Episode 76: Understanding the Three Tax Buckets: Maximizing Your Investments

Welcome to episode 76 of Accessible Finance! In this episode, we break down the three primary tax buckets—taxable, tax-deferred, and tax-free accounts. We explain the significance of each, and why understanding them is crucial for managing your taxable income and maximizing your investments. We discuss the pros and cons of each account type, including tax consequences, flexibility, and planning strategies. We also emphasize the importance of having funds in all three buckets to optimize tax efficiency in retirement. Tune in for a comprehensive guide to smarter investment planning!

Read the Transcript

Podcast Episode: What are the Three Tax Buckets and Why Do They Matter In Retirement?

Eric: [00:00:00] Welcome to episode 76 of Accessible Finance. Let's dive in. 

Rachael: Alright, first shout out to the new wig from, uh, my daughter, Zoe. Yeah. Um, okay, so Eric, we had a listener request that said, okay, you guys are frequently talking about these three tax buckets. Um. And it's something I think that can trip up even the most savvy of investors.

Okay, what are they and why do they matter? 

Eric: They matter because they impact the amount of taxes that you pay, and they limit your versatility in flexibility in adjusting your taxable income. On an annual basis. Okay, so, so that's a really good, 

Rachael: like bird's eye view. 

Eric: You did not, I did not answer your question though.

What are they? I'm 

Rachael: g we're gonna, I'm gonna break it down. 

Eric: Oh, okay. Sorry. I'm gonna bring it down for us. 

Rachael: Okay. So let's start with what are the three [00:01:00] buckets and which types of accounts are in each one? 

Eric: Okay. There's taxable, right? Which is what you think of when you say you have an account, probably a bank account, anything like that, right?

So checking accounts, savings accounts would fall here. Taxable brokerage accounts, um. Yeah, that's, that's pretty much it. Okay. Those are, those are the taxable, those are the most of the taxable high yield savings would count, right? Yeah. Money market funds, all those things are gonna be held in a brokerage account.

They could be held money market funds can, or security type. They could be held in a variety of accounts. Sure. Brokerage account is what we're thinking here. 

Rachael: Okay, so that's your taxable, so that's bucket number one. 

Eric: Correct. 

Rachael: What's bucket number two? 

Eric: Tax deferred. So this is, think of your contributions to your 4 0 1 Ks or 4 0 3 Bs, 4 57 B, the work place retirement accounts that you participate in.

Typically they're gonna be, um, tax deferred, 

Rachael: okay? 

Eric: Most will, some will have Roth options, which is the third account tax free, right? So tax free accounts are Roth accounts. So Roth, IRA, Roth 401k. Okay. [00:02:00] That's essentially it. So 

Rachael: we've got our taxable, our tax deferred, and then our tax free. 

Eric: Correct. 

Rachael: And I think that the majority of people when you're looking at what you've saved, are focused a lot on the number but not on the placement of those dollars.

Eric: That's a very correct statement and it, it's important to know that if we're thinking about like if my all in taxes pay owed to the government and the federal and state government. Gonna be, let's say 30% and I have a million dollars in my traditional IRA or my 401k at my workplace. Mm-hmm. And then I pull out the million dollars.

The amount that I can actually spend would be 700,000 in that case, right? Yeah. The million dollars minus the $300,000 of tax. 'cause we said my tax rate was 30%. 

Rachael: Yeah, it's actually, it's interesting. Super quick side note. We actually spent an afternoon slash evening, um, explaining this to our very inquisitive, um, 11-year-old.

Gosh, we should do that 

Eric: here. It's an incredible exercise. I think many planners would benefit from that. Exercise it. 

Rachael: It was really beneficial, I think, for him. Super. And he was really excited just to learn [00:03:00] about what it is that we do. Um, but it's really hard when you see you finally hit and for some reason a million feels like this weird benchmark that I think people feel like I've made it when I've cleared this, 

Eric: made it to seven figures.

