included in taxable income, and early distributions may also be subject to penalties in certain situations.
That creates what I call “tax concentration risk.” If most retirement income must come from one pre-tax bucket, the retiree has limited control over the tax result. Required minimum distributions, pension income, Social Security, portfolio withdrawals, and one-time expenses can all combine in ways that push income higher than expected. In some years, even a reasonable spending need can create an uncomfortable tax surprise. With multiple tax buckets, retirees can be more strategic about which account to use, when to use it, and how much taxable income to recognize.
Tax diversification can also help surviving spouses. After the first spouse dies, the survivor may move from married filing jointly to single tax brackets, which can make the same income more heavily taxed. Having Roth assets or taxable assets may give the surviving spouse more room to manage taxable income. It may also help heirs, depending on account type, beneficiary rules, and estate planning goals. While tax laws can change, flexibility generally remains valuable.
The Three Retirement Tax Buckets
A balanced retirement income plan often considers three broad tax buckets. The first is the pre-tax bucket: traditional IRAs, traditional 401(k)s, and other retirement plans funded with pre-tax dollars or tax-deductible contributions. These accounts may help reduce taxable income during working years, but withdrawals are generally taxed as ordinary income. The second is the Roth bucket. Roth IRA contributions are not deductible, but if the rules are met, qualified distributions can be tax-free.
The third bucket is the taxable, non-retirement bucket, such as a brokerage account or individually owned investments. These accounts do not provide the same tax deferral as retirement accounts, but they can be valuable because long-term capital gains and qualified dividends may be taxed differently from ordinary income. Taxable accounts can also provide liquidity before retirement account rules apply and may help fund large expenses, or early retirement, without forcing a larger pre-tax retirement withdrawal. None of the three buckets is automatically the best option in every circumstance, rather their power comes from how they work together.
Roth Conversions: Paying Tax by Choice
A Roth conversion is one strategy that can help build the Roth bucket. In a Roth conversion, money is moved from a pre-tax retirement account into a Roth account. The converted amount is generally included in taxable income in the year of conversion, but once inside the Roth account, future qualified withdrawals may be tax-free.
For many retirees and pre-retirees, the best conversion years may occur when income is temporarily lower. This could be after retirement but before Social Security begins, before pensions start, or before required minimum distributions create additional taxable income. During these years, a retiree may be able to “fill” a lower tax bracket with partial Roth conversions rather than waiting to withdraw the same dollars later at an unknown future rate. This does not make the conversion tax-free; it makes the tax decision intentional. The retiree chooses how much income to recognize and when.
Roth conversions should be planned carefully. A conversion can increase adjusted gross income, affect Medicare premium surcharges (IRMAA), increase the portion of Social Security that is taxable, or interact with deductions and credits. It may also create state income tax consequences. For that reason, conversion planning is usually best done annually with a financial advisor and tax professional. The right question is rarely “Should I convert everything?” A better question is “How much can I convert this year without creating an avoidable tax problem?”
Action Steps to Consider Now
Preparing for tax diversification does not have to happen all at once. Start by identifying how much of your retirement savings is in pre-tax, Roth, and taxable accounts. Next, estimate future income sources such as Social Security, pensions, annuities, required minimum distributions, and portfolio withdrawals. Then look for years when income may be lower and Roth conversions may be appropriate. Review whether new savings should go to pre-tax, Roth, or taxable accounts based on your current bracket, expected future income, and cash-flow needs. Finally, revisit the strategy annually because tax laws, markets, and personal circumstances change.
The key is to be proactive. Waiting until retirement can limit your options, especially once required distributions begin and taxable income becomes harder to manage. Building tax diversification before and during the early retirement years may help reduce tax surprises, create more predictable after-tax income, and provide greater confidence in your retirement plan. Taxes may be one of the largest expenses retirees face, but with thoughtful planning, they do not have to be left entirely to chance.
Advisory services are offered through Five Speed Financial Planning LLC, d.b.a. Schulz Financial Group, a SEC Registered Investment Advisor. All content is for information purposes only and is not intended to provide any tax or legal advice or provide the basis for any financial decisions, nor is it intended to be a projection of current or future performance or indication of future results. Investing involves risk, including the possible loss of principal and planning outcomes are not guaranteed. Please consult with a qualified professional for advice tailored to your individual circumstances.