Tax Bucketing: How Tax Diversification Can Save You Tens of Thousands of Dollars — or More

Introduction

Retirement? Exciting!

Taxes? Painful.

But if you aren’t prepared to handle taxes in retirement (or just decide not to put any thought into them because they’re painful), you stand to miss out on massive tax savings – tens or hundreds of thousands of dollars - and possibly never even realize that you did.

When I became an advisor in 2011, I noticed pretty quickly that most people are far more focused on how much they have saved for retirement than where it is. I also noticed that a lot of people go into retirement treating taxes as inevitable – again, without putting much thought into how their retirement savings actually get taxes.

To be clear: how much you have saved does matter. But where it’s saved opens a lot of doors. On the other side of those doors: more money for you, less for the IRS and your state taxing authority.

When you’re working, managing your tax bill requires a different approach. For most people, it works like this: You earn your living, and taxes are automatically withheld from your paycheck. Maybe you pay quarterly estimates if you’re self-employed. Maybe it’s both. You don’t really feel like you have a lot of control over your taxes. This doesn’t mean you don’t do everything possible to try to cut your tax bill. You contribute to a 401(k). You max out an IRA, and take that deduction – if you’re eligible for it. Really, you find every possible deduction you possibly can. But for the most part, at filing time, you find you’re eligible for a refund, or (begrudgingly) accept that your tax bill is what it is.

Here’s the good news: the rules are about to change. But you can only benefit from them if you take a proactive approach to taxes in retirement. Here’s how you can be prepared by utilizing tax diversification – a concept that gives you more control of what you owe to the IRS, and what you get to keep.

Death and taxes? Inevitable. How much tax you pay? Much more in your control.

Tax Diversification Through The Bucketing Approach

Diversification is an investing basic. The principle is simple: don’t put all of your eggs in one basket. If you wouldn’t put all of your eggs in one basket when investing, why do that with taxes?

Every dollar you’ve saved falls into one of three possible tax buckets. Each bucket has its own rules. In general, if you get tax advantages now, you’ll pay more taxes later; if you pay taxes now, you’ll get tax advantages later, with some caveats. You’ve likely heard of all these before. Here’s a quick refresher:

The tax-deferred bucket: This is your traditional 401(k), traditional IRA, or 403(b) – common retirement savings accounts many people default to using without thinking twice. You got some tax savings the year you put money in (usually - there are exceptions), and every dollar you pull out in retirement gets federally taxed as ordinary income, just like a paycheck. (Note that it is not subject to FICA – that 7.65% Medicare/Social Security tax you see deducted on your paystub, or that you pay twice if self-employed.)

Once you reach a certain age, the IRS requires you to withdraw a minimum amount from these accounts every year, regardless of whether you need it. Those are all called Required Minimum Distributions, or RMDs, and I’ll come back to those in a minute.

The tax-free bucket: This is the Roth IRA and Roth 401(k). You paid the tax up front – no tax advantages by making contributions to these. Generally, retirees don’t owe any tax on money coming out of these accounts later, as long as they’ve followed the rules along the way.

Your contributions can always come out tax- and penalty-free, even if you’re not 59 ½, and even if you just opened the account last month. The growth in the account is another story. A Roth IRA needs to have been opened for at least five years, and you generally need to be 59 ½ before the growth comes out tax-free, too.

Unlike the tax-deferred bucket, a Roth IRA has no required withdrawals during your lifetime. This is one of the most generous provisions in the tax-code, and one of the most appealing features of a Roth IRA.

The taxable bucket: Brokerage accounts, savings, or anything without a retirement wrapper attached to it. You already paid tax on the money that went in. Going forward, you’ll owe capital gains tax when you sell – which, if held for more than 12 months, is more favorable than ordinary income tax. This generally applies to stocks, mutual funds, and appreciated real estate. Interest and dividends are paid along the way too, and you’ll get a 1099 for those each year to file with the rest of your taxes.

It’s common for people I sit down with to have way more sitting in the first bucket than anywhere else. That’s nothing to feel guilty or worried about. When your employer invites you to contribute to a 401(k) on day one, that’s just the extent of how a lot of people approach saving for retirement. It makes sense that it ends up lopsided. But it means by the time you retire, most of what you touch is fully taxable, which means you either accept less control over your tax bill in retirement, or you start thinking about careful maneuvers to keep more in your wallet.

Two Retirement Stories

Cindy retires at age 62, and her friend Amy retires at the same age. They’ve both saved well, accumulating $1,500,000 each. Cindy has a mix of tax buckets: $750,000 in her traditional 401(k), a smaller portion in her Roth 401(k), and the remainder in a taxable brokerage account that holds stocks and mutual funds. Amy saved just as diligently, but nearly all of her retirement funds sit in a traditional 401(k).

Neither one is on Medicare yet, so both decide to buy coverage through the ACA marketplace. The differences in tax buckets are about to become very obvious, very fast. ACA subsidies are based on your taxable income in a given year. Cindy can pull from her Roth funds or her brokerage account to cover living expenses without adding a dime to her taxable income. That keeps her eligible for a significant subsidy – over a thousand dollars per month. The subsidy covers most of the cost of her health insurance premium.

