How to fund your retirements accounts to maximize wealth: Three bucket strategy?

Hello my friend..long time no see. Looks like you thoroughly enjoyed your vacation.

Hellooo..yes it has been a while and I did have a very relaxing vacation. It was a much needed break to recharge and hit the mid-year reset.

I totally agree about the need for taking a break to recharge especially when the first half of the year has been nothing less than chaotic. I also got a couple of weeks off and it definitely helped. I hope I can keep affording nice vacations for the rest of my life.

I am glad you got a break too. I know how keenly you were following financial news and were probably overloaded with information from our discussions. Getting away for sometime helps digest everything you have learned in a relaxed manner and helps prepare for more.

You are absolutely right! Even though I did not do any active learning, I feel that I could think peacefully about everything we have already discussed. I was enjoying the vacation so much that I began to wonder how to afford this even after I retire. It would most likely need immaculate retirement planning that uses all the types of retirement accounts you educated me about. [Check out this blog to learn more about the different types of retirement accounts] While I was calmly ruminating over the retirement accounts, I wondered what strategy I should follow to make the most of different types of retirement accounts?

That is an excellent question you came up with and I am glad you had the time to mull over our discussions to come up with that. Before we dive into the details let’s do a quick recap of the three types of retirement accounts that we talked about before:

1. Tax-free retirement accounts – These are your Roth accounts like Roth IRA or Roth 401k accounts where you put in after-tax money and when it comes time to withdraw, you do not have to pay any taxes on it. You also do not pay any taxes on dividends or fixed-income received from the investments in this account. Pay taxes now and not later is the mantra for this account. Also, importantly you can withdraw the amount you contributed to this account, not the growth on the contributions, without any penalty before the age of 59.5 years. The caveat is that the Roth account has to be atleast 5 years old to avoid the penalty. Another type of tax-free account is the Health Savings Account, which has a triple tax advantage. This means the money you contribute to this account can be deducted from the taxable income, thereby reducing your tax burden. This money can grow tax-free in the account and if you withdraw this money for medical expenses then even that is not taxed. So, it is a very powerful tax-free account to have not just for retirement but even to manage the medical expenses as and when they occur. 
2. Tax-deferred retirement accounts – These are the traditional IRA or 401k accounts where you save on taxes now by contributing using pre-tax money and reducing the taxable income. However, when it comes time to withdraw from this account, then taxes need to be paid depending on the tax bracket you fall in at that time. The amount you withdraw is treated as your ordinary income just like the salary you receive now. Here, if you withdraw the money from this account before reaching the retirement age, then you need to pay taxes on the withdrawal as well as pay a 10% penalty. Therefore, it is very costly to make early withdrawals from this account unless absolutely necessary. 
3. Taxable Brokerage or other savings accounts – These accounts do not have any tax advantages. The money contributed to this account comes after paying taxes on it. Based on your risk tolerance, you might decide to invest this money in higher risk assets like ETFs, stocks, etc. or in less riskier assets like Bonds, CDs, etc. The income received from the investments in these accounts either from dividend paying ETFs or interest received from CDs, bonds, etc. are considered as ordinary income and taxed at the rate based on the tax bracket you fall into. Moreover, when you sell the investments in these accounts to get money for spending, you need to pay the capital gains tax on the profits made from selling the investments. The only benefit of these accounts is that you do not incur a penalty if you withdraw from this account before the retirement age. The money in this account is at your disposal for use without any limitations.

That was helpful to go over the key aspects of the three types of retirement accounts. Every account has some pros and cons related to it and it looks like you need to strategize well to get the most of these accounts without getting hit by penalties or paying excess taxes. So, is it recommended to have all the three types of retirement accounts? And what is a good strategy to build money in these accounts?

Yes, it is highly recommended to have all the three types of retirement accounts because it gives you the best opportunity to minimize the tax burden during retirement as well as maximize the growth potential of your investments, which will be a major source of income during retirement. 

