April 17, 2024

3 Bucket Strategy – Case Study

Flexibility to fulfill your goals- whether those be personal or financial- is the ultimate objective as anyone plans for or begins to enjoy retirement. Being able to selectively plan your income needs can help you meet those goals in a tax-efficient manner- enter the “3 Bucket” strategy.

If you haven’t read our prior article, we recommend you do so to help outline the underlying components of the strategy: 3 Bucket Strategy

The 3 Buckets, Revisited:

  1. The Traditional IRA: Contributions to this bucket are tax deductible now and remain shielded from taxes until the time of withdrawal in retirement. This strategy potentially benefits individuals anticipating lower tax brackets later in life and is taxed as ordinary income upon withdrawal.
  2. The Roth IRA: With this bucket, you contribute after-tax dollars, but qualified withdrawals in retirement are entirely tax-free. This provides ultimate flexibility at time of withdrawal and potential tax advantages depending on your future tax situation. 
  3. The Investment Account: Penalty-Free Alternative: This third component is taxed on a completely different schedule: capital gains, which are the difference between what you paid for the asset and the sales price. Depending on your income, capital gains rates can be lower (sometimes significantly) than your ordinary income rate. 

Roth Conversion Primer:

To help explain the power of the three-bucket strategy, I’d like to introduce a case study.  Like many clients, this particular couple has stepped into retirement and wants to keep their current and long-term taxes as low as possible.

A critical piece of this case involves Roth conversions: moving money from a traditional IRA to a Roth IRA and paying taxes in the current year. Once converted to a Roth account, all funds grow tax-free and are available for tax-free disbursement in the future. Roth conversions tend to make sense when someone expects to be in a lower bracket in the future, as well as when tax rates across all brackets are historically low- which they are now. The clarity provided by a comprehensive financial plan helps guide the amount and timing of Roth conversions for each unique situation. 

Case Basics: 

Fortunately, this individual had built out a financial plan with us. This allowed us to thoroughly examine all facets of their situation and ensure we made the proper decision from a long-term financial perspective. The facts are as follows:

  • A client that has been retired for a number of years but hasn’t yet hit RMD age. 
  • They have the bulk of their funds in a traditional IRA, a small amount in a Roth IRA, and some funds they’ve picked over the years in an investment account. One holding has significant capital gains, while the others’ gains are minimal. 
  • They took out a loan to fund a $50,000 auto purchase last year. This was to avoid being thrown into a 10% higher tax bracket that would have resulted from a lump-sum distribution to pay for the vehicle in full. 
  • Roth Conversions are a main goal of this client, especially since lowered tax brackets will expire in 2026. 

The client’s goals are as follows:

  1. Payoff the loan this year. 
  2. Remain in the 12% ordinary income bracket. 
  3. Continue Roth conversions in these low tax years.
A lump sum distribution from their IRA to fully pay off the loan would take them into the 22% tax bracket along with making Roth conversions undesirable.

Enter the 3-bucket strategy. 

3-Buckets Applied:

In this situation, the 3rd bucket (investment account) is the proverbial “golden ticket” to ensuring the client can achieve all of their goals. Long term capital gains in 2024 are taxed at 0% as long as the taxpayer, married filing jointly in this case, has taxable income of less than $94,050. Knowing that Roth conversions are a main goal for this client, we were able to selectively disburse funds to meet all of their above goals. 

We disbursed a portion of funds from their IRA to make an immediate lump sum payment on the loan, saving them over $800 in interest. We will then circle back and sell the holdings in the investment account in a few months, once they have been held for over a year and receive long term gains treatment. Given the limited amount of gains, this will result in a small addition to income and keeps them in the 0% capital gains bracket. Doing this early in the year gives the client flexibility to handle any unexpected expenses that may occur later on and remain in the 12% ordinary income tax bracket. Closer to year end, we’ll circle back to Roth conversions and work toward that goal for the client. 

Without the flexibility provided by an investment account and the different treatment for capital gains, this client would’ve been forced to take income at a higher-than-desired tax bracket, as well as not achieving their goal of completing Roth conversions in these lower tax years. A comprehensive financial plan was the key to applying the 3-bucket strategy in this case, as is typical. We are always happy to discuss how a financial plan might be able to illuminate strategies that can address a variety of goals. 

Disclosures: 

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

Download the free retirement timeline checklist

A short guide to understanding what happens at different ages throughout retirement - for example:

  • Age 50 - Catch-Up Contributions for 401(k)s, employer-sponsored plans, and IRAs begin. $7,500 for 401k ($30,500 total), $1,000 for IRAs ($8,000 total)
  • Age 55 -Certain employer-sponsored retirement plans allow distributions without penalty beginning at age 55. HSA contributions are now eligible for a $1,000/year additional catch up for those over age 55.
  • And more
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