Tax diversification in retirement is just as important as investment diversification.
Regular readers will know that there are many paths to wealth. One of these paths is saving and investing steadily into your 401(k) or company retirement plan over a career. I think of this as the ‘get rich slowly‘ plan and it has proven to work throughout the past couple of generations of retirement savers.
The standard advice for this type of wealth building is to have a well diversified portfolio, with a mix of stocks and bonds, but heavier towards equities for long term growth. Starting young and investing a decent portion of your income over your career is a tried and true strategy that should work if the future is anything like the past.
One potential trap of this plan is that you may end up in an unfavorable tax situation. Just as it is important to diversify your investments in retirement, smart tax diversification in retirement can be just as valuable.
I saw this many times during my career as a financial advisor. Let me explain.
Meet Bob
Bob has had a long, successful career in corporate America and shows up in my office with an impressive portfolio like this:
Big Company 401(k): $1,400,000
Company Stock: $170,000
Cash: $90,000
Bob had excellent savings habits and did a good job choosing growth investments. He also got a boost from some company stock grants, but most of his investing happened inside his 401(k) plan.
However, he now has a tax problem.
Almost all of his retirement income will come from the 401(k), which is fully taxable as ordinary income. Additionally, these 401(k) distributions will likely cause most of his social security income to also be taxable. His higher income may even phase him out of certain deductions or cause him to pay higher medicare premiums (IRMAA)
Meet Sally
Sally was one of Bob’s peers at the company and also had excellent saving and investing habits. They both saved around the same amount, but Sally’s portfolio looks like this1:
Big Company 401(k): $900,000
Big Company Roth 401(k): $350,000
Roth IRA: $100,000
Taxable Portfolio: $270,000 (mix of company stock and tax-efficient diversified ETFs)
Cash: $90,000
While they both saved and invested diligently, Sally did a few things differently throughout her career.
When the company added a Roth 401(k) option a few years back she began directing her salary deferrals here instead of the pre-tax option. That means this savings was included in Sally’s income and therefore her tax bills were a bit higher during these years than when she contributed to the traditional 401(k). However, during retirement Sally’s Roth 401(k) will be a tax free source of cash flow as long as she follows the distribution rules.
Sally also started a Roth IRA early in her career and contributed for a few years until her income was too high to make a contribution. This account has grown tax-free for a couple of decades.
Finally, Sally managed to build up some taxable investments in a brokerage account along with her company stock, some of which she diversified into broad based equity ETFs.
Sally has significant control over what her tax bracket will be each year in retirement. She can manage her tax bracket through choosing which type of account (Fully taxable 401(k), Tax Free Roth IRA and 401(k), or taxable portfolio) to take distributions from. In other words, Sally has tax diversification in retirement.
She also should be in a stronger position to pass more along to her heirs.
Getting tax diversification in retirement means planning earlier in your career how you will allocate your retirement savings. There are tradeoffs that need to be taken into account (you will be deferring less tax each year for example) so you should run the numbers to make sure this makes sense for you.
The Financial Advisors I know are doing this for their clients each year and it is an underrated service. Whether you work with an advisor or want to do this on your own, looking into making your retirement more tax diversified is time well spent.
Certainly more valuable to you in the long term than trying to trade around 2025 tariff policy.
I hope this is helpful. If you have any questions about tax diversified investing or other content you’ve read here feel free to contact me. Please note that I am not a practicing advisor and do not give individual investment advice. I will try to point you in the right direction.
- *This example is not meant to be an exact representation. I made up the numbers to make a point. If you want to do this yourself, it is very important to take into account the balance of tax savings now vs. later. I did reduce the ‘tax diversified’ portfolio by $50k to account for more taxes paid earlier, but this also is just for illustration. Do your research. ↩︎
