Savings, whether from profits or windfalls, must go somewhere. Once money is earmarked for savings, it should be allocated to one of three categories. While there are many reasons to save for a future expense, breaking down all savings into one of three tax buckets can help you better prepare for future goals.
Three Tax Buckets
Every type of savings can fit into one of three categories:
- Pre-Tax
- Post-Tax
- Taxable
Thinking through every dollar of savings in terms of taxes can help you navigate spending your savings when the time comes. For example, most people who save into retirement accounts understand they are not planning to touch that money for years or decades to come. Alternatively, many people who are about to remodel a house this month know to leave the cash for the contractor in the savings account.
Placing savings into the right tax bucket can have extremely beneficial results, all dependent upon the timing of the savings. The account type and the time in the account will directly impact the amount of savings generated. Retirement accounts can arguably provide one of the best tax advantages for savings, but the more successful plans are set for years and decades away.
Therefore, every new financial goal or additional dollar in savings must run through a tax bucket optimization. Placing money where money is treated best (from a tax perspective) can be one of the easiest ways to reduce your lifetime tax bill and put more dollars towards your goal.
Pre-Tax Bucket
The first bucket is the pre-tax bucket. Perhaps the most common accounts that people have are a 401k or a Traditional IRA. But many other accounts could potentially fit here as well, like certain pensions, certain stock plans, and other “qualified” accounts.
The hallmark of the pre-tax bucket is that savings or contributions are “pre-tax” or “before-tax”. When someone contributes to a 401k, those contributions create a tax deduction for the individual. Many high-income earners and business owners prefer these contributions because they directly reduce their taxable income, and consequently their taxes for the year. For those who can put upwards of $70,000 into a Traditional 401k in one year, they can enjoy both a $70,000 tax deduction and $70,000 more earmarked for retirement.
The tradeoff for these pre-tax accounts is that if contributions are not taxed, then distributions will likely be taxable. Years or decades later, when retirement finally comes, distributions from a 401k or IRA will likely be taxed at Ordinary Income tax rates. This creates a problem, since many people predominantly have most of their savings in this bucket compared to the other two. During working years, the deductions are nice, but once retirement comes and the distributions are needed, they could cause serious tax consequences if handled poorly. This leads many people to want to get ahead of these taxes, which leads us to bucket #2.
Post-Tax Bucket
The post-tax bucket is generally the exact opposite of the first. A Roth 401k or a Roth IRA is a great example of the post-tax bucket, since all contributions into these accounts should occur after those dollars have been taxed, or “post-tax”. Contrasting with pre-tax accounts, these post-tax contributions do not provide a tax deduction. The benefit, however, is that after contributions are taxed, they will never be taxed again as long as they remain in the Roth account (with today’s legislation, anyways).
This is why Roth-style accounts are so popular, even if some people still don’t fully understand why. If someone can stomach paying the taxes now, then they can likely receive a forever-tax-free account to grow for the future. Sometimes this decision is not that simple, as is the case with high-income earners or those in their peak spending years, but a simple goal to balance pre-tax money with post-tax money can be a great start to a healthier retirement.
Many of both the pre-tax and post-tax accounts share the tax advantage of “tax-free growth”. In other words, regardless of whether the taxable status is at the beginning or at the end, the account can grow each year without any taxes due. This is why saving into retirement accounts and investing can be so powerful. The combination of compound interest and tax-free growth can help you multiply your retirement savings until the time finally comes. The catch, however, is that time is usually around your 60s, and rarely any earlier. This issue brings us to the last bucket.
Taxable Bucket
The Taxable bucket, in one sense, is the solution to the time problem. For those who want to spend savings before the Government’s pre-defined retirement age in their 60s, this bucket can be the solution. Essentially, this bucket could be any account that doesn’t get the preferred tax-free growth treatment. In other words, these accounts are taxable each year. Savings accounts, CDs, and brokerage/taxable accounts can all fit in this category. Likely, you’ve already had to file 1099s for many of these accounts for this specific reason. But more than just accounts can apply here; real estate, collectables, and business ownership could all be included here as well.
Since there are an infinite number of accounts and assets, the purpose of this whole exercise is to focus on tax status and timing. The single best benefit that the taxable bucket offers is the flexibility or liquidity of the funds. Especially for those far from their 60s, having zero taxable money and all retirement money can make you feel cash-poor. I’ve seen too many people who are working tirelessly and struggling to make ends meet, when the savings in their retirement accounts look like they are on the path to decamillionaire status.
Tax-Smart Savings
Ultimately, it is important to consider what savings you have and which account would be best for the job. Some accounts do not fit neatly into one of these categories (HSAs, 529s), so it is important to recognize what you are saving for and how you use tax-advantaged accounts to get you there. People in their 20s and 30s shouldn’t lock all savings in retirement accounts if they have nearer-term goals like starting a business or building a rental property portfolio. Alternatively, those who spend most of their money on the here and now and only save for short-term goals may miss one of the biggest tax savings available to them through retirement accounts. Focus on the financial goals you want to achieve and build a structure to best use the tax advantages available to you.
TC Falkner 