Retirement diversification is investing money for retirement in different types of investments. Diversification allows the retirement account holder to reduce risk and maximize the returns on the investments from the retirement accounts. In addition, retirement diversification ensures that the account holder has income from different sources at different points in their retirement years.
Investors can achieve a certain level of retirement diversification even in only one type of retirement savings account. For example, if the account holder only has a 401k sponsored by their employee, then the investor should choose different investments to create a balanced and diversified portfolio. The precise amount of diversification varies from person to person because it is based on their retirement goals and plans.
Another form of retirement diversification is investing money in different types of retirement savings accounts. For example, an individual may have an employer-sponsored 401k, in individual retirement account (IRA) and a Roth IRA. Diversification occurs by having these different types of accounts because contributions and withdrawals are treated differently with each type of account.
Even when part of retirement diversification includes having different types of retirement accounts, it is important that the account holder take diversification one step further. In addition to having different types of retirement accounts, it is important to ensure that the investments in each account are not the same or do not have too much overlap. If all of the retirement accounts have the same or similar investments, then retirement diversification is not being achieved.
Retirement diversification also plays a vital role when it is time to start taking withdrawals from the account. When retired, these withdrawals are income to the account holder. As the account holder goes through different stages of their retirement years, tax situations also change. Retirement diversification can help to create the most ideal tax situation during retirement as well.
This occurs because some contributions are taxed when going into the retirement account. Other contributions are pre-tax. Typically, these contributions are the withdrawals that are taxed when the retirement account holder takes money out of the account as income. Due to the fact that many retirees are at a lower tax bracket after retirement, the withdrawals may be taxed a lower rate.
Retirement diversification in each account also changes as the account holder gets closer to retiring. On a semi-annual or annual basis, the retirement account holder, financial adviser and tax consultant should all review the account to see any reallocation of the investments in the account need to be made in order to best meet the retirement goals of the individual.