Retirement Tax Diversification Checkup: Three Buckets

Picture two retirees who both saved diligently for 30 years and both arrived at 65 with $1.2 million. The first put everything into a traditional 401(k). The second spread savings across a traditional 401(k), a Roth IRA, and a taxable brokerage account. On paper, their wealth looks identical. In practice, the second retiree has something the first does not: the ability to choose which bucket to draw from each year, and therefore, meaningful control over their annual tax bill.

This is the core idea behind tax diversification in retirement. It is not about picking better investments. It is about building a structure that gives you options. Whether you are 48 with decades ahead or 62 with retirement on the horizon, understanding your bucket mix, and how to improve it, is one of the most practical steps in retirement planning.

Each account type you might hold in retirement falls into one of three broad tax categories. Understanding how each bucket works at the point of withdrawal is the foundation of a tax diversification strategy.

Bucket 1: Pre-Tax (Tax-Deferred) Accounts
This bucket includes traditional 401(k) plans, traditional IRAs, 403(b) plans, and SEP-IRAs. Contributions typically reduce your taxable income today, but every dollar you withdraw in retirement is taxed as ordinary income. This is often the largest bucket for American savers, partly because employer-sponsored plans have high contribution limits (up to $23,500 in 2025, or $31,000 for those 50 and older, according to the IRS). The catch: Required Minimum Distributions (RMDs) begin at age 73 under current rules, meaning withdrawals are eventually mandatory whether you need the money or not.

Bucket 2: Roth (Tax-Free) Accounts
Roth IRAs and Roth 401(k)s are funded with after-tax dollars, but qualified withdrawals in retirement are completely free of federal income tax, including the growth. Roth IRAs also carry no RMDs during the original owner's lifetime, making them a powerful source of flexibility later in retirement. Contribution limits mirror traditional accounts ($7,000 per year for IRAs in 2025, $8,000 if you're 50 or older), though income limits may restrict direct Roth IRA contributions for higher earners. Options such as the Backdoor Roth and Mega Backdoor Roth exist for those who exceed income thresholds.

Bucket 3: Taxable Brokerage Accounts
Ordinary brokerage accounts do not offer upfront tax deductions, and you will owe tax on dividends and realized gains each year. However, long-term capital gains (on assets held over one year) are taxed at preferential rates of 0%, 15%, or 20%, depending on your income. Importantly, there are no contribution limits and no withdrawal restrictions. This makes a taxable account uniquely flexible, particularly for those who retire before age 59½ or who want to manage income in retirement without triggering higher tax brackets.

The strategic value of having all three buckets becomes clearest when you look at how retirement income is taxed. Social Security benefits can become partially taxable depending on your total income. Medicare premiums can increase if your income crosses certain thresholds (a concept known as IRMAA, or Income-Related Monthly Adjustment Amount). And a large traditional IRA balance means large RMDs, which push ordinary income higher regardless of whether you need the cash.

When you hold assets in all three buckets, you can potentially:

• Draw from your Roth account in years when additional income would push you into a higher tax bracket or increase Medicare premiums.
• Pull from your taxable account to take advantage of the 0% long-term capital gains rate if your ordinary income is low enough. For 2025, single filers with taxable income up to $48,350, and married couples filing jointly up to $96,700, may qualify for this rate (IRS Revenue Procedure 2024-40).
• Use your pre-tax account in years when your income is lower and the marginal tax rate on those withdrawals is modest.

Consider a hypothetical couple in retirement. Their Social Security income and a small pension bring in $40,000 per year. If they need an additional $30,000 to cover expenses, they could draw from their Roth IRA without adding a single dollar to their taxable income. Had they saved only in pre-tax accounts, that same $30,000 withdrawal would be fully taxable as ordinary income, potentially affecting their Social Security tax treatment and Medicare surcharges simultaneously. This kind of coordination is explored further in our guide to building a retirement drawdown plan.

Tax diversification is about which buckets you hold. Asset location is about what you put inside each one. These are related but distinct concepts, and together they can meaningfully improve after-tax returns over time.