Amy has limited options. Her tax-deferred funds are really her only option, and every dollar she pulls is fully taxable. Depending how much she needs, this will shrink or completely wipe out her subsidy eligibility.

Cindy and Amy have the same lifestyle, and each saved well, but the difference is that Amy is paying over ten thousand dollars more per year for the exact same health insurance. And it doesn’t stop there.

Once Social Security begins, Cindy can lean on the tax-free and already-taxed buckets of money. Because of the unique way Social Security is taxed, Cindy can reduce or possibly eliminate any taxation associated with her Social Security. Amy’s income will very quickly make her Social Security taxable – possibly 50% or even 85% of it.

This is the power of tax diversification: less taxes, and possibly even lower healthcare costs. But those are things you only get by carefully planning and taking action before retirement.

The RMD Surprise

Imagine you’re about to turn 73. (You might not want to imagine that, but humor me.) You’re living comfortably off of Social Security and your planned withdrawals. One day, a letter arrives in the mail from one of the companies that holds or manages your retirement accounts. It says something to the effect of: “Dear Shareholder: Our records indicate you’ll soon turn 73, which requires you to withdraw a Required Minimum Distribution (RMD) from your IRA.”

If you are withdrawing more than your required distribution, this won’t matter much. But if your required distribution exceeds what you actually need, you could be in for an unpleasant tax surprise. No one is thrilled about paying taxes on money they do need. Finding out they now owe tax on money they don’t is even worse.

That’s the case with Required Minimum Distributions. It’s basically the IRS saying “hey, you’ve never paid tax on this money, you’re supposed to be using it for retirement, so pony up.” RMDs kick in a certain age. For those born between 1951-59, it’s age 73; and it’s age 75 if you were born in 1960 or later. The rule states that you have to withdraw a set percentage of your tax-deferred accounts every year, regardless of whether you need the income or not. The percentage increases every single year. If your tax-deferred accounts have grown well over the years, that forced withdrawal can land you in a higher tax bracket than you’ve been accustomed to.

But RMDs have consequences beyond tax brackets. One is higher Medicare premiums: a tiered surcharge called IRMAA (short for Income-Related Monthly Adjustment Amount.) The IRMAA surcharge takes effect after 2 years after your income crosses specific thresholds, and can add hundreds of dollars a month to what you and your spouse pay for Medicare Part B and Part D. Because of that two year lookback, it can sneak up on you.

We also touched on the taxability of Social Security – an RMD that’s a good deal higher than the income you’re accustomed to can mean those benefits become taxable, up to 85%.

And there’s a third consequence: losing access to lower capital gains tax brackets.

None of this means you should avoid tax-deferred accounts. The subject is tax diversification, and that means having tax buckets of all kinds, for as much flexibility as possible.

Creating Wiggle Room With Roth Conversions

A Roth conversion means moving money from a traditional IRA into a Roth IRA and paying tax on it when you do so.

The window of time between when you retire and required distributions (or Social Security) begin is often the best time to do this. The reason is that, for the most part, income is more in your control: you choose where the money is coming from and when.

Roth conversions require careful planning and careful strategy. This is not a once-and-done task: if you convert everything in your tax-deferred bucket in one year, you’ll end up bumping yourself into the highest tax bracket you’ve ever been in, and paying far more in tax than necessary. Depending on your age, you may also be setting yourself up for the highest Medicare surcharge possible two years from when you do it.

The better approach is a staged strategy, year by year. Running your numbers to figure out how much you can convert without blowing past a tax bracket you’re comfortable with – or IRMAA, if it applies – is the best place to start. (The next thing to do is to follow through and actually do it.)

One note of caution if you’re under 59 ½: don’t have tax withheld directly from the amount you’re converting. Any dollars withheld are treated as a distribution, not a conversion. Distributions under age 59 ½ trigger a 10% early withdrawal penalty. It’s better to pay the tax bill out of savings or a taxable account. Be prepared by estimating the additional tax you’ll owe on the conversion, and making sure it’s available and accessible. And keep in mind that pulling from a taxable brokerage account can trigger its own capital gains taxes.

The Roth IRA Clock

If someone is 58 and they decide to open a Roth IRA, they might logically assume that any growth they experience over the next two years will be eligible for tax-free distributions. After all, they’ll be older than 59 ½, and Roth money has tax-free growth. Right?

Wrong.

There is a five-year waiting period for any growth to be eligible for tax-free status. That means that someone who opens a Roth at age 58 must wait a full five years until age 63 to have tax-free distributions.

Note that this is completely separate from the five-year window that Roth 401(k)s have, but which functions the same way.

If you have a Roth 401(k) now but plan to roll it into a Roth IRA down the road, opening that Roth IRA now - even with a small contribution - starts its five-year clock sooner, so its ready when you need it.

