When saving for retirement, you always hear about the need to diversify your investments.  Don’t put all your eggs in one basket, right?  You can’t tell which asset class will be winners and which will be losers, so put some in stocks, some in bonds and some in liquid investments like money markets. This is great advice for managing an account like your IRA. But this is only one part of the diversification equation for your retirement.

There’s another part of the equation to think about. It is vitally important to diversify the types of accounts as well. Specifically, I’m suggesting splitting your retirement savings between traditional accounts, Roth accounts and fully taxable accounts.  They each have advantages. With a traditional IRA or 401(k) contribution, you get the big tax break now and pay no taxes until you withdraw from your account. At that time, these withdrawals are fully taxable. With a Roth IRA or Roth 401(k), you get no tax break now, but withdrawals are usually tax free at retirement. With a fully taxable account (like a brokerage account at Schwab), there’s no upfront deduction but you might get to take advantage of certain tax aspects such as lower long-term capital gains taxes or using losses to offset gains as you invest through the years. Plus, this money is available to you without penalties when you need it. So, diversifying these accounts means you are diversifying the tax treatments of your retirement savings.

How much of your savings should you be putting in each type? That’s a really hard question because the answer depends on what your future tax rates will be. Will it be higher, lower, or the same when you retire? No one knows this. That’s why it makes sense to diversify these account types. It’s not all or nothing.

There is no need to over-think things here as there are not absolute guidelines to follow. Here are my thoughts on these account types.

I feel younger people should generally be putting more money into Roth accounts and less into traditional. Because younger people often are in their lowest income years, the up-front tax deduction of traditional accounts is less valuable. Plus, they have more years to let their money grow and it could lead to millions of tax-free income in retirement from their Roth. Also, keep in mind that if your employer matches your 401(k) contributions, they are pre-tax (traditional), so you would always have that amount in traditional contributions.

When you hit your 40’s and 50’s, traditional IRAs and 401(k)s become more valuable.  Why? Because you may be in higher tax brackets then and you don’t have as many years for earnings to compound.

Too many people plow a lot of money into their retirement accounts but have little savings outside of them. I learned this lesson personally. Thus, I think it also makes sense to save outside of tax advantaged accounts so you will have few restrictions on this money in case you it. This money will be available to you in case of emergencies, large purchases and expenditures, and help you delay tapping into your qualified retirement account (or start social security) if you retire early. Set up an account at a low-cost brokerage such as Schwab, Vanguard, or Fidelity and put automatic deposits into it each month.

Let’s look at example for Sue the young saver. She’s 30 years old, earns $60,000 per year and saves 15% of her salary into her 401(k). Her plan provides a dollar for dollar match up to 5%, so she is saving 20%.  Congratulations to Sue as she is definitely on track for a well-funded retirement. All her withdrawals, however, will be fully taxable from her plan and she may face penalties if she needs to access these dollars early.

An alternative that would diversify her accounts might look like this.  Sue puts 5% into her traditional 401(k) and gets the match.  So, 10% of savings will be traditional and fully taxable at retirement. She sets up a Roth IRA and funds it with 5%. While she has a Roth option within her 401(k), she chooses the IRA for her Roth dollars because her 401(k) has high expenses. Finally, she sets up a brokerage account and starts to fund it each month with an amount equaling 5% of her pay. I’m not going to do all of the math on this to see which approach is “better”, because future tax rates and personal circumstances are simply unknown. From a practical standpoint, she is saving the same amount, losing some current tax deductions, diversifying the tax treatment of her savings, and is setting herself up with more flexibility to handle the uncertainties of the future.

Enjoy the journey!