The general logic of asset location is this: place investments with higher expected tax costs in tax-sheltered accounts, and keep more tax-efficient investments in taxable accounts. Here is how that logic tends to play out in practice:

• Pre-tax accounts (traditional 401(k), IRA): Often considered appropriate for assets that generate significant ordinary income, such as bonds, bond funds, real estate investment trusts (REITs), or actively managed funds with high turnover. Because all withdrawals are taxed as ordinary income anyway, sheltering these high-tax assets inside the account can defer a heavier tax burden.
• Roth accounts: Widely discussed as a good home for assets with the highest expected long-term growth, such as small-cap stock funds or other higher-volatility holdings. Because Roth withdrawals are tax-free, maximising growth inside a Roth can amplify the tax benefit over decades.
• Taxable brokerage accounts: Generally considered more suitable for tax-efficient investments such as index funds with low turnover, tax-managed funds, individual stocks held long-term, or municipal bonds. These generate fewer taxable events and benefit from preferential capital gains rates.

It is worth noting that asset location decisions interact with your overall asset allocation and investment goals. The right placement for any given investment depends on many personal factors, which is why working with a qualified financial adviser can be particularly valuable when optimising across multiple account types.

Running a tax diversification checkup does not require complex software. A basic review involves four steps, though a financial adviser can help you model the numbers with greater precision.

Step 1: List your account balances by bucket.
Gather your most recent account statements and sort each account into its bucket. Add up the totals. For most savers aged 45 to 65, the pre-tax bucket is the largest by a wide margin, often representing 80% or more of investable assets. This concentration is worth examining.

Step 2: Estimate your future income sources.
Project what your annual income will look like in retirement, including Social Security (the Social Security Administration's my Social Security portal at ssa.gov provides personalised estimates), any pension income, and income from part-time work. This baseline tells you how much room you may have in lower tax brackets before additional withdrawals become costly.

Step 3: Project your RMD burden.
If you have a large pre-tax balance, the IRS's Uniform Lifetime Table (available at irs.gov) can give you a rough sense of what RMDs might look like at 73, 75, and beyond. For a $1 million traditional IRA balance at age 73, the first-year RMD is roughly $37,000 to $40,000 based on the published divisor. If that lands on top of Social Security and other income, the combined taxable income figure may be higher than expected.

Step 4: Identify your gaps and options.
If your Roth bucket is thin or your taxable account is minimal, those are areas worth exploring with an adviser. Common approaches people consider to rebalance over time include Roth conversions during lower-income years (converting a portion of a traditional IRA to a Roth, paying tax now at a potentially lower rate), contributing to a Roth 401(k) going forward if offered by an employer, or building a taxable brokerage account to create a flexible bridge. The year-end tax planning checklist covers several of these strategies in more detail.

A retirement calculator can be a useful starting point for visualising how different mixes affect projected after-tax income over a 20- or 30-year retirement. fidser's planning tools are designed to help you explore these scenarios at your own pace.

A few persistent misunderstandings can lead savers to undervalue tax diversification or pursue it incorrectly.

Misconception 1: "Pre-tax accounts are always better because I get a deduction now."
This is only true if your tax rate in retirement will be lower than it is today. For many people, especially those with growing account balances or late-career income spikes, that assumption deserves scrutiny. Roth contributions forgo the deduction today but offer certainty: qualified withdrawals are not subject to future rate changes. If you are weighing this decision in the context of your current 401(k), the discussion in our piece on Roth vs. traditional 401(k) may be useful background.

Misconception 2: "Roth conversions only make sense if you're in a low bracket."
Conversions are most tax-efficient when done at lower rates, but the calculation also involves factors such as your expected RMD size, Medicare IRMAA thresholds, estate planning goals, and the potential tax treatment of your Social Security benefits. The answer is rarely simple.

Misconception 3: "A taxable brokerage account is a last resort."
For many savers, the taxable account is the most flexible tool they own. There are no age restrictions, no penalties for early withdrawal, and no mandatory distributions. For those retiring before 59½ or seeking fine-grained income control, the taxable bucket can be genuinely valuable.

Misconception 4: "I'll figure out the taxes in retirement."
The window for influencing your future tax burden is largely before retirement, not during it. Conversions, contributions, and account selection decisions made during working years shape the options available later. Acting with a longer time horizon typically creates more room to manoeuvre.

Disclaimer: This article is intended for general educational purposes only and does not constitute personalised financial, tax, or investment advice. Tax rules and contribution limits are subject to change. Every individual's situation is different. Please consult a qualified financial adviser, tax professional, or retirement planner before making any decisions about your accounts, contributions, or withdrawal strategies.