Concept of Four Tax Buckets

No one wants to pay more than his or her fair share in taxes. Yet few have a good understanding of how their savings will be taxed over time. A good way to gain a basic understanding is to consider the concept of the four tax buckets.

The first bucket is your “taxable” bucket. These accounts are funded with after-tax dollars. So any accounts or financial vehicles that you pay taxes on each year, whether or not you pull the money out, fall into this bucket. What does that include? Well, it includes bank accounts like money markets or CDs, or non-retirement investment accounts with stocks or bonds – anything that gives you a 1099 each year, even if you didn’t pull the money out, falls into this “taxable bucket.” Hence the taxes owed - are on what you make, not what you take.

The second bucket is the “tax deferred” bucket, meaning these accounts are funded with pre-tax dollars, not to be taxed until you withdrawal the money at a later point in time. Generally speaking there are three primary vehicles that fall into the “tax deferred” bucket;

• Qualified employer sponsored plans like 401ks, 403bs, SIMPLE IRAs or defined benefit plans like a pension
• Traditional IRAs
• And non-qualified annuities also fall into this bucket

The third bucket is your “tax-free bucket” which is funded with after-tax dollars, and accumulates to be withdrawn at a later date, tax-free. Again there are primarily three financial vehicles that are currently tax-free;

• Roth IRAs
• Municipal Bonds
• And properly structured life insurance – notice I said properly structured life insurance - so not all life insurance falls into that category.

Each has specific rules to follow to ensure they are tax-free, but nothing else falls into this bucket.

And finally, the fourth bucket is “income and estate tax free” and that’s where you get into trusts and other special arrangements, such as charitable trusts and irrevocable trusts.

Now, here’s what you need to know – if you want to reduce taxes on your assets over time, you need to move assets to the right. A common mistake many people make, if their objective is to reduce their tax liability, is often, right here; they have the majority of their assets in qualified retirement plans. This has the potential to create significant tax liabilities down the road.

So, before deciding which financial vehicles are right for your retirement strategy, consider what impact taxes may play in your retirement income plan over time. Follow us over the course of the next 6 weeks, as we discuss multiple strategies one might consider to reallocate some assets to the right and help reduce tax liability over time.

That’s the concept of the four tax buckets.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Haas Financial Group, US Financial Advisors and LPL Financial do not provide tax advice or services.

Securities offered through LPL Financial, Member FINRA and SIPC. Investment advice offered through U.S. Financial Advisors, a registered investment advisor. U.S. Financial Advisors and Haas Financial Group are separate entities from LPL Financial.

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