The takeaway: don’t wait until you’re ready to fund a Roth IRA heavily to open one. Opening one now, even with a modest contribution, starts the clock, and gives you more freedom later. (Make sure you’re eligible to contribute directly to a Roth – a fund or custodian might not stop you if you don’t have accurate income information on record with them. At tax time, that might mean being forced to recharacterize your Roth contribution as a non-deductible Traditional IRA contribution, which creates a whole new set of headaches later.)

If Most of Your Money Is In One Bucket

If the weight of your retirement tax buckets is uneven, it’s not too late to begin building some balance.

Roth conversions, covered above, move some of that traditional money into a Roth. Done carefully, and strategically, you’ll pay tax as you go. Ideally, you’ll be in a temporarily lower tax-bracket just after retirement, before RMDs, and before Social Security – but starting sooner might make sense, too.

Even simpler is just redirecting your future retirement contributions into your Roth 401(k), if offered by your plan. (I’ve found many people don’t even know if their plan offers one. In my experience, more plans do than don’t.) To be clear, you are not changing your existing balance into Roth money - you’re just directing money from future paychecks there.

The best part about the Roth 401(k) option is that, unlike Roth IRAs, there are no income limits to contribute. If you’re a higher-than-average earner, this is a great opportunity to begin tipping the scales in your favor. But the tradeoff is more taxes now. Traditional 401(k)s are salary reduction instruments, which means dollar for dollar, your salary is reduced. If you’re contributing $24,000 to a 401(k) and you’re in the 32% tax bracket, that means almost $8,000 in federal income taxes more now. It’s a careful balancing act.

Another thing to know: company matches will still land in the tax-deferred bucket, regardless of where you contribute. That part doesn’t vary by plan – it’s universal.

Overnight, this won’t feel like much – but starting a 401(k) from scratch didn’t, either. Over five or ten years of consistent strategy, you’ll have more flexibility open up.

Which Bucket Do I Withdraw From First?

Many people – and planning software – default to taxable first, tax-deferred next, and Roth last. The problem: this suggests you drain one bucket completely before touching the next, and that’s not how it typically plays out in reality.

Sometimes, the better approach in a given year will be pulling from a combination of buckets at once, in whatever mix keeps that year’s tax bill as low as possible. One year, that might mean pulling mostly from your taxable account and Roth to stay under an IRMAA threshold. The next year, once your income picture looks different, it might mean pulling more from the tax-deferred bucket, because your tax bracket is lower. The right combination varies depending on your tax bracket, how long until required distributions begin, whether IRMAA is on your radar, or what you want to leave behind (an inherited Roth is a much better gift than an inherited traditional IRA, for what it’s worth).

The smart approach is to look at which income buckets you’ll draw from, and how much, before the end of the year. Income, tax law, and account balances change, so this is the proactive approach to controlling as much as you possibly can.

Common Questions

Do you need money in all three buckets to retire well?

The short answer is no – plenty of people retire just fine with everything concentrated in one or two buckets. A mix is worth considering because it gives you flexibility to manage your taxable income year by year.

Is it too late to worry about this if I’m five years away?

No. Even a handful of years of Roth conversions, or directing future contributions to the Roth option instead of the traditional 401(k) at work, can broaden your choices. It’s not as much runway as starting at age 35, but it still helps.

Should I switch my retirement contributions from a regular 401(k) to a Roth 401(k)?

Consider your tax bracket now versus your tax bracket in retirement. If you expect your tax bracket to substantially drop in retirement, then continuing to contribute to a traditional 401(k) could be better. Keep doing that, and start conversions after you retire when your tax bracket is lower.

If your lifestyle requires large distributions from retirement accounts, that might leave little room for Roth conversions at a favorable tax bracket. In that case, it might just make sense to pay more taxes now and take advantage of the Roth 401(k) option. Unfortunately, there are too many factors that can change the right approach to give blanket advice.

Conclusion

There’s a lot of nuance behind tax diversification – way more than we can possibly cover here. When considering RMDs, Social Security taxation, IRMAA - not to mention the state you retire in - the right approach for one person can be dramatically different from their neighbor. If you’d like to see what your own bucket mix looks like, or whether a Roth conversion makes sense, schedule a complimentary intro call.

Or check out our retirement resources page - it’s packed with free information to help you fully prepare for retirement.

Scot Whiskeyman, CFP® and Lindsey Ciarrocca, CMC® are independent, fiduciary husband-and-wife financial planners, serving pre-retirees and widows nationwide. They help people approaching retirement make clear decisions with the full picture in mind. They primarily work with widows of any age, or diligent savers between ages 50 and 60 with $500,000 or in more investable assets.

The individuals mentioned in this article are fictitious and not representative of an actual client, prospective client, or other real person. All insurance subsidies and tax reduction strategies are illustrative in nature and strictly hypothetical. This article is for informational and educational purposes only and does not constitute financial, investment, tax, or legal advice. Providers & Families Wealth Management is not affiliated with, and does not endorse, sponsor, or guarantee the accuracy, completeness, or reliability of any third-party websites, tools, or calculators referenced herein. Use of any such tools is at your own discretion and risk. Investing involves risk, including the possible loss of principal, and past performance is not indicative of future results. Information is provided "as is" without warranty of any kind.