Reduce Your Retirement Tax Risk With the Three-Bucket Strategy
Splitting retirement funds into three buckets with distinct tax treatments can help you avoid a nasty tax bill down the line. Here's how the strategy works.


When I speak with prospective clients about their retirement goals, common concerns usually revolve around market volatility, rising health care costs, the future of Social Security and, lately, inflation.
However, one of the most critical factors in retirement planning is often overlooked: taxes.
Many people don’t realize how much taxes will impact their retirement until it’s too late. In my experience, here are the two most common reasons for underestimating tax liability:

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- Income assumptions: People often think they’ll need less income in retirement and, therefore, will land in a lower tax bracket. But this isn’t always the case.
- Tax-deferred savings: Many people overlook the “ticking tax time bomb” they’ve created by concentrating their savings in tax-deferred retirement accounts.
Most Americans rely heavily on these tax-deferred accounts to fund their retirement, and while they certainly have their benefits, there can also be serious tax consequences down the line for those who put all or most of their nest egg into that one basket.
Every time you make a withdrawal from a tax-deferred retirement account, you could be bumped into a higher tax bracket, leading to a larger-than-expected tax bill.
The real kicker comes when you hit the age for required minimum distributions (RMDs). These mandatory withdrawals could cause your taxable income to spike, unexpectedly increasing your tax liability.
Worse, taking a large withdrawal from your 401(k) for things like a vacation, home renovation or medical expenses could trigger additional taxes on your Social Security benefits or even Medicare premiums.
The good news is there are ways to help minimize taxes in retirement. A strategy that can help is to focus on diversifying the way your retirement assets are taxed.
It’s called the three-bucket tax strategy, and it’s designed to reduce your tax risk while giving you more control over your financial future.
What is tax diversification?
When people think about diversifying their portfolios, they tend to focus on investing in different asset categories, such as stocks, bonds, ETFs and real estate, to lower their risk.
What they don’t spend nearly as much time on is diversifying the tax status or tax treatment of those investments with the same goal.
The three-bucket tax strategy helps you spread your funds across different types of accounts, each with distinct tax treatments. This approach can help you optimize withdrawals and minimize your overall tax burden.
Here’s what those buckets look like:
The tax-deferred bucket
The contributions you make to the accounts in this bucket — 401(k)s and similar workplace plans or traditional IRAs — are typically tax-deductible, which reduces your taxable income in the year you contribute the money.
However, you’ll still have to pay taxes on the contributions and earnings when you withdraw the money in retirement. Withdrawals are generally taxed as ordinary income based on your current tax bracket.
And even if you don’t need the money, you must begin taking RMDs at either age 73 (for those born before 1960) or age 75 (for those born in 1960 or after).
The tax-free bucket
This bucket is for tax-advantaged accounts funded with after-tax money, such as Roth IRAs, Roth 401(k)s, municipal bonds or certain types of life insurance policies.
These accounts don’t give you an immediate tax deduction, but the real benefit comes when you withdraw the funds — there are no taxes on growth or withdrawals, as long as you meet the IRS rules. This can provide a significant tax advantage in retirement.
The after-tax bucket
This bucket holds accounts you fund with after-tax money, including brokerage accounts, bank accounts and CDs. While you won’t get any immediate tax breaks, the income (interest, dividends and capital gains) is taxable in the year it's realized.
Some earnings in this bucket may be taxed as ordinary income.
However, some may be taxed at the lower long-term capital gains rate (0%, 15% or 20%, depending on your income that year).
Benefits of the three-bucket tax strategy
You may not need or want to keep all three tax buckets filled to the same level all the time. But diversifying how your assets are taxed can give you more control over your taxes in retirement and, therefore, your yearly tax bill.
With more options, you may be able to:
Lower your RMD obligations: By contributing to a Roth IRA or Roth 401(k) or by converting traditional IRA funds to Roth accounts, you can reduce or eliminate RMDs. Although you'll pay taxes upfront, once the money is in a Roth account, growth and withdrawals are tax-free.
Maximize your savings: If you're already maxing out contributions to tax-advantaged accounts, opening a brokerage account can help you invest even more.
Another plus: You can do a tax-loss harvesting strategy that uses losses to offset gains in taxable brokerage accounts, but not in tax-advantaged plans. If safety is your priority, you can opt for more conservative investments like CDs or high-yield savings accounts.
Avoid additional taxes: Many soon-to-be retirees don’t realize a portion of their Social Security benefits can be taxed if their income exceeds certain thresholds.
You could be taxed on up to 50% of your benefits if your income is $25,000 to $34,000 for an individual or $32,000 to $44,000 for a married couple filing jointly. If your income is more than $34,000 (individual) or $44,000 (couple), you could be taxed on up to 85% of your benefits.
If those amounts seem low to you, you’re not wrong; they were set more than 30 years ago. If you plan to pull a significant amount of your retirement income from a tax-deferred account, you may inadvertently push your income over these limits and increase the taxes you pay on your benefits. Tax diversification can help you avoid this.
Leave more to your loved ones: Another benefit to tax diversification is that it can allow you to leave behind a legacy that’s less burdened with tax consequences.
Adult children, who often are in their peak earning years when they inherit a tax-deferred account, usually have only 10 years to draw down the account and pay taxes on the money.
Large distributions could push them into a higher tax bracket and, therefore, reduce the size of their inheritance.
Life insurance proceeds, which generally aren’t taxable as income, may be a less-fraught alternative. And though Roth accounts must be emptied within 10 years, those withdrawals aren’t taxed.
It takes commitment
These are just a few ways a three-bucket strategy can help reduce taxes, add flexibility to your retirement plan and make your money last longer.
Tax diversification isn't just about saving a few dollars on your taxes each year — it’s about long-term planning and strategic withdrawals.
But it can take a real commitment, investment and tax knowledge to ensure the money you save goes into and comes out of the right account at the right time.
If you haven’t already considered tax diversification as part of your retirement plan, talk to a financial professional about how it could work for you and your family.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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Bryan S. Slovon is founder and CEO of Stuart Financial Group, a boutique financial services firm exclusively serving retirees and soon-to-be retirees in the D.C. metro area. He is an Investment Adviser Representative and insurance professional focusing on retirement planning and wealth preservation to a select group of clients. (Advisory services offered through J.W. Cole Advisors, Inc. (JWCA). Stuart Financial Group and JWCA are unaffiliated entities.)
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