Wealth column: How Much of My Savings Should Be In Each Tax Bucket?

Frequent readers of this column and listeners to our radio program have heard us talk extensively about having "three buckets of money."

We typically reference those buckets as a means of diversifying your savings based on time horizon (short-term, mid-term and long-term), but they can also be used discuss how your assets may be taxed (tax-advantaged, tax-deferred and immediately taxable).

There is a common follow-up question that we typically receive when discussing the three buckets of money: How much should be in each tax bucket?

It's a great question, and it's something we wanted to touch on today. While we can't tell every reader how much money they should allocate to each tax bucket, we can give you some guidelines to consider when allocating your savings.

Overview of Investment Taxes

Before talking about how much should be in each tax bucket, it's important to first define how your investments may be taxed:

Tax-Advantaged: Contributions made to a tax-advantaged account are made with after-tax dollars. The earnings may grow tax-free, and there are no taxes due on qualified distributions. A Roth individual retirement account is perhaps the most common vehicle people use for tax-advantaged investments.

Tax-Deferred: Contributions are made with pre-tax dollars, meaning you get an immediate tax deduction, and any contributions potentially grow tax-deferred. Distributions are taxed at ordinary income rates.

Immediately Taxable: Investment income is annually subject to taxes. Assets held for longer than a year may be treated as long-term capital gains, which is more favorable from a tax perspective.

How Much Should Be In Each Tax Bucket?

As we said earlier, there is no one correct answer; the best way to divide your assets based on their tax status will vary for each person. As a starting point, we'll typically begin by putting a third of a person's savings into each tax bucket, but those numbers will ultimately rise or fall depending on a number of factors, including:

Your Current Income: If you're in your peak earnings years, the tax deduction from tax-deferred savings will never be more valuable. Conversely, if your income is currently lower, it's typically better to pay the tax now and invest in the tax-advantaged bucket.

Your Age: Assets in tax-sheltered accounts (IRA, 401(k) etc.) can be difficult to access before age 59.5 or age 55 in some cases with a 401(k). If you're younger and think you may have to make a large purchase in the near future (e.g., a down payment on a home), having more in your immediately taxable bucket gives you a potential source of income you can tap without incurring any penalties.

Legacy Planning Considerations: Assets in a non-qualified account typically receive a step-up in cost basis if the owner dies. If you buy Investment A at $10 and it's valued at $100 at the time of your death, your heirs would have a cost basis of $100 on Investment A, thereby negating $90 that would be subject to capital gains taxes. Tax-deferred investments do not receive a step-up in basis, meaning that immediately taxable and tax-advantaged savings are generally more beneficial to leave to your loved ones. If that's a priority for you, you may want to consider putting more into those two tax buckets.

As with so many financial planning topics, there is ultimately no single "correct" answer for how to allocate your savings into these three buckets. What we can say is that you should have some percentage in each. This will allow you greater flexibility when producing income in retirement and offer you greater opportunities to use powerful financial planning strategies.