Mastering Retirement: Understanding the Four Key Asset Buckets

One of the most common questions I get asked as an advisor is, How do I pull money out of my accounts in retirement? While I wish I could always just give one simple answer to this question, the best answer I can give is the old standby with an inevitable follow up discussion- it depends

Introduction to the Bucket Strategy in Retirement Planning

However, while withdrawal rates, sequence of returns, longevity, and various other factors all play into retirement, there is one strategy that consistently provides a disciplined, consistent process for providing income. While there are various titles out there, the most commonly referred to name is simply the “bucket strategy”. In this post, I’ll go into the concept behind it, the most common uses, and how to effectively maintain this strategy throughout retirement. 

The fact is, the majority of people in retirement will need to use their investment accounts to provide for at least some of their income needs in retirement. If you’ve used the most common vehicles for saving, you probably have money in some various combination of tax-deferred, taxable, and potentially tax-free accounts. If you are in this position, you might have wondered why you have so many accounts. While it’s usually not a good idea to have more accounts just for the sake of having more accounts, more account types leads to more options, and that is a good thing to have in retirement. 

Before I go into the ins and outs of the 4-Bucket Retirement Strategy, enter a few disclosures.

1 – This is not a “one-size fits all” strategy and might very well not be a suitable option for you, depending on your situation.

2 – The figures provided are for educational purposes only and can be very different from real-world outcomes. 

The most simple reason I can give for why the bucket strategy works is simply that it assigns the right assets to their best uses. Just as you would assign the proper materials to their respective uses in building a new home, so do each of your assets have a “best used for” aspect to them. Now, I am not just referring to account types. While this is an important component to evaluating what asset goes into what bucket, it is not the only component. One account can easily be used to accomplish 2, 3 or even more goals. What’s important is that both the goal and the bucket are clearly defined. 

Taxes are also an important role in assigning and distributing income in retirement. The proper knowledge of not just the tax effect on distributions, but also on an individual’s tax situation as a whole is key in determining how to structure the right buckets for the right purpose. 

Let’s jump into the four buckets(figuratively speaking, that is). 

Understanding the Four Buckets of Retirement

Bucket #1 – Immediate Needs, Ensuring Liquidity and Stability

In the spirit of keeping things simple to start, this bucket is pretty straightforward. However, it accomplishes arguably the most of any of the buckets. Purpose #1 of this bucket is to have enough liquid assets to be able to provide an income for an extended period of time(typically 1-2 years). A secondary benefit is to provide a buffer for market volatility, as it is the only bucket that shouldn’t carry any exposure to the stock market. Third, this bucket is a “catch all” of sorts that is easy to deposit distributions to. This may seem like a small benefit, but instead of having to worry about every single distribution posting to your checking/operating account, you can have everything deposited to this account to help keep your records simple. Ideally, this account should be held in a high-yield FDIC insured account that is separate from your operating account at your preferred bank or credit union. Many online banks are perfectly suited for Bucket #1. 

Bucket #2 – Short-Term Financial Planning for 1-3 years Ahead

The purpose of Bucket #2 is to line up assets that aren’t needed immediately, but could potentially be needed if Bucket #1 was to ever be exhausted. This bucket carries a timeframe of 1-3 years and allows one to capitalize on investments that carry a slightly longer timeframe. CDs, Treasuries, and other fixed income products with defined maturity dates are ideal candidates for this bucket as they can be structured to mature/be available at the right time when needed to refill Bucket #1. 

Taxable/Non-Retirement assets generally work best for Bucket #2. Examples of these account types include Individual, Joint, and Revocable Trusts. Since the assets in this bucket will generally be invested in low-yielding investments, there is typically not going to be a large amount of capital gains incurred and a low tax impact as a result. 

Bucket #3 – Medium-Term Investment Strategy for 3-5 Years

For assets that won’t be needed for 3-5 years, Bucket #3 is used to provide potential for some appreciation while still maintaining stability. Risk is matched with the timeframe, as a mixture of growth and income investments are typically going to provide the right combination of risk and return. 

The best types of assets for Bucket #3 are usually going to be tax-deferred assets, such as IRAs and 401(k)s. Since tax-deferred assets will be taxed upon withdrawal from the account, positioning these assets to be available for use if needed, while still potentially growing if not needed allows one to balance any distributions needed with the potential tax consequences of withdrawals. 

Bucket #4 – Long-Term Growth and Risk Management

Bucket #4 carries the most freedom of any of the buckets mentioned above. The assets in this bucket are where the “risky” assets should live that won’t be needed for at least 5 years. This bucket also carries the most consequences for not properly defining the goals for the assets in it. Thus, it is very important to clearly designate what the purpose is for the assets and make sure the rest of the buckets are properly funded and defined first. Stocks and other similar high yielding investments are perfect candidates for Bucket #4. 

Tax-free accounts are going to be the most friendly vehicle for any assets in Bucket #4 due to the long-term appreciation potential the assets carry. Roth IRAs, Roth 401ks, and HSAs have the potential to be withdrawn tax-free if done as a qualified distribution. 

Now that we’ve covered each of the buckets and their respective uses, let’s next go into the process of actually moving money between the various buckets. 

Navigating Tax Implications in Retirement Asset Allocation

Since Bucket #1 will be the same account that all distributions pay into, there is no need to have a separate place for interest payments to be deposited. They will simply post as they are paid. 

Bucket #2 can be structured to distribute dividends or interest to Bucket #1 as they accrue. One of the easiest ways to do this is to instruct the the custodian of these assets to recognize these transactions as they happen and automatically transfer them to Bucket #1. This is both convenient and efficient as it keeps Bucket #1 replenished while not having to manually transfer the income as it posts. 

