Tax Diversification Strategies for Retirees: Building a Reliable, Tax-Efficient Retirement Plan
Introduction
At times, preparing for a financially secure future can feel daunting. But having a well-thought-out plan can help you gain stability and control. At Two Waters Wealth Management, we believe in creating personalized, tax-smart retirement plans that help our clients feel secure, no matter what’s going on in the world. Tax diversification is a key part of that plan and one of the most powerful ways to reduce uncertainty in retirement.
Our SMART Retirement Blueprint was designed with one goal in mind: to help you retire with confidence. Today, let’s look at how tax diversification fits into that framework to create more reliable retirement outcomes.
What is Tax Diversification?
Tax diversification is about balancing your retirement savings across different tax “buckets”—taxable, tax-deferred, and tax-free accounts. Think of each bucket as a tool you can use in retirement to reduce taxes and gain flexibility. This approach gives you more control, especially during times of change, so you’re better prepared to manage what’s within your power.
One of the guiding principles I often discuss with clients is the benefit of keeping your options open. We want you to be in a position where your back isn’t against the wall financially, so you retain the autonomy to make choices in retirement. Tax diversification is one way we achieve that. With a diversified approach, you’re not locked into a single type of account or tax rate, which helps you adjust as life unfolds and make decisions on your own terms.
Why Tax Diversification Matters for Retirees
If your retirement savings are primarily in tax-deferred accounts like 401(k)s or traditional IRAs, you may be more exposed to tax surprises later on. Required minimum distributions (RMDs) can push you into a higher tax bracket and increase the taxability of Social Security benefits. By balancing your savings across different types of accounts, tax diversification helps protect you from these surprises, creating stability even in uncertain times.
The Three Buckets of Tax Diversification
At Two Waters Wealth Management, we guide clients through three main types of tax-advantaged accounts to create a tax-diversified retirement plan. Here’s a look at each bucket and how they fit into our SMART Retirement Blueprint.
1. Taxable Accounts
Examples: Brokerage accounts, individual stocks, mutual funds, or savings accounts.
Pros: Flexibility in withdrawal timing and fewer restrictions on contributions or withdrawals. Only capital gains and dividends are taxed, often resulting in lower tax rates compared to ordinary income.
Cons: Investment gains are subject to capital gains taxes, and high portfolio turnover can generate annual taxable events.
Taxable accounts are often ideal for shorter-term savings goals in retirement, providing a flexible way to fund new pursuits, like starting a business or investing in real estate. Drawing from taxable accounts first can also help keep taxable income lower early in retirement, preserving the value of tax-deferred accounts for later.
2. Tax-Deferred Accounts
Examples: 401(k)s, traditional IRAs, 403(b)s.
Pros: Contributions reduce taxable income during working years, enabling tax-deferred growth.
Cons: Withdrawals in retirement are taxed as ordinary income, and RMDs begin at age 73, which can force higher tax rates and reduce tax efficiency.
Tax-deferred accounts are a powerful savings tool, but in retirement, the tax deferral ends, which can lead to unexpected tax bills. Converting a portion of tax-deferred savings into a Roth IRA over time can help spread out taxes and increase your control. Roth conversions are particularly beneficial for retirees in lower-income years, allowing them to “rip the bandaid” when the math supports it.
3. Tax-Free Accounts
Examples: Roth IRAs, Roth 401(k)s, Health Savings Accounts (HSAs), Permanent Life Insurance (such as Whole Life or Indexed Universal Life).
Pros: Qualified withdrawals are tax-free, Roth accounts have no RMDs, and HSAs offer a unique triple tax benefit for healthcare expenses. Permanent life insurance often includes accelerated death benefit features, allowing policyholders to access a portion of the death benefit tax-free for qualified healthcare or impairment needs.
Cons: Contributions are made with after-tax dollars, meaning no immediate tax deduction. HSAs have specific eligibility requirements and contribution caps, while permanent life insurance policies require meeting health criteria, which may impact eligibility or premiums.
Here’s how each type of tax-free account supports a secure and flexible retirement:
Roth IRAs and Roth 401(k)s: These accounts allow tax-free growth and tax-free withdrawals in retirement, with unique benefits for retirees and their heirs:
No Required Minimum Distributions (RMDs): Roth IRAs have no RMDs, meaning you’re not required to draw funds during your lifetime, allowing Roth accounts to grow tax-free over time.
