The most important long-term financial goal for most people is to save for a comfortable retirement. It is also essential to save enough to alleviate concerns about running out of money during retirement. For most people, the best way to achieve these goals is to fill three “buckets” of money during your working years from which to withdraw assets during retirement. These buckets include: 1) taxable accounts; 2) tax-deferred accounts; and 3) Roth accounts.
Taxable investment accounts are funded with after-tax dollars. Unlike tax-deferred retirement accounts, taxable accounts have no restrictions on deposits or withdrawals. We manage our clients’ taxable accounts in a tax-efficient manner by minimizing the tax liability arising from dividends, interest, and capital gains. Our buy-and-hold approach avoids short-term capital gains, which are taxed at your marginal income tax rate, and delays the realization of long-term capital gains. If you leave taxable assets to your heirs, the cost basis is re-set on the day of your death, a valuable benefit that has been referred to as “free life insurance from the IRS.”
The second bucket represents traditional tax-deferred accounts, such as 401(k) and 403(b) plans, profit-sharing plans, and IRAs. These accounts are funded with pre-tax dollars, thereby lowering your taxable income, although there are income restrictions in the case of IRAs. These assets grow tax-free, but are taxed as income when withdrawn during retirement. The IRS requires annual taxable withdrawals from these accounts beginning at age 70½.
The final bucket is for Roth accounts, which are funded with after-tax dollars and grow-tax free. Withdrawals made after age 59½ are also tax-free. There are income restrictions on direct deposits to Roth IRAs, but there is no income limit on Roth conversions, which allow you to transfer assets from a traditional IRA to a Roth IRA. Some 401(k) and 403(b) plans offer a Roth option for employee contributions.
By filling each of these buckets during your working years, you can choose where to withdraw funds during retirement, which can help optimize your tax-efficiency. The bucket approach also provides an element of diversification which hedges your risks regarding future tax rates.