Minimize your Taxes Now and in the Future: Three Tax “Buckets”

Minimize your Taxes Now and in the Future: Three Tax “Buckets”

Minimize your Taxes Now and in the Future: Three Tax “Buckets” 624 312 Donna Skeels Cygan

Tax season (Jan. 15-April 15) has officially begun! It is time to strategize!

“Smart tax planning is essential for smart investing” says Donna Skeels Cygan, CFP®, MBA, who has been recognized as one of the top financial advisors in the United States and is the author of The Joy of Financial Security: The art and science of becoming happier, managing your money wisely, and creating a secure financial future. (Sage Future Press, 2013, ISBN: 978-0-989-77844-2, $24.95, www.joyoffinancialsecurity.com)

Albuquerque, NM (January 2016) – Donna Skeels Cygan reveals the principle behind Three Tax “Buckets” and explains how this practice will help you save money by minimizing your taxes now and in the future.

Over the past 70 years, the tax rates for high-income earners have varied significantly. In 1944, the top marginal federal tax rate hit 90%! It was reduced to 70% in 1965, where it remained until the early 1980s. Since that time it has declined significantly, with the top marginal tax rate capped at 35% between 2003 and 2012. In 2013 the top marginal federal tax rate was raised to 39.6%, where it remains today. Most people anticipate more tax increases in the future.

Compared with the past 70 years, 39.6% seems like a reasonable tax rate. However, wise tax planning can save you a significant amount in taxes, leaving more money for your family and your financial security. Federal District Court Judge Learned Hand stated the following in 1934:

Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

Clearly, minimizing your taxes is a wise strategy. The key with tax planning is to be proactive. The purpose of having three different tax buckets is to minimize taxes now or in the future, and to provide flexibility when taking withdrawals. This strategy is also called tax diversification. The following image shows a diagram of the three tax buckets.

Bucket #1 – Tax Deferred

This bucket is for tax-deferred assets, such as retirement accounts like traditional IRAs, 401(k)s, or 403(b)s. Typically, the money you invest in a traditional retirement account is deducted from your income in the year of the contribution. Taxes are not due until the money is withdrawn, and whatever amount is withdrawn is considered to be taxable income for that tax year. IRAs have been available since 1974, and these accounts have become the most common way to save for retirement.

Bucket #2 – Taxable Accounts

This bucket is for taxable accounts. Many people do not realize that saving and investing in a taxable account is always wise. The gains on this money are not tax-deferred, but investors with taxable accounts have benefitted for many years from the 15 percent preferential tax rate on capital gains and qualified dividends. This was raised to 20 percent effective January 1, 2013, but only for individuals and couples with high incomes (couples over $450,000 of taxable income, singles over $400,000). Most investors will still pay the 15 percent tax rate for capital gains and qualified dividends. (Persons in the 15 percent or lower marginal tax bracket do not pay any capital gains taxes).

Bucket #3 – Tax Free

This bucket contains tax-free accounts, such as a Roth IRA, Roth 401(k), or Roth 403(b). This is the newest bucket because Roth IRAs only became available to investors in 1998, with Roth 401(k)s and Roth 403(b)s becoming available during the past few years. Money invested in these accounts is not deducted from income in the year of the contribution, so there are no tax benefits on the front end. However, the tremendous benefit of a Roth IRA is that the contributions and the gains will not be taxed going forward. For this reason, a Roth IRA trumps a traditional IRA in my view.

Benefits of Having Multiple Tax Buckets

The three tax buckets provide you with choices regarding where to withdraw money during retirement, while also providing significant tax benefits and savings:

  • One reason having all your investments in an IRA is not recommended is because taking IRA withdrawals during retirement (to pay your annual living expenses) can place you in a higher tax bracket than if you took the withdrawals from a taxable account. It can also cause Social Security benefits to be taxed at a higher rate and Medicare premiums to increase.
  • In addition to reducing taxes by withdrawing from tax buckets #2 and #3, three tax buckets can also allow you to delay starting Social Security benefits, thereby letting the benefit accrue until a later date.
  • Converting a significant amount of a traditional IRA to a Roth IRA can reduce required withdrawals from the traditional IRA at age 70½. Roth IRAs do not have required distributions, so if the withdrawals are not needed for living expenses, then the money can remain invested in the Roth IRA, growing tax-free for many years.

Having your money in three different tax buckets is a valuable tax strategy that will put you on the path to financial security.