Taxable, tax-deferred and tax-free: the three account "buckets"

Two people can retire with the same amount of savings and have very different after-tax spending power, because what matters is not only how much was saved but which kind of account holds it. A common way to think about this is to sort accounts into three "buckets" by how they are taxed. The term "tax diversification" refers to holding money in more than one of them.

The three buckets

The taxable bucket

This is ordinary saving and investing outside any retirement account. Money goes in after tax. Interest and dividends are generally taxed in the year they are received. When an investment is sold, only the gain is taxed, and the IRS explains that gains on assets held more than one year generally qualify for lower long-term capital gains rates.

Features worth knowing:

• No contribution limits, no age restrictions and no additional tax on early withdrawals.
• No required distributions.
• Tax is owed along the way, even on income that is reinvested.
• The owner has some control over timing, since a gain is generally taxed only when an investment is sold.

The tax-deferred bucket

Traditional IRAs and pre-tax workplace plans let money go in before tax, or with a deduction, and grow without annual tax. The tax comes at the end. IRS Publication 590-B explains that distributions from a traditional IRA funded only with deductible contributions are fully taxable when received.

Features worth knowing:

• An up-front tax benefit in the year of contribution.
• Every dollar withdrawn is generally ordinary income, including the part that came from investment growth.
• Withdrawals before age 59½ generally carry a 10% additional tax unless an exception applies. See early withdrawals and the rule of 55.
• Withdrawals eventually become mandatory. The IRS says owners generally have to start taking withdrawals when they reach age 73.

A balance in this bucket is partly the owner's and partly a future tax payment. A $500,000 traditional IRA does not provide $500,000 of spending.

The tax-free bucket

Roth accounts reverse the order. The IRS states that Roth IRA contributions cannot be deducted, and qualified distributions are tax-free.

Features worth knowing:

• No tax benefit in the year of contribution.
• Qualified withdrawals, including all the growth, are not included in income. The requirements are covered in the Roth IRA five-year rules.
• No required distributions during the original owner's lifetime.
• Direct Roth IRA contributions are limited by income.

Health savings accounts are sometimes placed in this bucket as well, because withdrawals for qualified medical expenses are not taxed; HSAs: the basics covers their separate rules.

Why the mix matters

If all of a retiree's savings sit in the tax-deferred bucket, every dollar spent beyond Social Security and pensions adds a dollar of ordinary income. There is little room to manage the tax bill. A retiree with money in two or three buckets can decide, year by year, where the next dollar comes from.

A hypothetical example

Suppose a retired couple needs $80,000 for the year beyond their other income.

• Household A has only a traditional IRA. They withdraw $80,000, plus enough extra to cover the tax on the withdrawal itself. All of it is ordinary income.
• Household B has a traditional IRA, a Roth IRA and a brokerage account. They take $40,000 from the traditional IRA, $25,000 from the Roth IRA as a qualified distribution, and sell $15,000 of investments in the brokerage account that they bought several years earlier for $10,000. Their taxable income from these withdrawals is $40,000 of ordinary income plus a $5,000 long-term capital gain.

Household B takes out $80,000 with much less income on the tax return, though it still owes tax on that income. The numbers are round and illustrative only, and the example does not suggest that either household ends up better off over a lifetime. Household B paid tax earlier to build the Roth and brokerage balances.

Lower reported income can matter beyond the tax bracket. Adjusted gross income feeds into how much of Social Security is taxed and into Medicare's income-related premium adjustments, as described in how different kinds of retirement income are taxed.

Flexibility is the point, not a prediction

The usual argument between pre-tax and Roth saving turns on whether a person's tax rate will be higher now or in retirement. That depends on future income, future tax law and how long the person lives, none of which is knowable. Spreading savings across buckets is one common response to that uncertainty. It gives up the chance of having guessed perfectly in exchange for having options.

Some of the ways people shift the balance over time:

• Choosing between traditional and Roth contributions in a workplace plan. See traditional vs. Roth 401(k) contributions.
• Converting part of a traditional IRA to a Roth IRA in a lower-income year, which is taxable when done. See Roth conversions explained.
• Saving in a taxable account after retirement accounts are funded.

Questions worth asking

• Roughly what share of total savings is in each bucket today?
• How much of the tax-deferred balance will required distributions force out each year after 73?
• Is there enough in taxable or Roth accounts to cover a large one-time expense without a spike in taxable income?
• Who is likely to inherit each account? Heirs are taxed differently on each bucket.

There is no standard target mix. Because the right balance depends on individual tax circumstances and state tax rules vary, a tax professional can advise on specifics.