Yeah, I'm good to go. So when you hit a 

Rachael: million, it's really hard to separate that from what actually is yours and what's. Pre earmarked for the government. Mm-hmm. So, so it is really important to be able to break up, you know, what types of funds are where. Okay. So we just went over what those three accounts are.

Right. And again, to recap, we've got our taxable tax deferred and then tax free. So let's start with taxable, which was the first one, um, that you decided to discuss? Okay. So taxable accounts can confuse a lot of people. It's treated differently than the other two pretty significantly. So, sure. Um, can you speak a bit to some pros and cons of a taxable account?

Eric: Yes. You have the most immediate access to your money with the least strings attached. Right? So it's the most accessible to [00:04:00] you. Um, it's, it doesn't have to be the most liquid, but um, typically you'll have some portion of it in highly liquid assets, which is like, you know, checking account. Yeah. Savings account that you can pull from immediately and spend.

It, it will produce, um, tax consequences every year on an annual basis. So the things that happen in these accounts are gonna be reported to you on, you know, 10 90 nines, right? And you're gonna have to, that's, you're putting 

Rachael: that tax return every year, 

Eric: right? And it's going to impact your taxable income and therefore your, you know, tax liability.

And so you're gonna have to worry about what's happening in there because. The IRS does every year and they're gonna make you pay for it. 

Rachael (2): Yeah. 

Eric: So that's typically how it works, right? You're gonna either be paying capital gains or ordinary income tax. You know, interest income. So when you think of like your savings account income or ordinary dividends, um, which is like money market, you know, interest, things that are typically like interest like bonds, fixed income, that's gonna pay you a percentage of the principle or the total that you have in the account that's going to be taxed as ordinary [00:05:00] income.

And then when you sell the actual underlying securities, like if you own equities, um, or if you make a sale of either fixed income or equities, typically that's gonna generate, uh, capital gains. Right. So it's gonna be short term or long term depending on your holding period. And then dividends from equities are going to be taxed at capital gains rates as long as you've held it 60 days of the 1 21 period before they're dividends.

So basically, if you've held it for a while, yeah. And their US equities, you're typically going to be, um, they're gonna be qualified dividends and they're gonna have a more favorable tax rate on that. But the long and short is. Very accessible to you. Okay. You get it really quickly. Good. Right? And you have to worry about what's happening there because you're paying tax on it every year.

Annually. Yeah. And then just a real brief aside, I know I went to the one two, but I wanted to say that, um, you will hear the term tax drag thrown around. Oh, that's your By planners, because. Since you occur, tax consequences on the earnings in these [00:06:00] accounts, right? There's some amount of those earnings that evaporate, they go to the federal government instead of to the account balance to compound, 

Rachael (2): correct?

Right. 

Eric: So if you're in a tax deferred or a tax free account and you have earnings, those earnings stay there. They're not removed in any way. Right. And so they, you continue to earn interest on the interest, right? Yeah. Like you earn interest on those earnings. And when I say interest, I mean returns on those earnings, right?

So if we're talking equities there, equities do not produce interest. They produce dividends or capital appreci. But your 

Rachael: money's working for you. Your money's making money. Exactly. Um, there's no, 

Eric: there's no limit. I mean, I'm sorry, there's no drag right. Or there's no partial payment to the federal government of those earnings.

Rachael: Right. Whereas in this taxable account, you're doing it annually. Um, okay, so it sounds like the long and short of it, as you said, is that um, there's maximum like flexibility and liquidity. Um, but then the downside is that you are getting 10 90 nines and getting taxes, those accounts, right? We don't pay taxes annually.

Eric: Don't like taxes. 

Rachael: [00:07:00] Alright, so that was the taxable account. Um, the second account that we talked about is the tax deferred account. This is one that the majority of people working W2 jobs are probably quite familiar with. Right. Um, so what are some of the pros and cons of the tax deferred bucket? 

Eric: Okay.

Pros, it will reduce your, typically, not always, there are. Non-deductible contributions to IRAs and 4 0 1 Ks. We're gonna go to the exceptions first, right? Rather than the rules always. Sorry. Um, the pros are it will reduce your, or typically reduces your taxable income in the year that the contributions are made.

