By Jonathan Harner, CFP®
We can’t escape the inevitability of being taxed on our income. However, the tax bucket strategy can help you more precisely plan what percentage of your income you put into each of the buckets—and, therefore, how and when your income is taxed. The three buckets to think about when choosing where to save and grow your money: taxable, tax-deferred, and tax-free.
Storing some percentage of your money in each of the three types of tax buckets diversifies your portfolio and gives you control over how and when your retirement income is taxed.
Let’s define each of the three buckets and explore how they can fit into your overall financial picture.
Taxable Bucket
The taxable bucket includes savings vehicles that are funded with after-tax money. The accounts that fit into this bucket are taxed on the income gained each year but not on the contributions. Some examples of the accounts in this bucket are checking accounts, savings accounts, money market accounts, CDs, and brokerage accounts. If you have growth in any of these accounts during the year, you’ll receive a 1099 tax form from the IRS and you’ll owe taxes on those gains. The growth is considered income by the government.
Taxable accounts are accounts we tend to use on a regular basis. One benefit of using a taxable account is that there is no limit on contributions or withdrawals, unlike the accounts in the tax-deferred and tax-free accounts. Discuss with your financial advisors what percentage of your portfolio belongs in the taxable bucket.
Tax-Deferred Bucket
The tax-deferred bucket includes accounts like a traditional IRA, traditional 401(k), traditional 403(b), and traditional Thrift Savings Plan (TSP).
When you make contributions to these types of accounts, you get a tax deduction. The money that gets invested in this bucket of accounts is from pre-tax dollars. Your money continues to grow inside these accounts tax-free every year. However, when you withdraw money from these accounts, for example, during retirement, the money is taxed as ordinary income. So you are deferring tax payments when you invest in these accounts until you want to withdraw and use the money.
One tip regarding the tax-deferred bucket is that you keep aware of your current tax bracket and how much money you withdraw from a tax-deferred account so you don’t exceed your tax bracket’s maximum income amount and therefore move up to a higher tax bracket.
Tax-Free Bucket
The tax-free bucket includes accounts like a Roth IRA, Roth TSP, Roth 401(k), Roth 403(b), 529 college savings plans, and health savings accounts (HSAs) when used for qualified medical expenses.
When you contribute to funds like these, you pay taxes on the contribution. The money used to invest in these accounts comes from after-tax dollars; however, unlike the tax-deferred bucket, the gains made in these accounts are not taxable. Each year that you hold money in one of these accounts, the money grows tax-free. And as you withdraw from accounts in the tax-free bucket, you do not pay taxes. This is especially helpful during retirement when your income is fixed.
How Much Should You Invest in Each Bucket?
Being fully informed of the effects of taxation on financial portfolios is vital to a successful retirement plan. Choosing your exact tax bucket strategy is a great topic to discuss with your financial advisor. We at Wichita Wealth Management are experienced in mapping out solid retirement tax plans and can create one for your individual circumstance.
When you leave the tax bucket strategy formulation to us, it leaves you more time to devote to your family and hobbies. We’re happy to ease your retirement planning burden. Book a free 15-minute intro call with me on my Calendly page here.
About Jonathan
Jonathan Harner is a CERTIFIED FINANCIAL PLANNER™ practitioner at Wichita Wealth Management, a fee-only, fiduciary financial advisory firm dedicated to helping their clients thoroughly prepare for retirement. Jonathan’s goal is to simplify the complex so his clients can experience confidence and peace of mind as they work toward and live out their retirement dreams. He specializes in developing and implementing tax strategies that maximize his clients’ money and builds a tax-efficient withdrawal plan for retirement. Jonathan loves finding opportunities for his clients to save money and is dedicated to continual learning and growing in his profession so he can provide solutions for his clients’ financial needs. When he’s not working, you can find Jonathan spending time with his wife, Annie, and their daughter, staying active in his church community, and participating in his two favorite (but vastly different) hobbies: CrossFit and Dungeons & Dragons. To learn more about Jonathan and how he can help you, connect with him on LinkedIn.