Buckets
- emalden
- Jan 2, 2013
- 3 min read
Updated: Oct 7, 2019

The main goal for most investors is to save for a comfortable retirement. While each individual’s retirement planning strategy should be tailored to their own goals, time horizon, risk preferences, and personal circumstances, we favor a “bucket” approach for most people, whereby three separate buckets of money are filled during their working years, from which money will be withdrawn during retirement. These buckets represent the following types of investments: 1) taxable accounts; 2) traditional tax-deferred accounts; and 3) Roth accounts.
Taxable investment accounts, which include individual accounts, joint accounts, and most trust accounts, are typically funded with after-tax dollars. An advantage of these accounts is that there are no restrictions on the amount or timing of your contributions or withdrawals. There are also tax advantages, since dividends and long-term capital gains are taxed at a much lower rate than income for investors in the higher tax brackets. The recent fiscal cliff legislation raised the tax rate on qualified dividends and realized long-term capital gains from 15% to 20% for single filers with taxable incomes above $400,000 and joint filers with incomes above $450,000. Even with these increases, these tax rates are far below the 39.6% income tax rate for filers in the top tax bracket.
Our approach to taxable accounts is to manage them in a tax-efficient manner by minimizing dividends and interest. Our buy-and-hold approach also avoids realizing short-term capital gains, which are taxed at your marginal income tax rate, and delays the realization of long-term capital gains, which also defers the capital gains tax liability until the securities are sold. If you leave taxable assets to your heirs, the cost basis is re-set on the day of your death, a potentially substantial benefit sometimes 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, traditional IRAs and SEP-IRAs. An advantage of these accounts is that you can fund them with pre-tax dollars, which lowers your current taxable income, although this benefit is subject to income restrictions in the case of IRAs. The assets in these accounts grow tax-free, but are taxed as income when withdrawn during retirement. Furthermore, you are required to withdraw (and pay taxes on) a prescribed portion of these accounts each year beginning at age 70½. Conventional wisdom holds that this tax shouldn’t be too onerous because you’ll be in a lower tax bracket when you retire, but this is not necessarily true, particularly if tax rates continue to rise and tax brackets are not adjusted for inflation.
The final bucket is for Roth accounts, which are funded with after-tax dollars, grow-tax free, and have tax-free distributions. 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 provide a Roth option for employee contributions, and there is a new provision that allows you to convert any amount in your traditional retirement account to your Roth account, if your employer elects to offer this option. Roth conversions of pre-tax dollars are taxed as income in the year of conversion. Roth conversions are particularly attractive for investors who expect to be in a relatively high tax bracket during retirement and younger investors whose Roth accounts have more time to grow.
Filling each of these buckets has several advantages for retirement planning. If nothing else, it gives you more opportunities to save. One of the most common retirement planning errors is to assume that your employer-sponsored retirement account will be sufficient to guarantee a comfortable retirement, when in fact this is far from assured. With three buckets, you also have some ability to choose where to withdraw funds during retirement, which can help keep you in a lower tax bracket. The bucket approach also provides an element of tax diversification which hedges your risks regarding future tax rates. It may also allow you to delay taking social security until age 70, thereby boosting your monthly payments.
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital