The Three Bucket strategy is a popular financial planning method for those working towards financial independence. The strategy involves dividing your assets into three distinct “tax buckets”: tax-deferred, tax-free, and after-tax. The goal is to have a diversified portfolio that allows you to control your tax situation in retirement, regardless of the tax policy or tax rates in place.
The tax-deferred bucket includes accounts such as 401ks and IRAs, the tax-free bucket includes Roth accounts and Health Savings Accounts (HSAs), and the after-tax bucket includes investments that are not tax-incentivized but are taxed as you go through time and can be accessed at any point.By having these three distinct buckets, you can maximize the use of lower tax brackets, supplement your income from after-tax accounts, and pick and choose which accounts to use depending on your tax situation. This can lead to significant savings in taxes, especially in retirement when every dollar withdrawn from a pre-tax bucket becomes expensive due to ordinary income tax.
It’s worth noting that some financial advisors and experts consider the Three Bucket strategy as window dressing, however, it is a material thing, as taxes and fees are two of the most important things to pay attention to when building wealth.
Furthermore, as you reach a higher income situation, the asset allocation becomes crucial as it can greatly affect the taxes you pay. For example, conservative investments such as bonds and cash pay out as ordinary income, taxed at your highest marginal rate, while index funds pay out dividends and capital gains, which are taxed at a more favorable rate.
In conclusion, the Three Bucket strategy is a valuable financial planning method that allows you to control your tax situation in retirement and throughout the wealth-building journey. While it may not be for everyone, it’s important to consider the taxes and fees you pay as a crucial factor in building wealth.
To learn more about this topic, check out our show called, “How to Build Wealth With the 3 Bucket Strategy [By Age!]”