Why Tax Diversification Matters More Than You Think
You’ve probably heard the phrase, “Don’t put all your eggs in one basket.” Most of the time, we apply that to diversification in investment ownership, such as owning stocks, bonds, or maybe something alternative like real estate or gold. An often-overlooked form of diversification that we should consider for our investments is tax diversification.
Tax diversification simply means spreading your money across different types of accounts, or “buckets,” that are treated differently by the IRS. In brief, these include:
Pre-tax retirement accounts like a 401(k) or traditional IRA. You get a tax break now, but you’ll pay taxes when you withdraw funds.
After-tax retirement accounts like Roth IRAs and Roth 401(k)s. You pay taxes today, but funds grow tax-free and withdrawals are tax-free later.
Taxable accounts, like a regular brokerage or investment account, where you can access them anytime, but you’ll owe taxes on dividends or capital gains.
Charitable vehicles like donor-advised funds, which can reduce taxable income while supporting causes and missions you care about.
Now, if you’re a spreadsheet kind of person, you might be wondering: “Wouldn’t it be more efficient to just mathematically figure out the best bucket for today, and put everything there?”
Here’s where planning for the future comes in. The truth is, we don’t know what future tax rates will look like—or what our own income will be. A great way to mitigate the risk of this uncertainty, much like our investment portfolio allocations, is to diversify.
By diversifying across tax buckets, you’re giving yourself options. And options reduce stress and provide flexibility.
Let’s look at a few scenarios.
Imagine a retiree who saved everything in a pre-tax 401(k). At age 73 or 75, Required Minimum Distributions kick in, and suddenly they’re forced to pull out more money than they need, pushing them into a higher tax bracket and even increasing taxes on their Social Security.
Now picture someone with a mix of pre-tax, Roth, and taxable accounts. Each year, they can decide which bucket to tap, balancing their income to stay in a favorable tax bracket or take larger distributions dispersed across all three tax buckets.
Or, take a charitable giver: If they’ve built up appreciated stock in a taxable account, they can donate shares directly, avoid paying capital gains, and still support their favorite causes and investments.
And, in a market downturn, someone with a taxable investment account can avoid drawing down depressed pre-tax accounts by balancing capital gains and losses, or only selling stabilizing investments like bonds, to give their investments time to recover while drawing essential income.
The point is that tax diversification isn’t about perfection—it’s about flexibility.
So, here’s the takeaway: Think of tax diversification as having a toolbox instead of just a wrench. Will every tool be equally efficient in every situation? Probably not. But having options means a greater possibility to adapt to whatever life, tax policy, or markets throw your way.
That flexibility doesn’t just save money—it can give us peace of mind. Because in the end, financial freedom isn’t only about numbers. It’s about confidence, control, and the freedom to live generously and with expectations.