3 Tax Buckets: Strategies for Retirement Savings

There are several reasons to invest—one is likely to build wealth and secure a comfortable retirement.

However, one important question many forget to ask is, “How can that money be taxed in retirement?”

In general, there are three tax buckets you should be aware of while investing. It’s too bad they didn’t teach me this in dental school!

And in this article, we’ll discuss all three and if there’s one that’s better than the other.

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What Are The 3 Tax Buckets?

Tax buckets separate your investments into different categories based on tax treatment. This can influence how much money you’ll keep after taxes.

Bucket # 1: Taxable
Bucket # 2: Tax-deferred
Bucket # 3: Tax-free

#1. The Taxable Bucket

Income in the taxable bucket includes earnings from brokerage accounts. You pay taxes on these earnings, whether they’re from interest, dividends, or capital gains.

Unlike accounts where your money is protected from taxes until later, the money in taxable accounts is easier to access when needed. This makes them great for saving for both short-term and long-term goals.

Don’t have goals? Check out this video:

Two Big Tax Questions

1. How are taxable accounts taxed?

You put in money you’ve already paid taxes on.
You’ll pay capital gains tax on any profit you make—this can be short-term or long-term, depending on how long you keep the investment.
- Short-term capital gains: If you hold the asset for a year or less, you pay tax at your regular income rate.
- Long-term capital gains: If you hold the asset for more than a year, you pay a lower tax rate.

2. When are you taxed?

You owe taxes in the year you sell the investment.

Example

Let’s say you buy Tesla stock for $250. After a year, it’s worth $300, and you sell it. You don’t pay tax on the $250 you originally spent. Instead, you pay capital gains tax on the $50 profit.

Tax Rates for Long-Term Capital Gains

Depending on your income, long-term capital gains tax rates can be 0%, 15%, or 20%. Plus, if you earn over $200,000 (single) or $250,000 (married), there’s an extra 3.8% tax called the net investment income tax (NIIT).

For instance, most doctors/dentists in high-earning years usually pay a 23.8% tax rate on long-term capital gains. This is still lower than the top income tax rate of 37%.

#2. The Tax-Deferred Bucket

When you invest in tax-deferred accounts, you use pre-tax dollars, usually taken directly from your paycheck. Many employer-sponsored retirement accounts, like traditional a 401(k) work this way.

If you’re self-employed like me, you may have other tax-deferred accounts such as SEP or SIMPLE IRAs.

Aspect	Description
How Are Tax-Deferred Accounts Taxed?	The IRS taxes the money you take out (distributions) at ordinary income rates.
When Are Tax-Deferred Accounts Taxed?	You pay taxes in the year you take the money out. For example, if you withdraw $150,000 from your traditional 401(k) in 2024, you’ll pay ordinary income taxes on the entire $150,000 in 2024.
Benefits of Tax-Deferred Accounts	– Lower taxable income now: By contributing pre-tax dollars, you can save on taxes during high-income years. – Tax-free growth: You don’t pay annual taxes on investment growth in these accounts. All growth is taxed when you take it out during retirement.

When Can You Access Funds?

You can withdraw money from these accounts without penalty once you’re 59 ½ years old.

#3. The Tax-Free Bucket

Roth IRAs, HSAs, 529 plans, and Roth 401(k)s are examples of tax-free accounts. Contributions are made with after-tax money, but withdrawals are generally tax-free during retirement.

Two Big Tax Questions

1. How are these investments taxed?

You pay taxes upfront, so you invest with after-tax money.

2. When are these investments taxed?

Before you invest.

These accounts work the opposite of tax-deferred accounts. You invest with after-tax dollars, your earnings grow tax-free, and qualified withdrawals are also tax-free.

Benefits for Your Career and Retirement

If your income increases during your career, you might not be able to contribute directly to a Roth IRA, but there are ways to still use Roth accounts, like through a backdoor Roth IRA or a Roth 401(k).