Okay? So you're treated as not having realized that income until you pull it out at a much later date, which we'll talk about, right? So, reduces your income now. Um, and then it's, so, so it's very, it's good if you think that your income bracket is higher now than it will be later, right? So that's, that's a benefit.

Cons, you have to pay the tax when you take the money out first. There's a restriction on when you can access the funds. [00:08:00] You have to be typically over 59 and a half or 55 and separate it from service for 401k, but there's restrictions as to whether or not you can even get to the funds. And then when you get to the funds and you pull them outta the account, they're always going to be taxed as ordinary income.

And some people say, well, wait, it's No, no, no. It's, you don't understand, Eric. I bought VTI or I bought some equities in this account. I bought Apple stock. Okay. Yeah. And my Apple stock is appreciated Way up. That's a capital gain. No, no, no, no. That's not how, unfortunately, that's, that's not how the government sees it and that's not how this works.

Yeah. Um, regardless of what you owned in the account, you're gonna be taxed on the balance that you withdrew from the account. As ordinary income, granted you will have nothing. You'll have no tax consequences, incur no tax consequences on the things that happen inside of the account. So while that Apple stock is going up, right, if it's appreciating in value, maybe I bought it for a hundred thousand dollars.

Mm-hmm. And then it's worth a million dollars. I go and take out, like, let's say, assume now that I take out $50,000, I just increased my ordinary income. Buy [00:09:00] $50,000. Yeah, right. And then I pay tax on that at ordinary income rates, not capital gains. Even though it was an equity that appreciated if that were a taxable account, it'd be long-term capital gains.

Not the case here, but is not ordinary income. 

Rachael: Yeah. So, oh, that could be a pro for the taxable account right there too. Yeah. Um, okay. So now we've touched on the, um, taxable accounts. We touched on tax deferred and now we're gonna spend some time in your favorite 

Eric: Yes. 

Rachael: The tax free. 

Eric: It's definitely my favorite.

Yeah. Um, it's absolutely my favorite. And there's one con that I forgot to mention with the, uh, tax deferred accounts. Mm. And that is that they have what, what we call RMDs or require. Minimum distributions from the accounts, right? So if you are, uh, born between 1950 and 1959, then you have to start taking RMDs when you are 73 years of age or older.

Um, and then if you're born 1960 or later. It's gonna be 75. So for the young people out there like, like us, I guess I don't consider us young. 

Rachael: I [00:10:00] wish 

Eric: I'll 

Rachael: consider us young. 

Eric: I, I no longer do. 

Rachael: I'm wearing a pink wig. Eric, I feel like you're 

Eric: young now. Yes. Okay. You're reinvigorated. It makes me young. Yeah, that's good.

Hey, we'll take it. Yes. We like that. Yes, we feel good. Shout out. 

Rachael: Adam's blue Wig is gonna make an appearance next week. 

Eric: All right. Yes. That'll be cool. You'll be Joy from um, 

Rachael: oh, I do love her. Inside Out. 

Eric: She's my favorite. Good movie. It is a great movie, actually. Highly recommended if you love. That's Watch it.

Yes. Um, but anyway, sorry. RMDs, they're real. And they can put you in tax practice that you might not otherwise want to be in. 

Rachael: We've seen that happen a lot where if it's not strategically planned out. Ahead of time. Mm-hmm. Um, it can very quickly kick you up into some really punishing, uh, tax brackets 

Eric: for sure.

Correct. So, as you say, right. 

Rachael: So yes, tax free sounds like a dream Sounds ideal. 

Eric: It's, it's amazing. 

Rachael: Tell us why 

Eric: it's the best. Um, because as we said before, if I have the million dollars in a tax deferred account and then I withdraw it in my tax rate's 30%, I now have $700,000. Yeah. If I have $700,000 in a tax free account or a Roth IRA or a Roth 4 0 1 KA Roth account mm-hmm.

