You've probably heard of the concept of “diversifying your portfolio” before, probably when someone is talking about picking their investments. But diversification goes far beyond just investment choices and it's important to think about other ways it impacts your future and planning. One big way is something called Tax Diversification1 and it's a key factor for a successful retirement.
We need to start by looking at how things usually play out. Almost by default, the money most people have in retirement is going to get taxed when they need it. 401k account balances are taxed on withdrawal, Social Security benefits get taxed if you have other earned income coming in, rental income is taxed, part time work is taxed, and on and on and on…
But it doesn't have to be that way necessarily. There are ways to grow money so that when you access it in retirement years you don't have to pay taxes on it. The trick, of course, is that you have to plan ahead of time to make it work and understand the benefits of doing so.
Tax now vs later?
Most often, when discussing tax free money in retirement, what we're talking about is money that was subject to income tax when earned and then invested in some way that allows for the growth to be tax-exempt. This is contrasted with savings in, as a common example, 401k plans at work where the money you put in is not subject to income tax at the start, but the contributions and growth will be taxed on withdrawal later on. In other words, should you tax money now and let the smaller amount grow without being taxed in the future or should you avoid taxes now and let the larger amount grow, but owe taxes in that future instead?
What's interesting is that, mathematically, if your tax rate in the present and your tax rate in the future were the same, there's no difference in the amount of money you wind up getting to actually spend on retirement expenses. But that's a pretty monumentally huge “if” right there. No one knows what tax rates will be in the future, but they do change from time to time. In fact, as of this writing, they are set to change by default in 2026.
So part of tax diversification is trying to gauge whether you will be paying lower or higher taxes in the future. Which is hard to do! Not only are you guessing about tax rates in general, you're also projecting your own personal situation. What will your income be and what bracket will that be in? Did you include the right percentage of social security income? How about rental income that you're planning to have? That part time consulting gig you hope to have? And so on. Heck, do you have a good sense of your own income taxes right now? Federal, state, local? Deductions, personal and business if you own one? What about your spouse and the effects of filing jointly? Tax breaks you get now with young kids, but not in the future?
Of course, sometimes it's a lot simpler than all that and you can make a decent projection and choose accordingly. With a bit of luck, you'll be right and by choosing when to tax retirement savings you'll wind up with more when you need it.
Tax Changes Later
You might be wrong though. Or you might be right, but the long stretch of your retirement means that even if you guessed right on tax law at the start of retirement, it might change during retirement and make things difficult.
This, really, is the heart of tax diversification of money for retirement. Uncertainty about what will come. We don't know what is going to happen so by diversifying, you become able to adjust to the circumstances that arise. Taxes go up? You can pull more from tax-free accounts. Taxes go down? You can pull more from taxable accounts. Back and forth, year by year, letting you optimize your withdrawals as you go.
A common obstacle, as mentioned at the start, is that taxable money in retirement is the default. It takes more conscious effort and planning ahead of time to have a tax-free pool available to draw from. It can really be worth it though. As I say in my practice, adaptability is better than prediction. We don't know the future, but we can create the tools to adapt to it. Tax-free money being a powerful tool indeed.
1 Neither Champion Financial Strategies & Insurance Solutions, NYLIFE Securities LLC and its affiliates, nor its representatives, provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.