When people think about retirement planning, the focus is often on saving enough money. Questions like "How much do I need?" and "Will I have enough?" tend to dominate the conversation. Those are important considerations, but as I discussed in a recent TD Stories article, financial success is about more than simply reaching a number. It's also about creating flexibility, maintaining independence and building a retirement that supports the life you want to live. That is where another important question comes into play: how will your savings be taxed when it is time to use them?
Looking Beyond a Single Retirement Account
For decades, many Americans have built their retirement savings primarily through traditional 401(k)s and IRAs. These accounts offer valuable tax advantages while working, but withdrawals are generally taxed as ordinary income in retirement. According to the IRS, Roth accounts take a different approach, allowing for after-tax contributions with the potential for tax-free qualified withdrawals later in life1. Traditional and Roth retirement accounts may also impose penalties for before age 59½ for certain withdrawals2. Learn more from the IRS.
Taxable investment accounts can play a role as well. While earnings may be taxed along the way, these accounts generally offer more flexibility for accessing funds and may benefit from favorable long-term capital gains tax treatment3. IRS Topic No. 409.
Together, these account types create different opportunities and tradeoffs.
Tax diversification is ultimately about maintaining flexibility. If all of your assets are concentrated in one tax category, you may have fewer options when it comes to managing income and tax exposure in retirement.
Why Flexibility Matters
Retirement is rarely a one-size-fits-all experience. Income needs can change over time, markets can fluctuate, and tax rules may evolve.
Having assets spread across taxable, tax-deferred and tax-free accounts may provide more options when deciding where retirement income should come from in a given year. That flexibility can be particularly valuable when navigating income-sensitive considerations such as Medicare premium thresholds or other planning decisions4. Information about Medicare-related income adjustments is available through the Social Security Administration.
Rather than relying on a single source of retirement income, some investors choose to maintain multiple “tax buckets” that can be used strategically as circumstances change.
Understanding the Tradeoffs of Tax Deferral
Tax-deferred retirement accounts remain an important part of many retirement plans. However, they can also create complexities later in life.
For example, required minimum distributions (RMDs) can increase taxable income whether or not an individual needs the additional cash flow. For married couples, another consideration is that a surviving spouse may move from joint to single-filer tax brackets while maintaining a similar level of income.
Researchers at Stanford’s Center on Longevity have highlighted how this situation, sometimes referred to as the “widow’s tax,” can result in higher effective tax rates for some households5. Read more.
Having a mix of taxable, tax-deferred and tax-free assets can help investors adapt as their circumstances change. It allows for more thoughtful decisions about which accounts to draw from and when, especially during periods of transition.
Planning for the Long Term
Retirement today can span decades and involve multiple life stages. Income needs may shift, healthcare expenses can increase, and personal goals often evolve over time.
Tax diversification is not about predicting future tax rates. Instead, it is about creating flexibility and preserving options. By building savings across different account types, investors may be better positioned to make decisions based on their needs and circumstances rather than the limitations of a single account structure.
As retirement planning continues to evolve, many investors are looking beyond simply accumulating assets and placing greater emphasis on how those assets can be used most effectively over time.
Because in retirement, it is not just about what you have saved. It is also about how much of it you are able to keep.
1. IRS, “Roth Comparison Chart.” 2. IRS, “Retirement Topics: Tax on Early Distributions.” 3. IRS, “Topic No. 409: Capital Gains and Losses.” 4. Social Security Administration, “IRMAA Sliding Scale Tables.” 5. Stanford Center on Longevity, “The Widow Tax."
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