One of the main goals of asset accumulation is to save for a comfortable retirement. We recommend filling 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 These assets grow tax-free, but are taxed as income when withdrawn during retirement.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.