When it comes to retirement, the taxman’s bite can be surprisingly fierce—often gnawing away at the nest egg retirees have worked decades to build. While most investors understand the importance of diversifying their portfolios across stocks, bonds, and other assets, an equally critical but often overlooked strategy is tax diversification. This approach ensures your savings are spread across accounts with different tax treatments, helping to minimize the tax drag when you start withdrawing funds.
UBS’s latest research, led by Ainsley Carbone, Chief Investment Officer Americas, highlights a crucial insight: the sequence and source of your retirement withdrawals can dramatically impact how much you keep after taxes—and how long your money lasts.
The Hidden Tax Torpedoes in Tax-Deferred Accounts
Tax deferral during your working years is undeniably powerful. Contributions to 401(k)s and traditional IRAs grow tax-free until withdrawal, allowing for compounding on the full amount. However, this deferral can turn into a double-edged sword in retirement. Withdrawals from these accounts are taxed as ordinary income, which can push retirees into the highest federal tax brackets—up to 37%. This “tax torpedo” effect can erode your portfolio’s after-tax growth and reduce longevity.
But the tax implications don’t stop there. Retirees with a modified adjusted gross income (MAGI) above $106,000 (or $212,000 for joint filers) face significantly higher Medicare Part B and prescription drug premiums. For example, in 2025, individuals with MAGI under $106,000 pay a standard $185 monthly premium, but those with MAGI between $167,000 and $200,000 can pay an additional $295.90 on top of that. Even tax-free municipal bond interest counts toward MAGI, potentially pushing retirees into these higher premium brackets unexpectedly.
A Smarter Spending Waterfall: UBS’s Framework for Tax-Efficient Withdrawals
To combat these pitfalls, UBS recommends a “spending waterfall” approach that segments retirement spending into three buckets:
- Liquidity Bucket: Cash flow for the next 3-5 years.
- Longevity Bucket: Funds needed 5+ years out.
- Legacy Bucket: Money set aside for heirs or charitable goals.
The key actionable step is to first cover your liquidity needs with expected income sources like Social Security or pensions. Any shortfall then determines how much you need to withdraw from taxable or tax-deferred accounts.
Next, retirees should work closely with financial and tax advisors to project taxable income and establish a target marginal tax rate for each year. This proactive tax planning helps avoid “tax torpedoes” by spreading income withdrawals strategically, smoothing tax brackets over time.
For example, if your spending needs fall below your target tax bracket, it often makes sense to draw from tax-deferred accounts first to fill that bracket efficiently. Conversely, if your spending exceeds your target bracket, tapping into Roth accounts—which offer tax-free withdrawals—can prevent pushing your taxable income too high.
What Investors and Advisors Must Do Differently Now
The era of “set it and forget it” retirement plans is over. With tax rules evolving and healthcare costs rising, retirees must adopt dynamic, annual reviews of their withdrawal strategies. This includes:
- Integrating tax diversification into retirement planning from the start. Don’t rely solely on tax-deferred accounts; incorporate Roth IRAs, Roth 401(k)s, and Health Savings Accounts (HSAs) to create a tax buffer.
- Monitoring MAGI closely to avoid Medicare premium surcharges. This is a stealth tax many retirees overlook.
- Leveraging municipal bonds wisely. While their interest is tax-free federally, it still counts toward MAGI—plan accordingly.
- Using tax projections and withdrawal sequencing as a tactical tool. Work with advisors to model different scenarios annually.
A recent study by Vanguard underscores this approach, showing that retirees who strategically sequence withdrawals to manage taxes can extend their portfolio longevity by up to 15%. This is not just theory; it’s a tangible impact on retirement security.
What’s Next?
Looking ahead, tax policy changes could further complicate retirement planning. The current administration has proposed increasing capital gains taxes for high earners and adjusting retirement account rules. Investors should anticipate these shifts and build flexibility into their plans.
For advisors, this means deepening expertise in tax-efficient withdrawal strategies and educating clients on the importance of tax diversification—not just asset diversification.
Final Takeaway
Retirement success today demands more than just saving diligently; it requires mastering the art of tax-efficient withdrawals. UBS’s spending waterfall framework provides a valuable roadmap, but the real edge comes from ongoing, personalized planning that adapts to changing tax landscapes and individual needs.
At Extreme Investor Network, we believe that understanding and managing tax risk in retirement is the next frontier for investors. Don’t let Uncle Sam take more than his fair share—embrace tax diversification, plan your withdrawals with precision, and secure your financial independence for the long haul.
Source: How to avoid these ‘tax torpedoes’ in retirement, per UBS