By Bob Rall, CFP®
Do you know what tax bracket you will be in when you retire? Predicting future tax rates can be as difficult as predicting the stock market, interest rates and the weather. Taxes can have a huge effect on your retirement income, so having a strategy to minimize them is important. One strategy for minimizing taxes in retirement is called the three-bucket strategy. With the three-bucket strategy, you are creating three different pools of retirement savings.
How the Buckets Work
The first bucket consists of money that you have saved outside of any IRA or other employer-sponsored plan. This is the “post-tax” bucket, consisting of money that has already been taxed.
The second bucket is the “tax-deferred” bucket, containing money that you have saved in a traditional IRA or a 401(k) plan. It’s money that will be considered taxable income when you withdraw it. (For related reading, see: Not All Retirement Accounts Should Be Tax-Deferred.)
The key to the strategy is that third bucket, the “tax-free” bucket. You fill up this bucket by making post-tax contributions into a Roth IRA or Roth 401(k). The money goes in after tax and comes out tax-free - including all of the growth and income that has occurred in the account over the years.
Impact of New Tax Laws
The third bucket has become a much bigger part of retirement planning because of the new tax laws that went into effect this year. The new laws cut the current tax rate, but there are projected increases as a result of government deficits that may mean that tax rates are much higher in the future. If this occurs, tax-free income in retirement will be even more valuable. The three-bucket strategy allows you to effectively control the tax consequences of your retirement income. Here's an example of this strategy in practice:
For a married couple, filing jointly, the 2018 tax rates increase from 12% to 22% once your taxable income goes above $77,400. For our example, let’s assume that you need $90,000 of cash flow each year in retirement. Between your Social Security benefits and the interest, dividends and capital gains from your post-tax account, you have $48,000 in taxable income. Next, you withdraw $29,400 for the year from your IRA or 401(k), your tax-deferred bucket. Remember, everything from that bucket is taxable, so you are now at $77,400 in taxable income.
To get to your income need of $90,000, you withdraw $12,600 from your Roth IRA or 401(k) accounts, your tax-free bucket. By following this plan, you have accomplished your income goal and did not push yourself into the next tax bracket. Implementing this strategy will rarely be as clean as our simplified example and it will vary from year to year. But managed properly, you can get the cash flow you need and control the tax consequences. After all, a dollar saved in taxes is another dollar that you can use however you want in retirement. (For more from this author, see: The Best Way to Spend Your Retirement Savings.)
This article was originally published on Investopedia.