Many investors understand that diversifying your portfolio across different asset classes is essential to mitigating risk. But while that may offer downside protection in the markets, it largely ignores the threat of taxation.
However, a different type of diversification can help you address this. It’s called tax diversification. But it really has to do with account diversification. This is the process of spreading your assets across different types of accounts, each with its own tax treatment.
There are three main types of accounts that most people turn to when saving for retirement and other financial goals.
Taxable Accounts
These include brokerage accounts that hold securities such as stocks, bonds, and ETFs. You pay taxes on interest and dividends the year they are paid. And you owe capital gains taxes if you sell shares for a profit. Capital gains rates depend on your income, filing status, and how long you’ve held appreciated shares before selling. Long-term capital gains rates on securities held for more than one year are generally more favorable.
Tax-Deferred
These include accounts such as traditional IRAs, 401(k)s, and 403(b)s. Your contributions are tax-deductible. But you pay ordinary income taxes on qualified withdrawals. And you’d generally owe penalty taxes if you make withdrawals before reaching age 59.5.
Moreover, it’s important to note that tax-deferred accounts such as traditional IRAs and 401(k)s come with required minimum distributions (RMD)s. These are specific amounts of funds you must withdraw annually when you reach age 73. RMDs are subject to ordinary income tax too.
Tax-Free
These include accounts such as Roth IRAs and Roth 401(k)s. Your contributions aren’t tax-deductible, as with their traditional counterparts. But withdrawals are tax-free as long as you’re at least 59.5 years-old and at least five years have elapsed since you opened the account.
Why Have Multiple Accounts?
You may be thinking, why do I need all these types of accounts?
Having assets spread across different types of accounts offers a few protections.
Many people, especially those in their early working years, turn to tax-deferred accounts such as traditional 401(k)s and IRAs because they can lower their taxable income.
But when it comes time to make withdrawals in retirement, every dollar would be taxed at ordinary income tax rates.
Tax rates sit at historic lows. But considering the weight of the national debt, it’s not too farfetched to think those rates won’t stick around forever.
Moreover, tax-deferred accounts involve RMDs. You need to take your applicable RMD even if you don’t need the money. And that counts as taxable income too.
This could push you into a higher tax bracket and launch tax torpedoes or tax traps. This is basically when a higher income pushes you into new taxation territory. For example, a high RMD can trigger higher taxes on your Social Security benefits or surcharges on your Medicare premiums through IRMAA.
But with assets sitting in multiple accounts, you and your financial adviser can come up with a tax-efficient withdrawal strategy. In some cases, you may draw down from tax-deferred accounts in low-income years as you let your tax-free money grow. Tax-free accounts such as Roth IRAs don’t involve RMDs, so they can virtually grow throughout your life.
Moreover, having account diversification can help you hedge against sequence of returns risk. This is when you retire during a market downturn. As a result, you end up selling shares at a loss and draining your account faster. That could be the case if all your retirement assets were in one tax-deferred account such as a traditional 401(k). But in this scenario, you may consider first dipping into your taxable brokerage account. This would give your tax-advantaged dollars time to recover and grow. You may even be able to take advantage of long-term capital gains rates, which are lower than ordinary income tax rates.
Considering Roth Conversions
Even if you’ve been saving for a long time in a tax-deferred account, you can kickstart a tax-free account through a Roth conversion.
A Roth conversion is the process of converting funds from a traditional IRA to a Roth IRA. You’d owe income taxes on the converted amount for the year the conversion was made. But you could enjoy tax-free qualified withdrawals later in retirement.
Some advisers recommend you do this in low income years to minimize the tax hit. And some say there’s a Roth conversion sweet spot. This arises in the gap years between early retirement and when you begin collecting Social Security. This is when income would theoretically be very low and you’d have more control over your tax bracket.
The Bottom Line
Asset diversification is important. But so is account diversification. By spreading diversified assets over various accounts with different tax treatments, you have more control over your tax bracket and how to come up with an effective drawdown strategy. But the right mix of accounts would depend on variables such as your goals and time horizon. It can help to work with a qualified financial adviser to come up with an account diversification plan that works for you.
The Epoch Times copyright © 2026. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.