[00:11:00] Then I withdraw that $700,000. I still have my $700,000. Right, right. I have long, so you're not a worse, worse 

Rachael: position. 

Eric: Correct. As long as it's a qualified, um, distribution, you're good to go. 

Rachael: Yeah. 

Eric: Right. Which is typically I'm over 59 and a half. I've had the account open for more than five years. Right.

Then I'm gonna incur no penalties, um, and no tax on any of the things. 

Rachael: But someone here might say, okay, if I'm in the same position with $700,000 in my tax deferred. Or in my Roth, why is the Roth better? 

Eric: That's a great point. Thank you. And it it's own, it's all about the tax arbitrage. We actually should do a show on the spreadsheet that you did.

Okay. Um, well it was a nice colorful graph. Large, it's a graph, paper graph with, um, it's with a time series kind of analysis. We, we, 

Rachael: we were trying to visually explain to our. Very inquisitive children, like we mentioned earlier. Mm-hmm. Um, about if you were to put in some money to each of these three buckets, what the treatment would be if your tax brackets [00:12:00] remained the same in all three situations.

And 

Eric: the idea here is if we assume the same rate of return Okay. And the same contributions and the same compounding periods and everything else. Then the money that you would draw would be exactly the same. Yeah. At distribution. So if the tax brackets stay completely level. Mm-hmm. Right. And your effective tax rate is completely level, including things like Irma and net investment income tax, then six one half do whatever you want.

Yeah. Right. You're gonna be exactly the same in terms of how, how much after tax dollars you'll have in retirement, whether you're contributing to tax deferred or tax free. Mm-hmm. However, things are never gonna be the same in flat. Right. So. And you're gonna have to contend with things like Irma's and RMDs in retirement and they will impact your ability to a, manage your taxes.

Like you, it's just you're less flexible when you have RMDs, when the IRS says you have to pay yourself a hundred grand 'cause your account's big. Right? And then so you're thinking through like, what does that look like? You can't tell, you can't give it back. You know what I mean? [00:13:00] Correct. So the idea is what we're doing with the tax free accounts and the reason that you'll hear people talk about things like Roth conversions, the reason that.

These things are meaningful is we're trying to make sure that we're filling up the lower tax brackets throughout, whether that's early on in our career when we're not making a lot of money, we would wanna pay tax on all the money we're making. 'cause maybe I'm only making $50,000 a year. I just graduated, you know, LSU or something, right?

Like I, I just graduated, I'm making 50 k. I expect to make more in the future. Yeah. Right. So right now I'm gonna pay tax on all my income and then maybe later when, if I'm making, you know, a hundred K, 200 k, I'm gonna try to defer a bunch of my income. 

Rachael: Right. 

Eric: So that, um, 

Rachael: you can pay when you have to realize less income.

Eric: Exactly right. So what we're trying to do is fill up the lower tax brackets because it's better to pay lots of tax at 20% Sure. You know, then some tax at 20% and then later pay a bunch of tax at, you know, 32 30. 

Rachael: Yeah, exactly. So 

Eric: that's the idea is we're playing that game and that's the different, that's the differentiator between.

Tax free and tax deferred. 

Rachael: [00:14:00] And I think it really comes down to quality planning and tax knowledge and understanding. We've seen a lot of situations where we've had people who say, oh, now that I'm retired, I should be in a lower tax bracket. And the reality is that they're not, because RMDs, Irma, and various other things that they are unaware of or cannot avoid, 

Rachael (2): right, are 

Rachael: hitting them smack dab in the face.

And because there was not planning on the forefront, there's minimal things that they can do. Not to say they can't do things 

Eric: right, 

Rachael: but there's less opportunity, um, to be creative there. 

Eric: Correct. One other thing to mention is that there are no RMDs from Roth accounts, including 4 0 1 Ks Secure Act 2.0 eliminated the need for, or the requirement for.

Require minimum distributions from Roth 4 0 1 Ks. It used to be in there, but it was kind of in, it was silly because you could just convert it to a Roth IRA, which didn't have the same requirement. Just like the, so the government's fine if you've already paid the tax on the money? Yeah. Which is like the, you know, once to get into a [00:15:00] tax free account, you have to have paid the tax on the money that you're gonna put in.

