Most people think of diversification in terms of what they own: the balance between stocks and bonds, U.S. and international companies, large and small businesses or different sectors of the economy. These individual investment choices determine how a portfolio responds to market cycles and balance risk.
Another type of diversification that is often overlooked is where your assets are held. A dollar in a brokerage account, a traditional IRA, and a Roth IRA may look the same on a statement, but each is taxed very differently. Over time, that difference can have a meaningful impact on retirement income, tax planning, and financial flexibility.
The Three Tax Buckets
There are many different types of accounts, but they generally fall into three primary tax categories:
- Taxable accounts generate taxes as activity occurs. Interest, dividends, and capital gains distributions show up on your tax return even if you never saw the money because it was reinvested. Long-term growth is taxed at favorable capital gains rates. Examples include individual brokerage accounts and trust accounts.
- Pre-tax retirement accounts allow investments to grow tax-deferred so assets can be bought and sold without being taxed. Contributions are made with pre-tax dollars and then withdrawals are taxed as ordinary income. Common examples include traditional IRAs (including rollover and inherited accounts), 401(k)s, 403(b)s, and certain annuities.
- Tax-free accounts are unique in that the money grows tax-deferred, and withdrawals are tax-free if all the rules are followed. The most common example is the Roth IRA (including inherited), funded with after-tax dollars. Health Savings Accounts (HSAs) also hold funds that can be distributed tax-free for qualified medical expenses.[1]
Think of these accounts as three different “tax buckets” you can draw from over time, which adds resiliency to your long-term financial plan.
Where Your Money Lives Matters
With the advent of company 401(k) plans, many people are retiring with the majority of their savings in pre-tax accounts. The idea behind these accounts is that you contribute money from your paycheck during your working years with the plan to take money out in lower-income retirement years. When this works, it reduces the amount of tax you pay over your lifetime.
While this strategy can be effective, it also has potential drawbacks. When you start using your hard-earned savings, withdrawals are taxed at ordinary income rates. This can result in higher-than-expected tax brackets, especially once Required Minimum Distributions begin.ii Higher income may even impact Medicare costs (IRMAA), deductions, credits, and other parts of your tax return.
Having accounts with different tax treatments provides more options for tax efficiency and potentially puts more money in your pocket to spend in later years. For example, if all three account types are available, a coordinated approach to withdrawals may provide more spending money at a lower effective tax rate and reduce the tax impact of unexpected expenses such as a car repair or health event.
Personalizing Diversification
Building tax diversification starts with understanding that different account types serve different purposes. During working years, some households benefit from pre-tax contributions, while others may prioritize Roth savings, taxable brokerage accounts, or a combination of all three.
A household with the majority of its savings in a traditional retirement account will still have strong planning opportunities, but those plans might look different from a household with meaningful taxable assets or significant Roth assets. The right mix depends on income level, tax bracket, cash flow needs, age, estate goals, and expectations for future income and tax rates.
The goal is not to create a perfect formula or to force every family into the same three-bucket structure. Rather, the goal is to preserve flexibility, understanding that a good plan anticipates bumps in the road and incorporates alternate routes that allow you to stay on track over time.
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[1] HSAs are triple tax advantaged. Contributions are pre-tax, growth is tax-deferred and distributions for qualified medical expenses are tax-free. HSA contributions require having a high-deductible medical plan.
[2] Required Minimum Distributions (RMDs) are required starting at age 73 for people born between 1951 and 1959, and at age 75 for those born after 1959, an extension that came from SECURE 2.0.
