The Power of Tax Diversification in Retirement Planning

Today, I was talking with a client from Canada who now lives in the United States. We were running a retirement income plan — something we routinely do for our clients to help them invest wisely and adjust their portfolios to generate sustainable, tax-efficient income for life and beyond, while minimizing risk.

Unbeknownst to me, this client had an additional $1.5 million in Canadian-dollar assets he planned to bring into the U.S. and convert into U.S. dollars.

Why More Assets Led to Lower Withdrawals

In our prior retirement income projections, we estimated annual portfolio withdrawals of about $250,000 to cover expenses, taxes, and inflation for him and his family. This was net of Social Security and pension income.

However, after the client added that $1.5 million to a taxable account in our planning portal, the software showed a surprising change: projected withdrawals dropped to about $195,000 annually. He was baffled — how could adding more money reduce the required withdrawals?

The answer: taxes.

The Hidden Tax Trap of Traditional Retirement Accounts

Before the addition, nearly all portfolio withdrawals were coming from tax-deferred retirement accounts like his 401(k), which are taxed as ordinary income. This client — a successful pilot — had followed conventional advice for decades: maximize pre-tax 401(k) contributions for the immediate deduction and tax-deferred growth. But in retirement, when most withdrawals are from these accounts, the marginal tax rate can be punishingly high.

By adding $1.5 million to a taxable account, he was able to draw from assets taxed at lower long-term capital gains rates and control the timing of income. As a result, his marginal tax rate dropped, saving him roughly $55,000 annually in taxes.

Rethinking the 'Tax Rates Will Be Lower in Retirement' Myth

This came as a surprise to him — but it’s something I’ve emphasized for years.

Many clients enter retirement believing their tax rates will fall. But in reality, for many high earners, rates stay the same or even rise.

The Two Main Reasons Retiree Tax Bills May Rise

Inflation-adjusted spending is often higher than expected.
Rising net worth leads to higher income, and tax brackets don’t keep pace with inflation.

Further, retirees may be hit with hidden tax traps — such as the Alternative Minimum Tax (AMT), Medicare surcharges, or phase-outs of credits and deductions.

What Is Tax Diversification and Why It Matters

That’s why I’m a firm believer in tax diversification.

Having a mix of tax-deferred (e.g., traditional IRA/401(k)), tax-free (e.g., Roth IRA), and taxable accounts gives you the flexibility to optimize your withdrawals and minimize taxes year by year. The rules are always changing — so having different account types lets you adapt.

How Younger Investors Can Benefit Too

Even for younger investors, building up taxable accounts can meaningfully improve long-term outcomes. Relying on static projections or assuming tax rates won’t change is a mistake that leads to underestimating future liabilities.

Tax Realization Modeling: A Smarter Withdrawal Strategy

We use what’s called a tax realization model in our planning. This evaluates:

Portfolio turnover (to estimate long-term vs. short-term capital gains)
Dividends (often taxed as income)
Interest (taxable vs. tax-free)
Asset location (putting tax-inefficient investments in IRAs, and tax-efficient ones in taxable accounts)

The Importance of Asset Location in Portfolio Design

By managing for long-term gains and deferring them, reducing dividend exposure in taxable accounts, and placing bonds or income-generating assets inside tax-deferred vehicles, we can often lower a client’s effective tax rate significantly.

Leveraging Roth Conversions and RMD Flexibility

This kind of planning becomes even more powerful with the latest rules. With RMDs starting at age 72, and Roth conversions available before then, there are opportunities to reduce future tax burdens further — especially if you can fund early retirement spending from taxable accounts first.

Why New Tax Laws Aren’t Always a Boon for High Earners

And while some new tax laws provide benefits — such as business deductions or estate tax exemptions — many of the headline credits (like the $6,000 Social Security tax credit) are phased out at higher income levels. Many high-net-worth clients will not benefit as much as they think.

The Big Picture: Spend More, Give More, Keep More

The key takeaway: a well-structured tax-diversified portfolio can give you more spending power, more flexibility, and greater control.

You can:

Make your money last longer
Help your kids or grandkids
Donate more to causes you care about
Pay less in taxes over your lifetime

Don’t Let Conventional Wisdom Cost You

Following conventional wisdom blindly by maxing out your 401(k) without building taxable and Roth assets and investing in taxable accounts aggressively as well, can backfire. We've seen this time and again in real-world client cases.

Have tax diversification. You'll be glad you did.