Yeah. So once you've paid the tax, the government's like, all right, fine. You do what you want with it. Right. They're happier for you to take it out because then you don't get all this earnings tax free. Correct. But they'll let you, they'll let, they, they, they acknowledge you've already paid your tax.

You're good to go. When it's tax deferred, those earnings they would like to get tax on and they wanna get tax on, make sure the initial dollars that you've avoided paying tax on any, they're not 

Rachael: gonna get away with not getting paid. No. 

Eric: They, they need to make you take that money out so you, that you'll have to pay the taxes.

Rachael: Now, I can't let you get away with just saying all the pros of the Roth, so I, there are no 

Eric: cons. 

Rachael: The con that comes to mind, mind is just the fact that you don't get your tax deduction when you are. Sure. Putting the funds into the market, right? Correct. 

Eric: Right. So, so if my tax bracket right now is, you know, 37% Right.

I'm in the highest tax bracket and I expect that I'm gonna retire early, maybe, maybe I'm gonna retire at 55. Oh, look at you. Or 65 or, or anytime before I'm gonna elect social security. Yeah. And my r ds are gonna kick in. Sure. Because mine aren't gonna kick until 75 we talked about. [00:16:00] Mm-hmm. I'm born before 19.

Or 60. I mean, after 1960, sorry, I was gonna say, my gosh, 

Rachael (2): you're really aging yourself. 

Eric: That could have been rough. You 

Rachael (2): need the pink wig. 

Eric: Yeah. Um, so, so if I'm in a high tax bracket now, I expect that I'll be in either a lower tax bracket later. Well, I'll be in a lower tax bracket later for a number of reasons.

You know, if I'm retiring early, in this case, I'll be in a low tax bracket theoretically, unless I have just loads of money in my, you know, taxable accounts. But point is I might want to. Defer my income now, so pay as few taxes as I can or as little few dollars in taxes as I can in the 37% bracket, and then later I can fill up the, you know, 22, 24, 32 with Roth conversions and get the money into a tax free account at that point.

Rachael: Correct. Okay, love it. All right, so we've gone through what the three buckets are. We've gone through some pros and cons, and so then at this point you might be wondering like, okay, which one's the best bucket for me to put money in? Mm-hmm. Um, and the answer is all three. So [00:17:00] why, Eric? Is it important to have money in all three of these buckets?

Eric: I guess I'll answer your question, but if we could wave a wand and not pay any taxes, we put all of our money on a Roth account, that would be thrilled. Okay. 

Rachael: Sure. But like if somebody comes to us. Right. If a client comes to us and says, every dollar I own is in Roth, I have no checking. You're right, no savings.

I have no 401k, I have no tax deferred. Right. Um, that really limits your planning opportunities, 

Eric: honestly, that Yes. That that's happened, right? Like you don't want to, just to be clear. We are not advocating extreme one year Roth conversions where you take all of your tax deferred dollars and you put it all in a Roth account, convert it all to a Roth account.

That's typically wrong. 

Rachael: I will say that is caveat real quick before you get into your thing. I think the reason that get into my thing. Yeah. I think part of the reason that you're so pro Roth though is that there has been so much, um. Uh, confusion around Roths and what they are to the point where people have [00:18:00] avoided participating in them.

Um, especially like I know our parents' generation was kind of like, that's for like young people. Mm-hmm. Um, and so it's. An amazing tool that's been underutilized because people just simply didn't 

Eric: know enough. Yeah. There's, there's a version to things that are new. Right. So, you know, people didn't wanna use it right when it came out.

Yeah. Um, but it, it allows for flexibility and tax planning. Obviously the money's great when you get it there, but you, you would ask the question why would you want all three? Correct. Okay. So really part of the planning that would you would do tax planning is as you're approaching retirement, you want to have enough money in your taxable accounts.