Favorable Treatment for Heirs: Roth IRAs are highly advantageous for heirs compared to tax-deferred accounts, as beneficiaries can receive Roth funds tax-free. While inherited Roth IRAs follow a 10-year withdrawal rule, heirs can take distributions without income tax, providing a significant advantage over tax-deferred inheritances where withdrawals are taxed as ordinary income.
Health Savings Accounts (HSAs): Known for their “triple tax advantage,” HSAs offer tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified healthcare expenses. Key restrictions include:
Eligibility Requirements: You must be enrolled in a high-deductible health plan (HDHP) to contribute to an HSA.
Contribution Caps: Annual contributions are capped ($4,150 for individuals and $8,300 for families in 2024, plus a $1,000 catch-up for those 55+). Although these limits may restrict total savings, maxing out an HSA can be invaluable for covering healthcare costs without affecting other retirement assets.
Permanent Life Insurance: Permanent life insurance offers unique tax-free benefits that can enhance retirement plans. Whole Life and Indexed Universal Life (IUL) policies build cash value over time, which can be accessed through loans or withdrawals, generally without triggering taxes if structured correctly.
Tax-Free Legacy Planning: Permanent life insurance provides a tax-free inheritance, making it an effective vehicle for legacy planning.
Accelerated Death Benefit for Healthcare Needs: Many policies include an accelerated death benefit feature, allowing policyholders to access a portion of the death benefit tax-free for healthcare or long-term care expenses. This can be a flexible source of funds in retirement, helping you cover unexpected medical costs without affecting other assets.
Added Retirement Flexibility: Cash value can also provide supplemental income, accessed through loans or withdrawals without increasing taxable income.
Health Requirements: Permanent life insurance policies have health requirements, which may affect eligibility or premiums. Planning ahead can help you secure coverage at favorable rates.
Key Tax Diversification Strategies for Retirees
1. Roth Conversions
Roth conversions can help manage future tax liabilities. By converting portions of a traditional IRA to a Roth IRA in low-income years, you can spread out tax costs and reduce future RMDs. While there’s an upfront tax cost, the long-term benefits often justify this strategy, as the funds grow tax-free in the Roth account. For many, this is the “rip-the-bandaid” moment that leads to significant tax savings over time.
2. Tax-Efficient Withdrawal Strategies
The order in which you withdraw from each tax bucket impacts how much of your income is subject to taxes. Often, a tax-conscious withdrawal strategy involves drawing from taxable accounts first, then tax-deferred accounts, and finally tax-free Roth accounts. This approach helps keep taxable income lower, reducing Social Security taxability and minimizing Medicare premium impacts.
3. Maximizing Health Savings Accounts (HSAs)
For those still working with high-deductible health plans, maximizing contributions to an HSA offers a triple tax advantage. HSAs can be an invaluable resource in retirement, covering medical expenses without adding to taxable income and preserving other assets.
4. Charitable Giving Strategies
For retirees who prioritize charitable giving, Qualified Charitable Distributions (QCDs) from IRAs allow you to meet RMD requirements without impacting taxable income. This strategy can benefit clients looking to support causes they care about while maintaining tax efficiency.
Tax Diversification as Part of the SMART Retirement Blueprint
At Two Waters Wealth Management, tax diversification is a cornerstone of our SMART Retirement Blueprint, supporting the “T” in Tax-Conscious Planning. This approach isn’t just about minimizing taxes but creating flexibility, control, and peace of mind as you transition from work to retirement. By balancing short-term tax savings with long-term growth, you can build a plan that sustains your lifestyle and helps you Retire Better.
Closing Thoughts: Retire with Clarity and Confidence
Effective tax diversification allows you to make the most of your retirement assets, reducing tax surprises and empowering you to focus on what matters most. Tax diversification is more than just a strategy—it’s a commitment to using your resources in a way that provides flexibility and peace of mind. Whether you’re ready to explore Roth conversions, need guidance on withdrawal strategies, or want a personalized plan that matches your retirement goals, Two Waters Wealth Management is here to help you achieve a retirement that’s secure, fulfilling, and financially smart.
Ready to explore tax diversification? Contact us at Two Waters Wealth Management and let’s discuss how we can help you create a tax-efficient retirement plan that lets you Retire Better.
