How To Lower Your Taxes in Retirement Using the ‘Bucket Strategy’
Written by
Heather Altamirano
Edited by
Cory Dudak
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Managing retirement funds doesn’t end when you think you have enough set aside for your golden years. It’s important to monitor your money throughout, including finding ways to reduce your taxes. Retirees can lower their taxes using the bucket strategy, an effective method that helps you pay less to the IRS. GOBankingRates spoke with finance experts who explained what to know about the bucket strategy and how it works.
The Bucket Strategy
To help ensure your financial security during retirement, the bucket strategy is a smart way to save money.
“The bucket strategy is all about managing your retirement savings by splitting them into three parts: short-term (cash), medium-term (bonds), and long-term (stocks),” Rhett Stubbendeck, Chief Executive Officer at Leverage Planning, explained. ” This helps ensure you have money when you need it while also letting other investments grow.”
Timelines for the different buckets can be flexible, but here’s what Paul Carlson, CPA and Managing Partner of Law Firm Velocity, advised.
“The first bucket is for the next 1-3 years of expenses — this is where you keep your cash and super safe stuff like CDs and short-term bonds,” he said. “The second bucket is for years 4-10, and you can take a bit more risk here with longer-term bonds, preferred stocks, and income funds.” Finally, the third bucket is for 10+ years out — this is where you put your riskier growth investments like stocks to outpace inflation.”
The goal of the bucket strategy is to never run out of income. “There is a saying that running out of income before you run out of breath is never a good strategy,” Eric Mangold, CWS Founder of Argosy Wealth Management stated.
Why the Bucket Strategy Works
Putting your money into three different buckets helps create diversification in a tax-efficient way.
“The bucket strategy is most effective when you consider your current tax bracket and the tax bracket you’ll most likely be in during retirement,” Erik Krom, President of Clear Creek Advisors, told us. “If you think you’ll be in a higher tax bracket in retirement, you might want to invest more in your tax-free bucket of savings and pay taxes on your savings today.”
Krom added, “If you think you’ll be paying fewer taxes in retirement, you may want to delay paying taxes and boost your tax-deferred bucket.”
The bucket strategy gives retirees a clear way to manage their assets and “ensure that short-term income needs are met without having to liquidate long-term investments during market downturns,” Robb Hill, financial consultant and President at R Hill Enterprises, Inc said.
How the Bucket Strategy Reduces Taxes
Many retirees make the costly mistake of withdrawing funds without considering taxes, but the bucket strategy is one way to reduce the burden.
“By drawing from different buckets, retirees can manage their taxable income more effectively,” Justin Godur, founder of Capital Max, explained. “For example, drawing from the long-term bucket, which may include tax-advantaged accounts, during years when your income is lower can minimize tax liabilities.”
But there’s another way to look at the bucket strategy to keep retirement planning in perspective.
“Conventional financial wisdom says the goal is to pay the least amount of taxes as you can today, but the bucket strategy helps savers and retirees think more holistically about their tax situation,” Krom stated.
He continued, “Putting all of your savings in a 401(k) will spare you from paying taxes today, but it could lead to a major tax bill in retirement. For some people, it might make more sense to pay taxes on their savings today and reduce their long-term tax impact.”
Why it’s Important to Consider Taxes in Retirement
Taxes can greatly affect returns on investments and retirement savings, so it’s vital to watch your money and learn the best ways to avoid hefty taxes.
“We all want to get the highest return on our investments, but we often neglect the tax consequences or tax opportunities that exist depending on which bucket our investments live in,” Krom said, adding how important it is to work with finance professionals who understand how investments might be taxed.
You worked hard to earn your money, so don’t give it away to taxes you don’t necessarily have to pay.
“Taxes can sneak up and eat away at your retirement plans if they aren’t managed properly,” Mangold said. “I think many people believe that whatever taxes you pay are what you should pay and simply accept it.”
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