The 3 Tax Buckets for Investors

Tax-deferred accounts

e.g., 401(k), 403(b), traditional IRA

evolved as the investment and tax world that said wisdom was based on changed. For example, the top federal tax bracket in 1981 was 70%! Furthermore, for those who were married filing jointly, there were 16 different tax brackets. Today, there are only seven brackets with the highest bracket at 37%.

A married couple earning $120,000 in 1980 fell into the 64% marginal tax bracket in 1981. Back then, with so many brackets, if you earned a little more income, your tax bracket went up a level or two, and if you earned a bit less income, your tax bracket went down a level or two. As a result, the conventional wisdom became “We won’t need $120,000 in retirement because we can easily live on less (like $100,000) and, as a result, we’ll be in a lower tax bracket.” Hah!

Today, with only seven tax brackets, this couple would be in the same marginal tax bracket at both income levels, providing no tax benefit during retirement. So much for (outdated) conventional wisdom. And if tax rates increase beyond what we know, as many seem to suggest, to cover things such as Social Security, Medicare, Medicaid, interest on national debt, national infrastructure and national defense, the couple in our example will have created a bigger problem.

Not only is it possible that our couple living on a lower income during retirement will not be in a lower marginal tax bracket, but they actually may have deferred paying taxes at today’s historically lower rates only to pay higher taxes on a lower income during retirement.

Taxable accounts

e.g., bank account, brokerage account, family trust account

This will reduce their much-needed retirement income even more. And, like most retirees, they typically will have fewer deductions left to offset this problem. This is the opposite of the goal of having as much money as possible in retirement.

The three buckets

We already know that tax rates will be higher on Jan. 1, 2026, after the current tax law sunsets. It also is highly likely that taxes will go even higher down the road, given our country’s unfunded liabilities. So asset location and where people save or invest money over the next three years (2023, 2024 and 2025) can and will impact everyone’s retirement income stream when they retire.

This is a complex issue that, conceptually, is quite simple. Assume, generally, that there are three asset locations or “buckets” to save or invest money: 1) taxable, 2) tax-deferred and 3) tax-free. Simply plan to hold only enough cash liquidity in reserve for the unexpected in the taxable bucket. Plan to hold only enough money in qualified accounts (401(k)s, IRAs, etc.) to capture any free money (match) and not to trigger Social Security taxation in the tax-deferred bucket. And then plan to reallocate any surplus funds from the taxable and tax-deferred buckets to the tax-free bucket.

Do this slowly enough to avoid being in a higher current tax bracket now (or the lowest increase possible), but fast enough to be completed by Jan. 1, 2026, when tax rates go up permanently.

Tax-free accounts

e.g., Roth IRA, Roth 401(k)

There you have it: a three-year plan. A plan that flies in the face of conventional wisdom while better positioning your clients to have more income during retirement — which is the ultimate retirement goal.

Bottom line, asset location and dollar amounts in each bucket matter. In most cases, asset reallocation is needed to reduce or eliminate taxation in retirement. Doing this now, while tax rates are historically low, makes sense because tax rates likely will go up in the future. Doing this now will create more income during retirement. Unfortunately, the unintended consequences of following conventional retirement planning wisdom will be reduced incomes and accelerated spend down of existing assets — and that is not what is desired.

They say that the devil is in the details and that simple is not always easy. But grasping this idea and these concepts will make you more valuable to your clients and will separate you from those advisors who simply focus on conventional wisdom. Devil be damned! Embrace the simplicity of this approach and master the details ASAP, and you will be more productive as a result of creating better retirement income strategies for your clients. Do not delay. The clock is ticking!

Jeff Snyder is executive vice president of business development and insurance with Gateway Financial Advisors. He may be contacted at jeff. snyder@innfeedback.com.