The 3-Bucket Approach to Retirement Savings


What tax bracket will you be in when you retire? Unless you are retiring within the next year or two, this question might be a difficult one to answer. 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 that can help is what I call the three-bucket strategy.

The idea is to have three different buckets of retirement money. The first bucket consists of money that you have saved outside of any IRA or employer-sponsored plan. We’ll call that 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 401(k)-type plan. It’s money that will be considered taxable income when you withdraw it for cash flow.


A lot of people have the first two buckets under control. 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. This 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 tax rates for now, but projected increases in government deficits have many believing that tax rates will be much higher in the years ahead. If that’s the case, tax-free cash flow would become even more valuable.

By putting the three-bucket strategy in place, you can effectively control the tax consequences of your retirement income. I’ll use an oversimplified example to illustrate how it can work. 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.


Here’s how the three-bucket approach could work. Let’s say that 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.