If Bucket #2 has primarily non-retirement assets, the taxes will be recognized when the dividend or interest pays out. This is different from an IRA or 401k, when the taxes are recognized when it is distributed from the account. Therefore, there is no difference tax wise whether the dividend or interest payment is distributed or left in the account. For someone who is using their assets for income, it makes sense in most cases to have the dividends/interest distributed as they are paid.

For Buckets 3-5, the process becomes a bit more strategic as taxes begin to play a part in the distributions. In some scenarios, there will be a set amount that needs to be taken out of various accounts either for Required Minimum Distributions(RMD), or to simply cover the income needs of the owner. In these cases, a periodic distribution can be established that will cover the required need over the course of the year. For example, if an individual with a $12,000 RMD wants to set up a monthly distribution to cover the RMD over the course of the year, they would simply set up a $1,000 distribution to come out every month. Different frequencies/amounts could also be established, such as bi-weekly payments of $500, or quarterly payments of $3,000.

For tax-free accounts, taxes might not be as big of an issue if they can be withdrawn as qualified distributions. If this is the case, the amount being distributed will depend on multiple factors, including overall tax rate and portfolio withdrawal rate. We will cover managing taxes and other strategies in more detail later in this post. 

It is important when setting up a distribution strategy to first ensure it is sustainable with the amount of assets and expected return of the portfolio it is coming from. Working with a qualified financial professional who is a CFP® can make sure you have evaluated all perspectives and have a well-rounded financial plan. 

Effective Strategies for Moving Money Between Buckets

Our next topic will center around the timing of money movement between asset buckets. There are multiple internal and external factors that can affect the value of each bucket. External factors include market volatility, interest rate changes, and geopolitical concerns. Internal factors such as lifestyle changes and health changes can also have an effect on the income needed from each bucket. 

With these considerations in mind, let’s review some scenarios for the optimal times for changes and other types of movements between buckets.

Stock Market is Up

A rising market lifts all boats, er buckets, in this case. Higher bucket values allow a bucket strategy to be realigned, primarily for the purpose of shoring up assets that might have been depleted during a period of poor performance. While Buckets 1 and 2 won’t generally see as much of an increase due to not being invested in stocks, Buckets 3-5 will usually see more of a significant lift. 

Depending on your age and amount of assets in each bucket, an up stock market is usually the best time to take profits from the riskiest accounts. If the assets are invested in a Roth IRA and can be taken as a qualified distribution, these profits can be withdrawn without any tax penalty. These assets can then be used to refill Buckets 1 and 2 and replenish any shortfalls. 

Stock Market is Down

In a down stock market, a properly established bucket strategy has inherently prepared for the bad times and there is a storehouse of 1-2 years of expenses in Bucket #1. Drawing out of this bucket should be the primary movement in a down market while waiting for it to recover. If there are assets maturing soon in Bucket #2, those should be transferred to Bucket #1 until the account is back up to the proper level. If a market downturn looks like it could be prolonged, those assets should also be moved to Bucket #1. 

Unfortunately, there can be times where you are forced to take money out of an account when the market is down. One of these situations if you have to take Required Minimum Distributions. Depending on the outlook of the market, it may make sense to shift the timing of the RMD to either earlier or later in the year to take advantage of the best possible time. 

Charitable Giving

The general rule of thumb, if an asset is down, sell it. If it’s up, donate it. Directly donating investments can be one of the most tax advantageous ways to support the causes you care about. However, if an asset is down from when you purchased it, it usually makes more sense to either hold onto it, sell it to incur a loss and donate cash, or choose a different investment to donate. For more detail on the best ways to donate to your favorite church or charity, check out our previous post on 3 Tax-Efficient Tithing Strategies for Charitable Giving.

A sub strategy that can also arise in some cases is if someone is required to take an RMD for the year, but the market is down. In this case, the tax benefits from utilizing a QCD(Qualified Charitable Distribution) may still outweigh the decreased asset value. Selling lower appreciating investments or fixed income to donate might make the most sense while still allowing the tax benefits of a QCD and the appreciation potential of stocks. This is one of the only times when moving money out of Bucket 3 or 4 might make sense in a down market. 

Adapting to Significant Income Changes in Later Years

The final scenario we’ll examine is if your income is going to change or has already changed significantly. In this case, managing the amount of distributions coming out of any tax-deferred buckets will be important. 

If it’s expected that your income will be going down, delaying these distributions until a later tax year will generally lead to a lower tax burden. In contrast, if your income is expected to be going up in a subsequent tax year, accelerating needed distributions now can help to make sure the distributed dollars will be taxed at the lowest possible rate. 

Sustaining a Balanced Retirement Strategy Over Time

Our final topic for this post is how to maintain a sustainable bucket strategy throughout retirement. While it’s hard to predict the future, we do know that there are repeatable economic patterns that can help guide our decisions. 

Here are five parting tips to keep in mind. If you need help with your retirement bucket strategy, set up a call with us.

  1. Don’t Short your Emergency Fund
  2. Take Advantage of Taxes When They are Low
  3. Don’t Panic in a Down Market
  4. Sleep on Big Decisions
  5. Work with a Trusted Advisor

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This content is developed from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Evergreen Financial Group, LLC is a registered investment advisor offering advisory services in Montana and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision. All opinions and estimates constitute Evergreen Financial Group’s judgement as of the date of this communication and are subject to change without notice. Evergreen Financial Group does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk.