Alert – Why a traditional 401k is NOT the best retirement account… and other ingenious expert tips to slash taxes to ZERO in later life

It might sound too good to be true, but paying little to no taxes in retirement can be a reality if you plan ahead. 

Whether you are approaching the end of your career, or are still a way off, there is one key move to minimizing taxes as a retiree: tax diversification.  

As investment advisor Patrick Donnelly told Daily Mail: ‘Put simply, tax diversification means having your money spread out across multiple account types that have different tax treatments.’ 

Traditional 401(K) or individual retirement accounts (IRAs), for example, are tax-deferred. This means money in the accounts can grow tax-free throughout your working life, and is only taxed when you draw it in retirement. 

Contributions to a Roth 401(K) or IRA, meanwhile, are money that has already been taxed. These are known as ‘tax-free’ accounts because you can take cash out without incurring a penalty as long as you meet certain conditions, such as reaching a specific age and holding the account for a set period of time. 

Checking accounts, savings accounts, money market accounts and brokerage accounts, on the other hand, are taxable. This means you pay taxes on any interest, dividends and capital gains earned. 

Tax diversification is the key to paying fewer taxes in retirement, said investment advisor Patrick Donnelly

‘Generally people draw from these three types of accounts in retirement,’ said Donnelly, of Donnelly financial services. 

‘If you have money sitting in all three of these buckets, or even just two of them, you have a lot of flexibility and control over your annual tax situation.’

You pay zero levies on tax-free, or Roth money, as long as you are over 59.5 years of age and the account has been open for over five years. 

‘In my opinion, this makes Roth the most powerful retirement wealth building tool available to investors, period. It can always be used to top up or even fully provide your retirement income with absolutely zero tax costs,’ Donnelly said. 

If you take Roth accounts out of the equation for now, you are dealing just with taxable investments and tax-deferred money, which includes traditional 401(K)s and IRAs.

When planning how to use your retirement funds, there are two key numbers to know – and these will depend on your tax status as a retiree. 

The first is your standard deduction. This is a fixed amount you can subtract from your income to reduce how much of it is taxed, and it depends on your age and filing status among other factors.

The second is your 0 percent long-term capital gains tax bracket. Capital gains tax is what you pay when you sell an investment, such as stock shares, bonds or real estate. Long-term gains are taxed on investments held for more than a year. 

Let’s take an example. For a retired married couple over 65 filing jointly in 2025, the standard deduction is $33,200 and the 0 percent long-term capital gains bracket tops out at $96,700. 

The couple will pay no tax if they withdraw up to $33,200 from either a tax-deferred traditional retirement account or from Social Security income, or any combination of the two. 

If they also had taxable investments, they could withdraw up to an additional $96,700 from that account in the same year without paying capital gains. 

This combination means they can recognize a total of $129,900 of income and pay zero federal tax on it. 

‘If we also bring a Roth account back into the equation, they can also top up their income by whatever amount is necessary and still end up paying zero taxes,’ Donnelly explained. 

‘The greater amount of dollars you have spread out across these three tax buckets, the longer you can sustain – or at least have the possibility to sustain – zero tax years.’

This applies to federal tax, Donnelly points out, as state tax varies. 

In order to make this work, you have to be really on top of your tax situation and pay close attention to just about every dollar of income. 

‘But it’s very possible, and savvy individuals and advisors make it work all the time,’ Donnelly said. 

Whether you are quickly approaching the end of your working years, or are still a while away, there are moves you can make to minimize taxes as a retiree

Contributions to a Roth 401(K) or IRA are made with money that has already been taxed

He recommends opening all three types of accounts as soon as you enter the workforce. 

The earlier you begin, the better off you will be and the more flexibility you will have over the long term. 

‘With that said, there are inherent tax advantages to the tax-deferred and tax free accounts, so I would definitely recommend favoring those at a young age,’ he added.  

‘However it’s never going to hurt you to also have some taxable money to create this type of planning flexibility when you are ultimately retired.’

Another factor to consider is that when you reach the age of 73 or 75, depending on the year you were born, you will have to begin taking required minimum distributions, or RMDs. 

RMDs are annual withdrawals that the IRS demands you take from certain types of retirement accounts. They are calculated using a formula based on how much money you have, your age and your life expectancy. 

The rules around these withdrawals are complicated, Donnelly warned, but the tax implications can also be negated, either completely or to some extent, if you start planning early enough.

‘Any advisor worth their salt is not going to be looking at a five year horizon. They are going to be looking at a 20 to 30 year horizon. 

‘So that should be something that is taken into account the moment that a plan is created,’ said Donnelly. 

Donnelly recommends opening all three different types of accounts – tax-deferred, taxable and tax-free – as soon as you enter the workforce

If you are several years away from retirement, the best thing you can do, according to Donnelly, is heavily favor investing in Roth retirement accounts. 

‘We can do all this fancy financial footwork when people are retired, pulling some money from traditional IRA accounts and pulling some from taxable accounts, if the money is there.

‘But it just makes everything way more simple if you just have as much as possible in a Roth account. Because as the law stands today, none of that money is ever going to be taxed.’

For the people who are just starting out thinking about tax diversification, it often makes a lot more sense to favor tax-advantaged accounts – the traditional 401(K) and Roth 401(K) or IRA.

This is especially true, according to Donnelly, given where tax rates are now. 

Legislation brought in during the first Trump administration under the Tax Cuts and Jobs Act in 2017 made sweeping changes to the tax landscape. 

This included lowering individual income tax rates, almost doubling the standard deduction and raising the federal estate tax exemption.

These rules were due to expire at the beginning of 2026, but President Trump has promised to extend the tax cuts. Congress is currently debating how and whether this could happen. 

For Donnelly, this means it is worth taking advantage of the tax situation we are in right now.

‘I think it’s important for people to understand that, relative to historic tax levels, we are in a fairly favorable income tax environment.’