When planning for retirement, it is easy to focus on how much you have saved. But where that money is held can be just as important. Pre-tax retirement accounts, Roth accounts, and taxable brokerage accounts each have different tax rules, and having a combination of account types can give you more flexibility when it is time to use your savings.

Tax diversification is about building that flexibility into your retirement plan. Rather than relying entirely on one type of account, you can potentially draw income from different sources depending on your tax situation, spending needs, and stage of retirement.

What Is Tax Diversification?

Tax diversification means spreading your retirement savings across accounts that are taxed differently. The three most common categories are pre-tax accounts, such as Traditional IRAs and 401(k)s; Roth accounts, such as Roth IRAs and Roth 401(k)s; and taxable brokerage accounts.

Each account comes with its own tax treatment. Pre-tax accounts generally allow you to defer taxes until you withdraw the money, while Roth accounts are funded with after-tax dollars and can provide tax-free qualified withdrawals. Brokerage accounts do not provide the same tax advantages, but they offer flexibility and access to your money without the distribution rules that apply to retirement accounts. Understanding how tax-advantaged retirement accounts work can help you compare the different account structures and determine how they may fit into your overall retirement strategy. 

Pre-Tax Accounts Can Help You Defer Taxes

Traditional IRAs and many 401(k) plans allow you to contribute money before it is taxed, potentially reducing your taxable income while you are working. The money can then grow tax-deferred, with taxes generally owed when you take distributions in retirement.

This can be valuable if you are currently in a higher tax bracket and expect to be in a lower bracket during retirement. However, withdrawals from these accounts generally count as taxable income, and required minimum distributions eventually limit how much control you have over when you take money out. That makes it important to consider not only how much you save in a pre-tax account, but also how those assets will fit into your retirement income plan.

Roth Accounts Can Provide Tax-Free Income Later

Roth accounts take the opposite approach. Contributions are made with after-tax dollars, so you do not receive the same upfront tax deduction available with many pre-tax accounts. In exchange, qualified withdrawals can generally be taken tax-free in retirement.

That tax-free income can be particularly valuable when you are managing your taxable income later in life. Roth IRAs also do not have required minimum distributions during the original owner’s lifetime, which can provide additional flexibility. Understanding the differences between Traditional and Roth IRAs can help you determine which approach may make sense for your retirement savings strategy. 

Brokerage Accounts Add Flexibility

A taxable brokerage account does not offer the same tax advantages as a Traditional or Roth retirement account, but that does not make it less useful. In fact, the flexibility of a brokerage account can make it an important part of a diversified retirement strategy.

You can generally access the money without the withdrawal restrictions that apply to retirement accounts, and there are no required minimum distributions. You also have greater control over when you sell investments and realize capital gains. Understanding how a brokerage account works can help you see how these accounts may provide flexibility alongside other retirement savings.

Different Accounts Give You More Choices in Retirement

One of the biggest advantages of having different account types is that you may have more choices when deciding where your retirement income should come from. For example, you could potentially use:

• Pre-tax accounts when a taxable distribution makes sense for your income needs
• Roth accounts when you want qualified income without increasing your taxable income
• Brokerage accounts when you want flexibility or want to strategically realize capital gains

The right combination can change from year to year. A retiree might draw more heavily from a brokerage account in one year, take a distribution from a Traditional IRA in another, and use Roth assets when limiting taxable income becomes a priority. Having different types of accounts gives you more options than relying entirely on one source.

Tax Diversification Can Help With RMD Planning

Required minimum distributions are one reason it can be helpful to have assets outside of pre-tax retirement accounts. Traditional IRAs and many other tax-deferred retirement accounts eventually require you to take distributions, and those distributions are generally included in taxable income.

Roth IRAs do not have RMDs during the original owner’s lifetime, and brokerage accounts do not have RMD requirements either. This can give you more control over your income as you move through retirement. Planning for required minimum distributions before they begin can help you understand how much income you may be required to take and how your other accounts could complement those distributions.

Tax Diversification May Be Especially Valuable in Uncertain Tax Environments

Nobody knows exactly what tax rates will look like decades from now. Your own tax situation can change as well. You may have a different level of income in retirement than you expected, tax laws may change, or a large retirement account balance could eventually lead to significant required distributions.

Having money in different types of accounts gives you some ability to respond to those changes. If most of your savings are in pre-tax accounts, you have less flexibility when you need taxable income. With a combination of pre-tax, Roth, and brokerage assets, you can potentially adjust which accounts you use based on the circumstances at the time. This can be particularly useful during the years between retirement and the start of Social Security or RMDs, when you may have more control over your taxable income and can take advantage of strategies for reducing taxable income in retirement.

Everyone’s Retirement Is Different

There is no ideal percentage of retirement savings that should be held in pre-tax, Roth, and brokerage accounts. The right balance depends on your income, current tax bracket, expected retirement income, investment strategy, and long-term goals.

The important thing is to think beyond the total amount you have saved. Having different types of accounts can give you more choices about when and how you use your money, which can be valuable when managing taxes throughout retirement. Tax diversification is ultimately about giving yourself options so your retirement income strategy can adapt as your circumstances change.