The 3 Tax Buckets Strategy for Retirement

The “3 tax buckets” strategy is a framework for categorizing investment accounts based on their tax treatment. The goal is to sort every account into one of three categories: tax-deferred, tax-free, or taxable. Each bucket has a unique relationship with the tax system, affecting when taxes are paid. By allocating money across these buckets during your working years, you can create flexibility and control over your taxable income in retirement.

The Tax-Deferred Bucket

The first category is the tax-deferred bucket. Contributions to these accounts may be tax-deductible, lowering your current taxable income. Inside the account, all investment growth accumulates without being taxed annually, allowing funds to compound more rapidly.

Accounts in this bucket include:

• Traditional 401(k)
• Traditional IRA
• 403(b)
• SEP IRA

For example, an individual can contribute up to $23,500 to a 401(k), with an additional $8,000 catch-up contribution for those age 50 and over. For a Traditional IRA, the contribution limit is $7,500, with a $1,000 catch-up. The deductibility of Traditional IRA contributions can be limited by income if you or your spouse have a workplace retirement plan.

The trade-off for these tax advantages comes in retirement, as every dollar withdrawn is taxed as ordinary income. Withdrawals before age 59½ incur a 10% penalty in addition to income tax. Starting at age 73, you are subject to Required Minimum Distributions (RMDs), which mandate annual withdrawals.

The Tax-Free Bucket

The second category, the tax-free bucket, operates as the inverse of the tax-deferred bucket. Contributions are made with after-tax dollars, meaning there is no immediate tax deduction. The benefit emerges over the long term, as investments within the account grow completely tax-free. Qualified withdrawals in retirement are also entirely tax-free, providing a source of income that does not add to your taxable income.

The most common examples are the Roth IRA and the Roth 401(k). Contribution limits for a Roth IRA are similar to a Traditional IRA, but the ability to contribute directly is phased out at higher income levels. A Roth 401(k) has the same contribution limits as a Traditional 401(k) but without income restrictions. For a Roth IRA withdrawal of earnings to be qualified, five years must have passed since the first contribution, and you must be over age 59½ or meet another exception.

Another account in this bucket is the Health Savings Account (HSA). HSAs offer a triple-tax advantage: tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. After age 65, funds can be withdrawn for non-medical reasons but are subject to ordinary income tax.

The Taxable Bucket

The third category is the taxable bucket, which includes standard investment accounts like brokerage accounts, savings accounts, and CDs. Contributions are made with after-tax dollars, and there is no upfront tax deduction.

This bucket does not shield investments from ongoing taxation. Income generated from dividends or interest is taxed in the year it is received, creating a tax liability even if you do not sell any investments.

When you sell an asset for a profit, the gain is subject to capital gains tax. The rate depends on how long you held the asset. A profit from an asset held for one year or less is a short-term capital gain, taxed at your ordinary income rate. A profit from an asset held for more than one year is a long-term capital gain, taxed at lower rates of 0%, 15%, or 20%, depending on your income. This distinction provides an opportunity for tax management by controlling the timing of asset sales.

Strategic Allocation and Withdrawal Sequencing

Using the three buckets strategically unlocks their potential for tax diversification. During your working years, the allocation decision between the tax-deferred and tax-free buckets depends on your current income versus your expected income in retirement. If you anticipate being in a higher tax bracket in the future, prioritizing the tax-free (Roth) bucket is advantageous. Conversely, if you expect to be in a lower tax bracket in retirement, the immediate deduction from a tax-deferred account might be more valuable.

Filling the taxable bucket often occurs after tax-advantaged accounts are maxed out, as it provides liquidity and flexibility. The primary application of the three-bucket strategy comes during retirement through a thoughtful withdrawal sequence. The goal is to manage your annual taxable income to minimize your tax liability. By controlling which bucket you draw from, you can influence your income level each year.

A common withdrawal strategy aims to prolong growth in tax-advantaged accounts by drawing from the taxable bucket first. Selling long-term assets may result in capital gains taxed at lower rates than ordinary income, providing a tax-efficient source of funds. This approach allows the tax-deferred and tax-free accounts to continue growing untouched for as long as possible.

The next step is to withdraw from the tax-deferred bucket. These withdrawals are fully taxable as ordinary income and will count toward the income thresholds that determine if your Social Security benefits become taxable. Depending on your combined income, a portion of your Social Security benefits may become taxable. Therefore, you might withdraw only enough from this bucket to meet spending needs while trying to stay within a specific tax bracket.

The tax-free bucket is reserved for last. Since qualified withdrawals from Roth accounts are not considered income, they do not increase your tax bill or affect the taxation of your Social Security benefits. This makes the tax-free bucket a useful tool for covering large expenses or for supplementing income in high-spending years without pushing you into a higher tax bracket. Some retirees also employ a blended approach, taking proportional withdrawals from each bucket annually to smooth out their tax liability.