What Is Tax Diversification and Why Should You Care?

For many future retirees, taxes can be a surprisingly large part of the retirement budget. Tax diversification refers to holding savings across different types of accounts that are taxed in different ways. Instead of relying on a single tax treatment, tax diversification allows retirees to spread income across multiple “tax buckets,” giving them more flexibility to manage taxes over time.

This flexibility matters because research consistently shows that higher-income retirees often pay a meaningful share of their retirement income toward taxes. A study from Lincoln Financial Group found that retirees with six-figure incomes spent roughly 31% of their retirement dollars on taxes, highlighting why proactive tax planning matters well before retirement. ¹

For mid-career professionals and pre-retirees with strong earnings today, tax diversification can be an important way to prepare for an uncertain tax future while maintaining greater control over retirement income later on.

Defining Tax Diversification

Tax diversification is the practice of spreading retirement savings across accounts with different tax rules. Some accounts are funded with money that has already been taxed, others allow taxes to be deferred until withdrawal, and some offer tax-free growth and withdrawals under certain conditions.

Rather than trying to predict future tax rates, tax diversification focuses on flexibility. By having multiple account types available, retirees can decide which accounts to draw from based on their income needs and tax situation each year. This approach helps reduce the risk of being forced into higher tax brackets later in life due to limited withdrawal options.

Types of Tax Buckets Explained

Most retirement savings fall into one of three broad tax buckets.

Taxable Accounts

Taxable accounts are funded with after-tax dollars. These include brokerage accounts, savings accounts, and certificates of deposit. Because the money is contributed after taxes are paid, there is no upfront tax deduction.

Earnings in taxable accounts may be subject to taxes along the way. Interest and dividends are typically taxed in the year they are earned, while capital gains taxes may apply when investments are sold for a profit. Long-term capital gains are often taxed at lower rates than ordinary income, which can make taxable accounts useful in retirement income planning.

One advantage of taxable accounts is flexibility. Funds can generally be accessed at any time without penalties, making them useful for covering expenses or supplementing income without increasing retirement account withdrawals.

Tax-Deferred Accounts

Tax-deferred accounts include traditional 401(k) plans, traditional IRAs, and similar employer-sponsored retirement plans. Contributions to these accounts are often made with pre-tax dollars, which can reduce taxable income in the year of contribution.

The tradeoff comes later. Withdrawals from tax-deferred accounts are taxed as ordinary income in retirement. In addition, required minimum distributions (RMDs) eventually force account holders to withdraw a certain amount each year, whether the income is needed or not.

For individuals who accumulate large balances in tax-deferred accounts, these withdrawals can increase taxable income later in life.

Tax-Free Accounts

Tax-free accounts are funded with after-tax dollars, but qualified withdrawals are not taxed. Roth IRAs and Roth 401(k)s are the most common examples. While contributions do not reduce current taxes, earnings and withdrawals can be tax-free if requirements are met.

Health Savings Accounts (HSAs) are another example when used properly. Contributions may be tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are also tax-free. This combination makes HSAs a valuable tool for addressing healthcare costs in retirement.

Tax-free accounts can play an important role in managing retirement income because withdrawals do not increase taxable income.

Why Tax Diversification Matters in Retirement

In retirement, the source of income matters just as much as the amount. Withdrawals from different tax buckets affect taxable income differently, which can influence several important factors at once.

Higher taxable income can:

• Increase the portion of Social Security benefits subject to taxation

• Push retirees into higher federal or state tax brackets

• Trigger higher Medicare premiums through Income-Related Monthly Adjustment Amounts (IRMAA)

Medicare IRMAA surcharges apply when income exceeds certain thresholds, and those thresholds are based on tax returns from two years prior. For higher-income retirees, even a single year of elevated income can result in higher Medicare premiums for a full year.

Tax diversification can help smooth income and reduce these spikes. For example, retirees who can combine withdrawals from tax-deferred, taxable, and tax-free accounts may be able to meet spending needs while keeping reported income below certain thresholds.

Research supports this approach. A study published in the Journal of Financial Economics found that in a progressive tax system with uncertain future tax rates, most households benefit from holding both traditional (tax-deferred) and Roth (tax-free) retirement accounts. ² This mix allows retirees to adapt withdrawals as tax laws and personal circumstances change.

Planning Considerations for Managing Future Taxes

Tax diversification is most effective when it is addressed well before retirement. For individuals still in their earning years, several general principles can help guide planning.

Balancing Contributions Across Account Types

Rather than directing all savings into one type of account, many savers benefit from contributing to both tax-deferred and tax-free accounts over time. This creates flexibility later and reduces reliance on a single tax strategy.

Building Tax-Free Income Sources

Tax-free accounts can be especially valuable for managing taxable income in retirement. Having access to income that does not increase adjusted gross income can help retirees stay below key tax and Medicare thresholds.

Maintaining Taxable Savings for Flexibility

Taxable accounts can provide liquidity and planning flexibility. Because withdrawals are not restricted by age rules or required distributions, they can be useful for managing cash flow and minimizing taxable income in certain years.

Considering Timing of Income and Allocation of Assets

Some retirees experience lower-income years between leaving work and starting Social Security or required distributions. These years may offer opportunities to reposition assets in a tax-aware way, though any such decisions should be evaluated carefully.

Monitoring Medicare and Tax Thresholds

Because Medicare premiums and tax brackets are sensitive to income levels, planning withdrawals with these thresholds in mind can help avoid unintended cost increases.

Reviewing Plans Regularly

Tax laws, income needs, and personal goals change over time. Revisiting tax diversification strategies periodically helps ensure they remain aligned with long-term objectives.

Final Thoughts

Tax diversification is about creating options. By spreading savings across taxable, tax-deferred, and tax-free accounts, retirees gain more control over how and when taxes are paid. For higher earners and those who may face higher tax brackets or Medicare surcharges in retirement, this flexibility can make a meaningful difference.

While the concepts are straightforward, applying them to

a real-life situation often requires careful analysis. If you would like help evaluating how tax diversification fits into your broader retirement strategy, consider reaching out for a conversation. A personalized review can clarify your options and help you make informed decisions with confidence.

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This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

1. Lincoln Financial Group, The Lincoln Retirement Power® Study (Radnor, PA: Lincoln Financial Group, 2018).

2. Jeffrey R. Brown, John B. Shoven, and Clemens Sialm, “Asset Location and Tax Efficiency,” Journal of Financial Economics 88, no. 3 (2008): 457–480.