We all know it’s important to save for retirement. But, with so many different account options and rules, what is the best one for you? In my attempt to make the complicated simple, I choose to educate my clients on a plan I refer to as the “3 Bucket Method”. Each bucket has a purpose both in the present and in the future. While it’s tough to know with certainty where your life, finances or tax circumstances will be in 10, 20, 30 or even 40 years, I encourage my clients to manage their finances as best they can to minimize their tax burdens.
Accordingly, the 3 buckets are divided into 1) pre-tax, 2) tax free, and 3) taxable investment accounts. The following is a brief description of each:
This bucket consists of various 401k options, as well as Individual Retirement Accounts (IRAs). Contribution limits, which are set by the IRS, vary on each option.
A 401K is a common employee benefit that often offers a company match to encourage participation by employees. Your contributions reduce your taxable income dollar for dollar, thus giving you a tax break in the year of the contribution. After age 59 1/2 you can withdraw from your 401K without penalty. Because you receive the tax break in the year the money is contributed, however, these accounts are considered tax-deferred, meaning you pay ordinary income tax on every dollar you withdraw.
An Individual Retirement Account (IRA) is another option for you to invest in your pre-tax bucket. Most often, this option is used because you don’t have a 401k through your employer. IRAs have the tax-deferral benefit of lowering your taxable income in the year you contribute, thus you pay taxes later on when you take withdrawals.
This bucket consists primarily of a Roth IRA. It has now been 20 years since Uncle Sam began offering us the opportunity to save money with income we have already paid taxes on, and withdraw it tax free after age 59 1/2 — including the gains! There are income limits that are set by the IRS regarding your eligibility to contribute to a Roth. Often times your employer’s 401K has a Roth option on their platform, and the eligibility for this Roth option is not limited by your income. There are other, more complex, options to save in the tax-free bucket, but this is the most common.
3) Taxable Investment Accounts:
This bucket consists of Individual & Joint Investment Accounts and bank savings accounts. These accounts are funded by money that you’ve already paid income taxes on. They do not have withdrawal rules around them, so you’re free to use the money invested in this account at any time. Taxes are paid on the gains, both short term and long term, when they are realized. Other characteristics these accounts possess are: they are not income based; they have no barriers to entry; there is no penalty for withdrawing before age 59 1/2; and there are no contribution limits. These accounts are a great source to provide income if you want to retire prior to age 59 1/2!
As I stated earlier, it’s tough to know where your life journey will take you, but doing your best to diversify within the 3 buckets will provide balance and tax diversification for your future. As you learned by reading my brief descriptions of the 3 Buckets above, the one thing that is certain is there are tax considerations with each.
Talk to your financial advisor about the specifics involved with your situation and the saving options that are right for you. They’ll discuss what’s available to accomplish your short-, intermediate-, and long-term goals and formulate a plan that maximizes your wealth to the fullest. You’ll be glad you did, and not wishing you would have!
Limitations and Early Withdrawals: Some IRAs have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney.
Retirement Plans: Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
Roth IRA: Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.