The Secret to Reducing Lifetime Taxes for Retirees in the 2% Club, From a Financial Planner

For most of your working life, "diversification" referred to one thing: Investment diversification.

You might have been told, "Don't put all your eggs in one basket," "Spread your risk," or "Hold a mix of stocks and bonds."

But for retirees with pensions, especially those with $1 million or more in savings, there's another kind of diversification that often matters just as much. It's called tax diversification.

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Many Midwestern Millionaires (I wrote a book on this concept) have done things the right way. They showed up every day. They stayed loyal to their employer. They saved well. And now, many have a pension and more than $1 million saved.

What surprises most of them is that nearly all of their money is in tax-deferred accounts, and with the uncertainty of future tax rates, it's critical to rethink how you allocate your retirement dollars across the three tax buckets.

Tax diversification can dramatically reduce lifetime taxes, preserve your hard-earned pension income and help you avoid hidden costs such as Social Security taxation and Medicare IRMAA surcharges.

In this article, I will cover how the buckets work and why this strategy is especially important for pensioned retirees.

Why pensioned retirees are different

If you have a pension, you're already in a group that represents less than 20% of Americans. Add over $1 million in savings, and you join what we call the 2% Club (you can request the book I have written on this here). This is when your situation becomes even more unique.

Most retirees without pensions see themselves falling into lower tax brackets. But pensioned retirees often don't, as their pension keeps their income high.

Your Social Security is taxed more, your Medicare costs more, and required minimum distributions (RMDs) can push your income even higher in retirement.

In fact, most retirees with a pension end up in the same or higher tax bracket in retirement than when they were working. This alone is an important reason to think differently about your tax allocation.

The First Bucket: Tax-deferred (the bucket where most people have all their money)

Tax-deferred accounts include:

• 401(k)s
• IRAs
• 403(b)s
• Thrift Savings Plans (TSPs)
• 457 plans
• Lump-sum pension rollovers

This is where most retirees have stacked their savings for decades. Contributions reduced their taxable income, and back in the 1970s and 1980s, when top tax rates were around 70% , that made perfect sense.

But here's the issue today: Tax rates are historically low right now, and your withdrawals will be taxed in the future, possibly at higher rates.

When your $10,000 contribution grows to $100,000, you don't pay taxes on the $10,000; you pay it on the $100,000. And once RMDs kick in at the age of 73 or 75, the IRS forces withdrawals whether you need the income or not.

A pension plus RMDs plus Social Security, and many retirees are shocked to find themselves:

• Pushed into the 22% or 24% brackets (and potentially higher rates in the future)
• Paying IRMAA surcharges for Medicare
• Paying tax on 85% of Social Security
• Losing control over their income in the future

The Second Bucket: Tax-free (the bucket most retirees wish they had filled sooner)

This bucket includes Roth IRAs, Roth 401(k)s, Roth 403(b)s and other employer plans that offer Roth options. Here, growth and withdrawals are tax-free. And there are no RMDs.

So why don't more retirees have money in this bucket? Because these options weren't around for most of their working years. Roth IRAs became available in 1998, and Roth 401(k)s began in 2006, though many employers didn't add Roth features to their plans until much later.

The good news? There's still a way to fill the tax-free bucket through something called a Roth conversion. This is one of the most powerful strategies available to pension holders, as it allows you to move money from the tax-deferred bucket into the tax-free bucket.

You pay the taxes when you move the money, at today's historically low rates, and avoid paying taxes later, when:

• Your income is higher due to RMDs
• Social Security becomes taxable
• Tax rates themselves may rise after 2026

Also, if you pass, your spouse's filing status would go from married filing jointly to single. This change can cause the surviving spouse to have to pay nearly double the taxes compared to what they were paying, known as the "widow's penalty." A Roth conversion now spares the surviving spouse from those higher taxes.

For many in the 2% Club, today's environment is a once-in-a-lifetime opportunity to convert strategically while we have lower tax rates because of the One Big Beautiful Bill Act (OBBBA).

The Third Bucket: Taxable (the bucket that's the most flexible — and the most misunderstood)

This bucket includes:

• Savings accounts
• Brokerage accounts
• Certificates of deposit
• Treasuries
• Money markets
• Non-qualified investments

Here's why this bucket matters: Taxable accounts create planning flexibility. Capital gains may be taxed, depending on income, at 0%, 15% or 20%.

Taxable accounts can be used to:

• Contribute to Roth IRAs if possible
• Help fund Roth conversion taxes
• Act as a bridge account before Social Security
• Fund a donor-advised fund (especially with highly appreciated investments)
• Be repositioned to reduce ordinary income

Why you shouldn't rely on only one bucket

Imagine entering retirement with:

• Your pension
• Social Security
• All your savings in tax-deferred accounts

Every dollar you withdraw would inflate your taxable income. Every increase in income would trigger new taxes, and every tax increase would reduce the value of your pension.

Now, imagine having money in all three tax buckets and being able to control which bucket you pull from, depending on:

• Market conditions
• Tax brackets
• Social Security thresholds
• Medicare IRMAA tiers
• Capital gains optimization

This isn't just tax diversification, it's retirement income flexibility.

But this doesn't happen accidentally. It happens with an intentional strategy. And the sooner you structure a plan, the more options you'll have.

Related Content

• For the 2% Club, the Guardrails Approach and the 4% Rule Do Not Work: Here's What Works Instead
• If You're in the 2% Club and Have a Pension, the 60/40 Portfolio Could Hold You Back
• Here's What Being in the 2% Club Means for Your Retirement
• Five Opportunities if You're in the 2% Club in Retirement
• Are You a 'Midwestern Millionaire'? Four Retirement Strategies