Save Hundreds of Thousands with this Simple Concept!

Published On: April 8th, 2024Categories: Accounting, Business Tax, Individual, Small Business, Tax Planning, Taxes

The Three Bucket Approach

All money IS NOT created equal in the eyes of the taxman. Some is fully taxable while other money has a future tax bill attached to it. But the best is money that grows truly tax free! This approach to retirement income is often referred to as the three bucket approach and here is how it works.
The place to start is to divide all your savings into three buckets. The buckets are:

  • BUCKET 1: Taxable bucket. Savings in this bucket creates earnings that are subject to both federal and state income taxes. Examples include investments and various bank accounts.
    Goal: Fill your taxable bucket with enough money to cover 6 to 12 months of living expenses as well as enough to fund unexpected emergencies.
  • BUCKET 2: Tax-deferred bucket. Funds in this bucket are money you don’t have to pay taxes on until a future date. Tax-deferred accounts include 401(k)s, traditional IRAs, SEP IRAs, and SIMPLE plans.
    Goal: Make tax-efficient withdrawals from this bucket that result in very little or no income tax liability whenever possible. For example, unplanned distributions from tax-deferred retirement accounts could inadvertently push your total taxable income high enough to cause some or nearly all of your Social Security benefits to be taxed!
  • BUCKET 3: Tax-advantaged bucket. This bucket contains money that will never be taxed. These accounts include Roth IRA and Roth 401(k) accounts, limited types of annuities, and select mutual fund accounts that are state tax exempt.
    Goal: Maximize the balance in this bucket to reduce future taxes AND provide funding flexibility to minimize the tax in your other two buckets. The key in this bucket is to FUND the bucket as tax efficiently as possible.

The three-bucket concept in action

Using this new found bucket knowledge:

  • First, fill up bucket one to ensure you have enough money in case of an emergency.
  • Always fill bucket two when contributions are matched by your employer or when you are in a high tax bracket so you can take advantage of the tax deduction now at high tax rates for any contributions.
  • Fill bucket three after one and two are maximized or if you can do so with earnings taxed at a low rate. So it could be a great option for a young worker!
  • Review your buckets EACH year for tax-efficient ways to move funds from buckets 1 AND 2 into bucket 3 by contributing to a Roth IRA or rolling funds into Roth IRAs when you have years that you are in lower tax brackets.
  • Calculate the most tax-efficient way you can withdraw from these buckets each year in retirement to maximize the lowest tax brackets over time.

To recap, savvy tax planning includes understanding the three bucket concept – Taxable, Tax-deferred, and Tax-advantaged. Review each bucket every year with your advisors and make adjustments as necessary to leverage this knowledge to your benefit.

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About the Author: Shelly Spata, CPA

Shelly Spata joined the firm in 1998, and her name went on the door in 1999. She now serves as the Managing Partner of the firm. "As a business owner myself, I understand the complexities and challenges business owners face, and I strive to add value by helping clients understand their financial statements, manage tax consequences, and clearly see the financial and tax ramifications — both positive and negative — of decisions they make," she explains. "Without good financial information, it’s like driving a car blind, but with good information, clients are able to maximize profits."