Buckets of Money (08/06/2015)

In my study of financial planning, one of the first concepts I learned was to create a future income stream for retirement using three imaginary buckets of money. The first bucket would contain tax-deferred savings. The second would contain a combination of after-tax and tax-deferred savings. The third bucket would contain after-tax dollars potentially growing tax-free.

The first bucket contains your actual retirement savings in the form of your 401(k), 403(b), traditional IRA, or any other tax qualified investment that allows you to defer funds today before they are taxed. You pay the tax when you withdraw the funds from the investment. For many people, this bucket can be large, as there are many options available from employers to save on taxes today by investing in the various retirement vehicles with a company match.

The second bucket is often referred to as an investment account. This could be a CD, mutual fund or a portfolio of various stocks and bonds and savings instruments. The money you invest here has already been taxed, and is known as your cost basis. This money will not be taxed when you withdraw it, but you will be taxed annually on the dividends, interest and capital gains growth of the investment. This growth is added to your cost basis, so you will not pay tax on it again when you withdraw funds. You might also see capital appreciation (an increase in the market price of an asset) in this type of account. You will not pay tax on the capital appreciation until you make an actual withdrawal. You could think of this investment as the “combination bucket” where you could pay tax on a portion of your withdrawal but your cost basis will not be taxed.

The third bucket could be a Roth IRA or Cash Value Life Insurance savings. With the Roth, you invest after-tax dollars. As long as certain conditions are met, the funds grow tax-deferred and are withdrawn tax-free. With Cash Value Life Insurance, you are investing after-tax dollars that first pay for life insurance. If you have paid more for life insurance premiums than your cash value, the balance grows tax-deferred and very often can be withdrawn tax-free.

The overall concept is to have the three different streams of income available to you in retirement. You could help your tax situation in retirement by having some income streams that are either taxed minimally or are tax-free. Most people will have IRA or Pension distributions that will be taxable. If you are able to supplement the taxable income in retirement with your other two streams, you could provide some tax relief as you continue to enjoy your current standard of living.

Lisa Dugan

Posted August 6, 2015 1:15 PM