As for how to fund these accounts as you are saving for retirement, there is a general guideline that we can talk about but it would depend on your financial goals as to what makes the most sense. One thing that is consistent in whatever strategy you choose is to follow the order of investing that we discussed before [Check out this blog to find out the optimal order of investing your salary]. This would also determine the order in which you fill the different types of retirement accounts. Sometimes, the retirement accounts are considered equivalent to buckets of money which you fill up to retirement and then withdraw from them after retirement. Since we have three types of retirement accounts, the strategy to fill and withdraw money from them, is also referred to as the three bucket strategy.

Let’s say you are in your 20s and have just started saving for retirement. You would be in the initial steps of order of investing where you might be building up cash reserves to cover the insurance deductibles and an emergency fund for 3-6 months that covers your essential living expenses in case of loss of employment. 

Assuming you have completed these two steps, you would then make sure that you get the employer match for the 401k contributions. This is the part where you are now starting to fund your retirement accounts or filling up the buckets. The employer contribution currently can go to only the Traditional 401k account i.e. the tax-deferred account. However, the contributions you make can be made either to the same account or a Roth 401k account. It is recommended that if your effective tax rate is less than 25% [Check out this blog to learn how to calculate your taxes and the effective tax rate], then it is better to contribute to the Roth 401k account as you can pay lower taxes on it now and assuming you would end up in a higher tax bracket during retirement, you can save on taxes later. During this time it is also recommended to make contributions to the HSA if you are in a high deductible health plan. Therefore, in terms of priority you should:

1. Tax- deferred account: Contribute enough to 401k to get the full employer match as it is as good as free money. The employer match would go towards the tax-deferred account and you can choose to make your contributions to the Roth 401k account.

2. Tax-free account:

• The contributions you make to get the 401k employer match could go to the Roth 401k account.
• Maximize the contributions to atleast the Roth IRA account, whose contribution limits are lower than the Roth 401k account. The contribution limits change every year so check what the limits are for the current financial year.
• Maximize the contribution to the HSA if you have a high deductible health plan. Now, you can also make a 50-50 contribution towards  the Roth and HSA accounts if you feel strongly about saving money for medical expenses from the very beginning. This is where you personal preferences would kick in since both are tax-free accounts but HSA has advantage of saving taxes now but the money can only be used tax-free for medical expenses.

3. Taxable brokerage account: You do not have to focus on building this account at this point unless you have excess money left after maxing out the contributions to 401k, IRA and HSA accounts.

That is great advice! It gives a good idea on prioritizing filling the retirement buckets when starting out at a young age. The focus has to be maximizing the contributions to tax-free accounts so that they have the maximum time to grow. Moreover, you can save on paying taxes by paying them now when you are in the lower tax brackets and not paying any taxes after you retire, where you might be earning much more than you are now and taxes are most likely to increase over time. Would the strategy change in the 30s and later?

You perfectly summarized the logic of filling the retirement accounts in your 20s. It is important to remember that the more you save early, the more you will gain by the time you retire because of the power of compounding.

I would say the situation in the 30s would change based on your personal situation since this is when you may make major life decisions like marriage, buying a house, having kids, etc. Assuming you have worked through your 20s, you would have got several pay increases and your salary would have gone up. This means you be able to save more than you were in your 20s if your spending did not increase significantly compared to the increase in your salary. Of course, if you have had major life events like buying a house or having kids then you might have periods where your savings rate goes down but that is understandable. The important thing is to keep saving whatever you can and stick to the order of investing so that you do not go too far off track. 

In a situation where your salary has increased such that your effective tax rate is more than 30%, then it might make sense to switch from making 401k contributions to the Roth account to the Traditional account. This is because the tax rate now is reasonably high and there will not be a lot of benefit in paying taxes now. Now the approach to filling the retirement buckets would be:

1. Tax-deferred account: Keep contributing to your 401k account to receive the full employer match. Your contributions can be to a Roth 401k if your effective tax rate is below 25% and to a Traditional 401k, if it is above 30%. Between 25-30% effective tax rate, your financial goals will determine what makes the most sense.

