Using Buckets for a Long Term Savings Strategy
In our last blog, we talked about how important human capital can be as it relates to your total economic wealth. Saving as much of your income as possible, especially in your early earning years, is critical. Just as important is the location of those savings. For sure, there are many ways to save today – your company retirement plan whether that be a 401(k) plan or a 403(b) plan, traditional IRAs and Roth IRAs, individual and joint after-tax accounts and the list goes on.
From a high-level perspective, there are three “buckets” into which every investor should consider making ongoing contributions: the pre-tax bucket (examples include a traditional 401(k) plan or a traditional IRA), the Roth bucket (examples of these savings vehicles include a Roth IRA or a Roth 401(k)) and the after-tax bucket (an individual or joint brokerage account would be a good example in this case).
One of the key reasons investors should attempt to contribute into each of these buckets is that withdrawals (as are contributions) are treated differently from an income tax perspective. And while you may not be thinking of this now, when you enter the distribution phase of your life, having the flexibility to take money from multiple buckets could ultimately save you quite a bit of money. The chart below shows the income tax treatment today of funds for each of the buckets when withdrawals are made:
As shown, the income tax rate on withdrawals from a Roth account is 0%. The income tax rates shown for the other two buckets are examples of potential income tax rates today, which will vary, depending on your annual income. Under the current income tax law there are seven income tax brackets a taxpayer could fall within, beginning with 10% and going as high as 37%, that would apply to withdrawals from the pre-tax bucket. Income from investments in the after-tax bucket is generally taxed at lower capital gain tax rates which could be as low as 0% or as high as 23.8%, depending on your level of income. The key point here is that your marginal income tax rate for the pre-tax bucket likely will always be higher than the capital gain tax rate on the after-tax bucket.
By having substantial savings in each “bucket type”, a future retiree has the ability to control, to a certain degree, their income tax liability. For example, pretend you are retired, it’s November and you need $40,000 to buy a new car. You have already withdrawn all the funds you need to live on for the year from your pre-tax bucket and that has put you at the top of the 24% marginal income tax bracket. If you withdraw any additional funds, you would find yourself paying 32% on the funds withdrawn to purchase the new car. However, if you had adequately saved to your Roth bucket while you had the opportunity during your working years, you could withdraw those funds and pay no additional income tax on the extra distribution. With today’s income tax rates, such a move would save you $12,800 in income taxes. Someone who has spent their entire working years saving only into a traditional company 401(k) plan would not have this flexibility.
Let’s think about another area of potential savings – health insurance premiums through Medicare, the government run program for Americans age 65 and older. Medicare premiums are means tested and are based on your income level as reported on your latest income tax return. Most retirees this year will pay $134 per month for their Medicare coverage but premiums could be as high as $428 per month if your income exceeds preset thresholds. So, if you put yourself back in the situation described above and need to withdraw a healthy amount from your pre-tax account because you did not substantially fill those three buckets during your working years, your Medicare premiums could get a healthy bump the following year.
No one knows what income tax rates will be 20, 30 or 40 years from now. The income tax thoughts and policies of future US administrations will change many times between now and the retirement years for the 20-somethings and 30-somethings of today. Developing an ongoing financial plan that enables you to systematically save into each of the three buckets mentioned above may likely serve you well in the distribution phase of your life.