And enough money in your tax deferred accounts to be able to fill those lower tax brackets as we're in those artificially low years. 

Rachael (2): Yeah, 

Eric: because if I retire, if I pay all my taxes at 37% Right. My whole life, yeah. I'm a, I'm just, I'm a high earner and congratulations me. Maybe I'm a doctor or lawyer.

Great. Um, high earner paying all these taxes. Okay. And now I retire at age 50 or 55, let's say. Okay. [00:19:00] My tax bracket might be very low. Yeah. I might be in the 1220 2% bracket. And so now I pay so many taxes, income, 37%. I lost the difference between the 37%. Yeah. And the 22%. 

Rachael (2): Yeah. 

Eric: I've lost that 15% delta in taxes.

I handed on a lot of dollars. Exactly. I, I handed an extra 15% to the government. What I would rather do. What I ought to do is have enough in the tax deferred so that I can convert that over time. Mm-hmm. To fill the lower brackets, I can either withdraw, you don't have to do a Roth conversion, you might wanna spend the money.

So I could get a boat. Yeah. Get a boat. Get a boat or two. Yeah. I think be really sad that you did. Um. Um, you absolutely can. The idea is you wanna fill those lower brackets, whether it's with distributions, um, or withdrawals from the accounts, or Roth conversions. You want to have that able to be done, right?

Like, so you wanna be able to convert the money, but when you convert the money, you're still not touching it, right? Yeah. It's going into a Roth. So I need the taxable account to be able to substantiate a, my spending if I'm retiring early. And B, the [00:20:00] taxes on the Roth conversions. 

Rachael (2): Yeah, 

Eric: because it does remember we have to pay the government, even if it's a 22%, which we're happy to do because it's not 37%.

Correct. It's still 22% of whatever, you know, we're putting into the bracket that we have to, we have to pay. 

Rachael: Exactly. So it sounds like in order to be able to have a strategic withdrawal strategy, you need to be able to have funds in all three accounts. Correct. So that depending upon what your actual situation looks like annually, you can make decisions.

You know, accordingly. 

Eric: Correct. Um, it gives you the most flexibility. 

Rachael: Correct. 

Eric: Right. So I, I mean, if you only could pick one you'd put most in your Roth, you'd have some in your taxable. Um, but obviously you don't want, you, you, you just wanna avoid the years where you're gonna have almost no way to fill the 12 and 22% brackets.

Right. Those are low brackets. You should pretty much always pay, be willing to pay taxes. And it's interesting in the 10 and 12, if you don't feel the 10 and 12, you're probably doing something wrong. We did on your, and it sounds 

Rachael: really, um. Antithetical to say like you're looking to pay taxes in the [00:21:00] 10, you're looking to pay taxes in the 12, and the reality is that the government's gonna force you to pay tax on exactly every single dollar anyway.

Yeah. So if you get to control where you're paying it rather than them, you're gonna end up paying a lot less than taxes. 

Eric: Exactly. Chances are, if you're not paying taxes now, you either paid too much in the past or you're gonna pay too much in the future. 

Rachael: Yes. 

Eric: That's the way I would think about it. Correct.

Rachael: I mean, we've had. Um, you know, clients come to us that were really proud that there were years that they were in the 0% tax bracket. And that's such a missed opportunity because 

Eric: sometimes not even using the standard deduction. 

Rachael: Yes. Yep. So there are, the reality is that, and we all know the government's gonna get their piece.

Mm-hmm. Um, so as much as you get to control the narrative there, you're far better off. And so having those three buckets is really the way to do it. 

Eric: All right. 

Rachael: All right. Anything else that you wanna say to viewers or clear up or clarify? 

Eric: I think we're good. 

Rachael: All right. I'm excited. Um, if you have [00:22:00] any other questions about, um, the three buckets or if you have a breakdown you want us to weigh in on, like, I have X percent in Roth, X percent in taxable, let us know.

Shoot us any questions that you have at podcast@equilibriumfp.com. 

Eric: Alright. Thanks guys. 

Rachael: Till next time.