2. Tax-free accounts:
   • Maximize contributing to Roth IRA and if below 25% effective tax rate then maximize contributions to Roth 401k.
   • If your effective tax rate is more than 30%, then first maximize contributions to the Roth and HSA accounts. Then try to maximize contributions to the Traditional 401k account.
3. Taxable brokerage accounts: If you have money left after maximizing contributions to the above accounts then first of all, congratulations! You can start contributing to taxable brokerage accounts of your choice like Fidelity, Robinhood, Charles Schwab, etc. There are several strategies to invest in these accounts and it will depend on your risk tolerance. You might choose to favor stocks or related ETFs if you want to be more aggressive in terms of growing your money or you might invest more in bonds or related ETFs if you are more conservative.

Awesome, I can see some changes in approach here where the focus has started to shift to the tax-deferred accounts if your salary put you in a high tax bracket. In the most optimistic scenario, there might be enough money to even start filling the Taxable brokerage accounts. I wish I end up being in that position but at least now I know the course of action if I end up there. How will the strategy change as we get closer to retirement?

As you age more and get in your 40s and 50s, your earning power will most likely increase as you would have established yourself in a career of choice or the business you may have started earlier would be turning up profits. Now the strategy should be:

1. Tax-deferred accounts: Maximize contributions to your 401k Traditional account if your effective tax rate is more than 30%. You may keep doing that in your 40s and then assess your situation in the 50s to decide if you want to switch contributions to the Roth 401k account. The reason you would want to do that is that there are required minimum distributions (RMDs) from the Traditional 401k accounts beyond a certain age around your 70s. This means that you are forced to withdraw a minimum amount of money from this account and that amount is directly proportional to how much money you have in the account. Since the money withdrawn from this account is treated as ordinary income, the more you withdraw the more you will have to pay in taxes which will again come out from your account.Therefore, you need to think from a tax liability point of view and ensure that you have a good split between the Traditional 401k and Roth 401k accounts by the time your retire so that you are not forced to pay large taxes if you concentrate all your money in the Traditional 401k account. 
2. Tax-free accounts: You would continue contributing to Roth IRA accounts and HSA. However, there are income limits on contributing to Roth IRA accounts so you need to keep that in mind as your salary gets closer to the limits. You can contribute to a Roth 401k account to reduce your tax burden during retirement as we talked before. 
3. Taxable brokerage accounts: There is a good chance you will have excess money to save more in these accounts. This will give you more flexibility in your spending power too since any big purchase you make can be financed from selling investments in these accounts rather than taking a loan to finance depreciating assets like a car. You need to remember that you have to keep saving 25% of your gross salary, so don’t get complacent and make sure you keep that 25% savings rate. Your strategy to invest in this account as well as the other retirement accounts could change towards a more conservative approach since you want to preserve your wealth at this point to have a tension free retirement. It does not make sense to keep investing in riskier assets like equities which could fluctuate a lot and affect your spending potential when you do not have any other source of income. 

You have to remember that as you approach retirement you will be in a better position to estimate your expenses during retirement which will depend on your health, lifestyle choices, pending loans, etc. At some point it might be worth working backwards from knowing how much money you will need after retirement and finding out the optimal way of withdrawing that from the three retirement account buckets such that you minimize paying taxes while maximizing the time the money lasts in these accounts. This analysis could affect how you decide to keep filling the three retirement buckets. I would highly recommend getting a financial advisor at some point or take the help of a modeling tool that can factor in all your needs during retirement and suggest the best plan to keep investing in these retirement accounts.

Thank you for going over that! I really like the idea of working backwards from how much I will need during retirement and then find out how the distribution between the three types of retirement accounts should look like. This way I can manage how I fill up these accounts up to retirement. I know life will throw a lot of curveballs and it will not be straightforward to decide the best approach but now I know a tentative guideline that I can abide by for the time being, which I will reevaluate a few years down the line.