Managing Tax Risks with Diversification

One of the fundamental principles of investing is managing the volatility of investment assets by building a diversified portfolio. Allocating your investments across different asset classes can provide the steady income stream you need as you transition into retirement and rely on your savings and investments.

The goal is to generate a sustainable, risk-adjusted return, one that supports your lifestyle without causing unnecessary stress. This means selecting investments that offer both peace of mind and the potential for growth, so you don’t miss out on future opportunities.

Building, monitoring, and updating your portfolio to stay in line with market shifts is a continuous task. When you're ready to withdraw funds, you'll want to ensure you're withdrawing enough for your needs while still leaving room for your investments to grow. This process involves carefully considering risk, returns, historical performance, and your personal risk tolerance.

But once you've addressed these factors, there’s yet another consideration—how taxes will impact your withdrawals.

Depending on the type of account your funds are held in, your tax liability could erode your investment gains significantly.

Understanding the Basics of a Tax Diversification Strategy

As you prepare for retirement, there are three primary types of accounts you can contribute to. Each type has distinct tax advantages and is taxed at different stages, which means you can optimize your tax strategy by diversifying your investments among these accounts. Being strategic about how and when you withdraw funds in retirement can maximize the benefits of each account type, both while you're working and once you're retired.

1. Tax-Deferred Accounts These accounts, such as traditional 401(k), 403(b), or IRA, allow you to invest pre-tax dollars. Your contributions lower your taxable income for the year, providing tax savings. Your savings grow tax-deferred, meaning you don't pay taxes on the gains until you withdraw them. At withdrawal, both the contributions and growth are taxed as ordinary income. If your retirement tax bracket is lower than your current working tax bracket, these accounts allow you to withdraw funds at a reduced tax rate. However, one downside is that your investment choices are typically limited to the options provided by your retirement plan.
2. Taxable Accounts Taxable brokerage accounts offer the most flexibility. These are funded with after-tax dollars, and you can choose from a wide range of investment options. Since you’ve already paid taxes on the money you invest, you only owe taxes on the gains when you sell investments within your account, or from dividend and interest income generated. These are taxed at either short-term or long-term capital gains rates, depending on how long you’ve held the investments.
3. Tax-Free Accounts Tax-free accounts, such as Roth IRAs, are funded with after-tax dollars, so there are no taxes when you withdraw funds. The main benefit is that your investments grow tax-free, meaning there are no taxes on either the income or capital gains when you take distributions in retirement.

By utilizing all three types of accounts as you save for retirement, you may be able to reduce your overall tax burden when combined with a drawdown plan tailored to you.

You can contribute up to $7,000 to an IRA or $23,500 to a 401(k) if you’re under age 50. If you’re 50 or older, you can take advantage of catch-up contributions, allowing an additional $1,000 for an IRA or $7,500 for a 401(k). (These numbers are based upon the contribution limits in 2025, and may be increased in future years).

Once you hit your contribution limits, or if you have a significant goal you are saving towards that occurs before you retire, consider opening a taxable brokerage account to continue saving. These accounts offer flexible investment options and further diversify your tax strategy.

If you earn too much to contribute directly to a Roth (over $161,000 for single filers in 2024), you might consider waiting until retirement, when your income is lower, to convert to a Roth. You may also consider utilizing what's known as a 'Back-Door' Roth contribution.

Crafting a Flexible Plan

So, how do you use these three account types to minimize your tax liability as much as possible? Let’s look at a hypothetical example of withdrawing $150,000 from investments in retirement, assuming a 25% tax rate.

If you take the entire amount from a tax-deferred 401(k), you’ll be left with $112,500 after taxes.

But what if you withdraw from all three accounts?

• Withdraw $75,000 from the tax-deferred account. After paying 25% in taxes, you’ll receive $56,250.
• Sell $50,000 in long-term investments from your taxable account. At a 15% capital gains tax rate, your after-tax proceeds will be $42,500.
• Finally, take $25,000 from your Roth account, where there’s no tax due.

In this scenario, you’d receive $123,750 after taxes, an additional $11,250 to help fund your retirement.

Additional Tax Benefits Through Diversification

You may also be able to further reduce your tax burden by using tax-loss harvesting in your taxable accounts, which can offset some capital gains or ordinary income. Furthermore, the type of assets you hold in each account can impact your taxes. For instance, you could place municipal bonds in your taxable account and taxable bonds in a tax-deferred account to lower your overall tax exposure.

The Bottom Line

By creating a diversified tax strategy, you can keep more of your income in your pocket. Combined with a well-thought-out investment allocation, this approach can help you achieve the retirement lifestyle you desire while minimizing taxes.

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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

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