How to Protect Your Retirement Income: Tax Diversification Strategies

Say you saved X million dollars in your combined retirement savings plans. You’re set for life, right? Unfortunately, not necessarily. To paraphrase a great superhero, with great wealth come great taxes. As soon as you start withdrawing money from your retirement accounts, you’ll start paying income tax on it. So how can you protect your hard-earned savings from Uncle Sam? Read on to learn how to reduce taxes in retirement.

What’s the cost of taxes in retirement?

Tax-sheltered retirement plans are one of the best investment vehicles ever conceived. Tax deferral makes it easy to build hefty retirement savings even on a modest income. And the money you invest in a retirement plan can grow for decades, without its growth getting curbed by income tax.

But there’s a difference between tax-deferred and tax-free. When retirement swings around and you start withdrawing money from your retirement plan, you will have to pay taxes on it.

A large retirement portfolio means large distributions, particularly once you reach age 70 ½ when required minimum distributions (RMD’s) kick in. An annual 4% “safe withdrawal rate” on a $2 million retirement portfolio could result in an income that’s higher than the salary that built the portfolio in the first place. And that means higher-than-expected income taxes. In fact, many retirees actually pay more in taxes than they did when they were working.

What are Required Minimum Distributions?

Required Minimum Distributions (RMDs) are minimum amounts you must withdraw annually starting with the year that you reach 70 ½ years of age or, if later, the year you retire. However, if the retirement plan account is an IRA or you have a 5% ownership in the business sponsoring the retirement plan, the RMDs must begin when you turn 70 ½, regardless of whether you retire.

So how can you prepare for this possibility? The trick is in diversifying your retirement savings.

What types of retirement plans require minimum distributions?

The required minimum distributions (RMD) rules apply to all employer-sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. However, they don’t apply to Roth IRAs while you are alive.

How to reduce taxes in retirement

Retirement plans are a great way to save for your retirement, but they’re not the only way. Plus, there are programs out there that are totally tax-free.

Are you looking to maximize your savings and minimize your losses in your retirement? Then try these 8 easy ways to reduce taxes in retirement.

Get a Roth IRA

Getting a Roth IRA is a great way to reduce taxes in retirement. Unlike a traditional IRA, contributions to your Roth IRA are not tax-deductible. However, once you reach retirement age, all withdrawals from your Roth IRA are totally tax-free. In other words, you pay a little more in taxes upfront in order to pay no taxes in retirement.

Plus, if you intend to retire early, your Roth IRA offers another benefit. You can withdraw from your Roth IRA as early as age 59 1/2. That’s several years before you get access to Social Security and/or pension benefits.

Open an HSA

This tip is especially helpful if you have a health insurance plan with a high deductible. Taxes are deferred on your contributions to an HSA, and as long as you only use the money for qualifying health costs, it stays tax-free forever. That makes it a great resource for late-life medical expenses. Every dollar you pull from your HSA is a dollar you don’t have to withdraw (and pay taxes on) from a taxable retirement account.

Curious if an HSA can help you? Read about what’s considered a qualifying medical expense here.

Pay off any long-term loans before retirement

Are you still paying off your mortgage, auto loan, or other long-term loans? If you’re able, it’s wise to finish paying off these loans before you retire. After all, the less you need to withdraw from your taxable retirement accounts, the lower your tax bill will be overall.

Sell stocks when your income is low

We all know that we have to pay taxes on the interest and dividends we make from investment sales. But did you know that the tax rate you pay on your 1099-INT and your 1099-DIV depends on your income for a given year? If you just got a fat Christmas bonus, you might want to hold off on selling stocks until next year, when your lower income will earn you a lower tax bracket.

Invest in municipal bonds

Municipal bonds are typically tax-free. Of course, municipal bonds won’t offer you the same growth that you might see from other investments. But you can withdraw the money at any time without paying a dime to Uncle Sam, bringing flexible, stable income to your retirement.

Make charitable donations from your IRA

Once you’re old enough to pull money from your traditional IRA, remember to use it to make any charitable donations. That’s because you can donate up to $100,000 a year from your traditional IRA, totally tax-free. Just remember that you can’t also claim a tax deduction on that donation.

Invest in non-tax-sheltered plans

Tax deferment is convenient today, but it can haunt you later in life. That’s why it’s wise to put some of your savings in investments that aren’t sheltered from taxes. Examples include certificates of deposit (CDs), treasury bills, broker accounts, mutual funds, and exchange-traded funds.

You’ll have to pay taxes on your gains now, but that means there will be no taxes to pay on them in your retirement. Of course, paying taxes on your gains now means that these accounts won’t grow as fast as your tax-deferred accounts. But it’s nice to have money put aside that you know won’t shrink whenever you use it.

Browse top brokerages here.

Draw from your retirement accounts strategically

Now that you’ve distributed your savings across a number of tax-deferred and tax-free accounts, you can be strategic with your withdrawals. During a year when you’re in a lower tax bracket, pay your living expenses with money from your taxable accounts, like a traditional IRA. On years where your tax bracket is higher, pull from tax-free accounts, like a Roth IRA. If you want to be really strategic, you can even use low-tax-bracket years to draw money from your traditional IRA and feed it into your Roth IRA. That way, you get to pay a lower tax rate to get your cash into an account where it can continue to grow, tax-free.


Most people assume that they’ll be in a lower tax bracket at retirement. But if you’re prudent enough to build a very large retirement portfolio, that may not be the case. To protect your savings, be sure to diversify your retirement portfolio. The sooner you start, the more financial security you’ll have in your old age.

For more ways to secure your future, browse top investment advisors here, or compare wealth management firms here.