I recently shared on my blog about how there are millions of different investment options you can choose to fund your retirement, but the planning process is as simple as a three bucket system.
These three buckets are the taxable bucket, the tax deferred bucket, and that magical bucket that I call the tax free bucket. Of the three available buckets, the one you’re probably most familiar with is the taxable bucket. Why? Because this is the main bucket most of us have used during our lifetime.
The bucket works something like this: A new month rolls around, and some type of income is deposited into the bucket, and it starts to fill up. Then the minute the money clears the bank, we start taking the money out to cover our monthly living expenses, and the bucket starts to go down. If you’re lucky, when you get to the end of the month, you’ll have some money left in your bucket. The money left should then be used to help make sure your taxable bucket maintains a safe level of assets, which is six months of income, or the money should be used to invest in your tax free bucket.
But unfortunately, this is not what usually happens. All too often people decide to do one of the following with the money.
The first group, they decide to completely empty the bucket. The second group, they decide to keep growing the bucket way beyond the amount it should contain. And the third group, they take the money out and invest in the tax deferred bucket believing they’re doing the right thing for their retirement. Unfortunately, all three of these actions can create major problems with your retirement.
Let me start by talking about the first group who choose to empty the bucket. All we have to do is look around us, and we realize emptying our taxable bucket to zero is not a good idea. In life there are way too many economic ups and downs, and we need to make sure we have a reserve to cover ourselves when these times happen. As I mentioned earlier, it’s my belief that this bucket is full when it contains six months of income. This means that if you have an annual salary of $50,000, you need to have $25,000 in this bucket.
You need to be aware you’ll find advisors who disagree with this number. There is a group of advisors that believe the appropriate amount of money in this bucket is six months of bare bones basic living expenses, not six months of income. There is also a group of advisors that believe you only need three months of income in this bucket if you’re married and both spouses are working.
I’m not here to argue with either of these options. The final decision is up to you on what amount you want to put in the bucket. But I will tell you that what I found over the years of doing this is that for most of the people, the problem isn’t when they follow the advice of one of these other advisors. The problem is when the bucket is emptied out to zero or when they over fund the bucket.
What’s so bad about over funding the taxable bucket? The biggest problem is you have succeeded in subjecting the assets in this bucket to a bunch of unnecessary risks that can derail your future retirement. These risks include inflation risk, market risk, and tax rate risk. Since each of these risks can create a major problem with your future retirement, let’s take a minute and talk about each of them.
The first risk we need to talk about is inflation risk. Inflation risk is the risk that your investment earnings will not keep up with annual inflation. A client of mine who was so risk averse kept all of his money in a bank account, completely ignoring inflation risk, but unfortunately, inflation risk wasn’t ignoring him. In fact, if you look at what happened to the million dollars he had in the bank over the last five years, he lost over $100,000. Yes, $100,000 worth of buying power to inflation. And yet, he was only able to earn between 400 and $500 of interest during this time.
You may not realize it, but inflation risk is one of the biggest risks facing most retirement and is single handedly destroying thousands of retirement plans because retirement assets are not structured correctly to overcome the risk. This problem isn’t just during the years you are trying to grow for your retirement. It also applies once you hit retirement.
As you approach retirement, inflation risk becomes even more concerning because many people are on a fixed income in retirement. When you’re on a fixed income, the longer you live, the worse your retirement is going to look. A good way to calculate inflation risk in retirement is to use the rule of 72. Most of you are familiar with the rule of 72 because you’ve used it with your investment accounts. The rule of 72 is used to determine the approximate years it will take for assets to double.
Let’s assume you’re getting an average rate of return of 8%. If you take 8% and divide it into 72, you learn that it will take about nine years for your assets to double. Well, as exciting as this formula seems when you’re growing your assets, it gets equally as discouraging when you reverse the calculation against fixed income in retirement. Let’s assume for example, you’re retired, and your fixed income is $40,000 and that inflation is 3%. If you take 3% and divide it into 72, you get 24. So in 24 years, the purchasing power of your $40,000 has just been cut in half, at only $20,000. I hope you’re starting to see some of the major issues inflation risk can cause with your retirement.
You may be hearing what I’m saying and think to yourself, no worries, I have my money invested in the stock market and the average stock market returns have been way higher than inflation. So what do I have to worry about? Well, the answer is you have a lot you still need to worry about. But, specifically, you now have to worry about the stock market risk, which is the risk that the stock market is going to go down and negatively affect your retirement.
When you’re young and investing for the long term.,stock market risk can usually be overcome because historically, after the market goes down, it comes back up. What happens when you get closer to retirement and the time you will need to use these bonds to cover your basic living expenses? When this happens, it becomes disastrous to your retirement because in a downmarket in the early years of your retirement can cause you to run out of money up to fifteen years faster than you expect.
I don’t know about you, but I don’t know anyone that wants to run out of money fifteen years before they pass away. In fact, the most important years to avoid stock market risk are the five to ten years leading up to retirement and the five to ten years after you retire.
The last risk I want to talk about that you’ll face if you overpaid your taxable bucket is tax rate risk. Tax rate risk is the risk that taxes will be higher in the future than they are today. You don’t have to look very far to realize keeping taxes at the historically low rates we’re currently enjoying is impossible. In fact, we already know the date taxes will go up, and that date is January 1, 2026.
If taxes are going to go up, is the taxable bucket the best place to store your extra assets? Absolutely not. Not only will it cause you to lose more of your money in retirement in the form of higher taxes, but having this much money in your taxable bucket may also create provisional income.
What is provisional income, you asked? Provisional income is the term used by the IRS to determine if your Social Security benefits are going to be taxable in retirement. Provisional income is made up of your taxable income, your tax free municipal bond income, and one half of your Social Security. When you add all these together, if the total amount is over $25,000 for a single person, and $32,000 for a married couple, a portion of your Social Security benefits will also be taxed. If your provisional income exceeds $34,000 for a single person, or 44,000, for a married couple, then 85% of your Social Security benefits will be taxed. When this happens, you can expect to run out of money five to seven years faster than you would expect to.
The question I often get asked after I talk about these three risks is how do I eliminate them? How can I take them off the table so I can get into the zero percent tax bracket and change my retirement? There are two main things you need to do.
First, you need to establish a process that will ensure you always keep the right amount of money in the taxable bucket. This is going to require some planning and some time on your part. However, if you’re diligent about the process, you will find there are great benefits for your future retirement by keeping the taxable bucket at the levels it should be.
Second, you need to establish a plan to move the extra money you have in the bucket into your tax free bucket. This will include making sure you’re maximizing your contributions to your Roth IRA and your Roth 401k. It may require you to take some of the money and put it into a life insurance retirement plan. The life insurance retirement plan, or what we call a LIRP, is designed to help you eliminate the risk your assets face in the taxable bucket.
A correctly structured LIRP will also have a floor and a ceiling. If the market drops, you don’t lose any of your money, thus, removing market risks. A LIRP grows tax free, and distributions can be taken out tax free. So, it also helps you eliminate tax risks.
If this is not enough, in addition to these benefits, you can add a long term care rider and reduce the risk a long term care event can cause on your retirement. You may not realize it, but the average retired couple has over a 70% chance that one of them will need long term care services at some point in their retirement.