A big advantage of these accounts is reducing future tax risks. If you withdraw $250,000 from a Roth account instead of a traditional account, you don’t pay taxes on that money, assuming you follow the rules.

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Managing Retirement Income and Taxation

Controlling your retirement income and understanding how taxation affects it can help you retain more of your savings.

Effective management entails knowing the tax rules of different retirement accounts and strategically planning withdrawals.

Retirement Account Withdrawals

Withdrawing from your retirement accounts strategically can help you minimize taxes.

Traditional accounts, such as 401(k)s and IRAs, require you to start taking Required Minimum Distributions (RMDs) typically at age 73.

With RMDs, you must withdraw a specific amount each year, which is considered taxable income, potentially pushing you into a higher tax bracket.

Roth accounts offer more flexibility. Withdrawals from Roth IRAs and Roth 401(k)s are tax-free because contributions are made with after-tax money.

Unlike traditional accounts, Roth IRAs don’t have RMDs while you’re alive, giving you more control over your taxable income.

Consider a phased approach to withdrawals. For example, you might start taking withdrawals from traditional accounts before you are subject to RMDs, reducing large taxable distributions later.

Tax Implications for Retirement Income

Your retirement income may come from various sources, including Social Security benefits, pensions, and savings. Each source has different tax implications.

Up to 85% of your Social Security benefits can be taxed, depending on your combined income. Keeping your taxable income in a lower tax bracket helps reduce this burden.

Withdrawals from traditional retirement accounts are taxed as ordinary income, impacting your tax bracket.

Balancing withdrawals from traditional and Roth accounts can help you manage your taxable income.

You might also have income from after-tax money or investments.

Capital gains from these sources are taxed differently, typically at lower rates than ordinary income. Properly timing these withdrawals can provide additional tax advantages.

Frequently Asked Questions

How are the three tax buckets categorized for income tax purposes?

The three tax buckets are:

Taxable: This includes any earnings subject to tax in the year they are earned such as wages, interest from savings accounts, and dividends.
Tax-Deferred: Accounts like traditional IRAs and 401(k)s where you pay taxes upon withdrawal.
Tax-Free: Accounts like Roth IRAs where you pay no taxes upon qualified withdrawals.

What are the differences between the tax rates in 2023 and 2024?

In 2023, tax rates ranged from 10% to 37% for individuals, depending on your income level. For 2024, there might be minor adjustments due to inflation, but the overall structure typically remains similar with rates spanning from 10% to 37%.

Which investment types are taxed at the ordinary income tax rate?

Ordinary income tax rates apply to:

Wages or salary
Interest from savings and CDs
Traditional IRA and 401(k) withdrawals
Short-term capital gains (gains on assets held for one year or less)

Can you explain tax diversification and its relation to the tax buckets?

Tax diversification means spreading your investments across the three tax buckets: taxable, tax-deferred, and tax-free. This strategy helps manage taxes efficiently and offers flexibility.

During retirement, you can withdraw from different buckets based on your tax situation, potentially lowering your overall tax burden.

What tax considerations are there for savings and CDs in terms of taxable investments?

Interest earned from savings accounts and certificates of deposit (CDs) is included in your taxable income. This interest might push you into a higher tax bracket if it’s substantial.

Thus, understanding how interest income affects your income tax bracket is important for tax planning.

How can the concept of income buckets aid in financial planning and tax strategy?

Using income buckets helps you plan when to withdraw money and from which account.

By managing withdrawals from taxable, tax-deferred, and tax-free accounts, you can minimize your tax burden. Also, you can maximize your retirement savings and control your income more effectively during retirement.

How can a financial advisor help me manage my tax buckets?

A financial advisor can offer personalized advisory services to help you optimize your investments across the three tax buckets. They can provide tax advice, recommend suitable investments like mutual funds, savings accounts, and municipal bonds, and assist with strategies like Roth conversions. By understanding your financial goals and tax situation, a financial advisor can help you minimize your tax liability and maximize your savings.