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Written by John Buerger   
Wednesday, 02 December 2009 10:09

John Buerger

An Extra 5%

How would you like to have 5% more net wealth without sacrificing anything to get it?

There is a legal, ethical and relatively simple way to make this happen ... but you must cast away some conventional wisdom (most of which your tax advisor believes) to make it happen.


This is a pretty long post - and the most important point is at the end. Make sure you read The 3 Buckets - a Better Way to Save ... You will then want to understand the tax planning errors that can cost you hundreds of thousands of dollars in net wealth.

A Different Approach

This blog post was going to offer a bunch of end-of-year planning tips, but that is going to have to wait a week. Before I can get into the subject of end-of-year tax planning, I must spend some time addressing a fundamental misconception about tax deferrals.

I suspect this post is going to ruffle a few feathers among a tax-planning crowd that I greatly respect and thoroughly appreciate for all that they do. In your never-ending quest to find financial advice that is trustworthy and useful, you cannot (in most respects) do better than a CPA or Enrolled Agent (EA). In the battle between the big, well-known financial services salespeople and the smaller, nimbler and more client-centered fiduciary advisor community, your tax-advisor is an ally to both you and me.

Your tax advisor is paid by you with one major objective - and that is to save you money on your taxes this year. The more he/she can whittle down your tax bill for 2009, the greater value you feel you are getting in return for your fee.

There is nothing wrong with this ... but the fiduciary financial planning approach is a little different. Unfortunately, most tax advisors operate under some assumptions that I believe are ... well ... less than beneficial to you, your Wealth Health and the security of your family's future.

I want to address the two-and-a-half most dangerous of these assumptions here today and explain the "3 Bucket Approach" to retirement savings that is at the core of our personal financial planning practices at ALTUS Wealth Solutions.

Once we reveal these faulty assumptions, the next question becomes "what can you do with this information?" THAT would take me about 40 minutes to explain (or more material than I want to write and most people want to read). So we are offering a 45-minute webinar next Tuesday to put this all together in a format that is fun, easy to understand and will really help you improve the security of your family's financial future.

Join our FREE Wealth Health Webinar
Tuesday, December 8, 2009
6:00 pm PDT
Register in the box at the right

I hope you will join me - It is completely free and is provided (both audio and visual) completely over the web. No phone calls needed. Just sit back, turn up the speakers, watch, listen and learn.

Tax Planning Error #1 - The Cheap Retirement

There is a long standing assumption in both the financial planning community as well as the accounting profession that the average person will spend less in their retirement years than they do while they are working. The official figure is between 70-80%.

I don't know about you, but I think that is crazy.

When I retire I plan on travelling more, eating out more and playing a lot more golf. None of those things is less expensive than what I'm doing now (too tired to go places on the weekend, brown-bag my lunch and only hit the course four times a year). We haven't even touched upon medical costs which only go up the older you get.

The case for tax savings is built on the assumption that you will have less income needs in your senior years. Less income means you will likely be in a lower tax bracket and therefore pay a lower tax rate. If you can avoid a 35% tax today with an IRA deferral and pay a 25% tax later when you use the money, then the deferral makes sense.

I argue that in most cases, it works just the opposite. We need higher incomes to cover more expenses in our senior years. That extra income could easily kick you into a higher tax bracket (not lower) which means that the taxes you "saved" when you were young and took the deferral actually cost you when you finally had to "spend" them.


I have been doing an informal poll for the past two years. How many of you really think that tax rates are going to be at their current, historically low level even two years from now (much less 5, 10 or 20 when we need the money). So even if you DID spend less in your senior years, the odds are pretty good that tax rates will be higher in the future.

Tax Planning Error #2 - The "Present" Bias

An even bigger challenge in traditional tax planning thinking is the belief that tax savings today always trump tax savings in the future. This is the tax equivelent of the old saw, "A bird in the hand is worth two in the bush."

While tax savings today will generate in most people a feel-good, appreciative, warm-and-fuzzy hug-your-tax-advisor response, those savings may not be the best medicine for your long-term Wealth Health.

The objective of quality tax planning is to pay the least amount in taxes (period)!

If paying a 25% tax today means you will avoid paying a 35% tax tomorrow, then your overall Wealth Health benefits from the painful realization of paying that tax today. As difficult as this may be to accept (and I've heard plenty of arguments about how this cannot be so), sometimes it is better to accept a little pain now rather than get a whole lot later.

Tax Planning Error #2 - No Tax Diversification

This last error is a directly related to Tax Planning Error #2. Diversification is the cardinal rule in the investing world, but it seems to be completely ignored by most tax advisors and many of the financial guru's you see on TV.

They all want you to defer as much as you possibly can into your IRA or 401(k) plan. Putting all of your retirement savings into a qualified account is simpler and for many people (who are brain-dead about their money habits) it is a strategy that is less prone to forgetful or irresponsible behavior. The money is socked away before you ever see it - so you don't miss it and aren't tempted to spend it.

But when it comes time to take that money back out during your retirement years, the consequences can mean (hundreds of) thousands of dollars of unnecessary tax pain and a diminished quality of life.

Failure to diversify your retirement investments across multiple types of accounts will focus a direct hit on your Wealth Health and the security of your family's future.

The 3 Buckets - A Better Way to Save

Let's say you are saving 10% of your income for your future.

First off, good for you. You're already well ahead of the averages. But rather than save all of that money in your company's 401(k) plan, instead you should split it up between the 401(k) and two "after-tax" accounts ("buckets"): (1) a regular taxable investment "bucket" and (2) a tax-advantaged "bucket" like a Roth IRA.

The end result will be an increase of up to 5% of your total net worth over the traditional tax-planning method of putting all of your retirement savings into a tax-deferred IRA-type account.

This can result in a many thousands of extra dollars available to you in your retirement years.


Austin and Alexa both save $6,500 of their income (before taxes) per year towards their retirements. Austin puts all of his money into a qualified IRA-type account. Alexa spreads hers across three major types of accounts: (a) qualified IRA-type, (b) regular after-tax investment and (c) tax-advantaged (Roth type) accounts.

Both of them add to these retirement accounts for 25 years (let's say they both start at age 40 and retire at age 65). When they get to the age of 65 ... Alexa has $409,325 saved (all investments are assumed to grow at 8% per year). This is great because she only contributed $162,500 (before taxes). Meanwhile, Austin is looking even smarter because his retirement account is now worth $519,700. This happens because Alexa had to pay the taxes each year on the income she ended up putting into her Roth IRA and regular investment buckets (both are considered to be "after tax" accounts), meaning she had less to start with than her brother who didn't have to pay the taxes on any of the $6500 he put into his retirement account.

If we stopped the story here, Austin would be the hands down winner. He has amassed almost 25% more money than his sister. This is as far as your average tax-planner takes the analysis and is why conventional wisdom is to defer as much in taxes as possible.


At age 65, both Austin and Alexa retire and begin to draw income off of their retirement accounts.

THE MATH (You can skip this if you want for now)

Austin takes $44,500 out of his account each year, but he has to pay income taxes on all of that money. We assume that tax rates haven't changed at all so after taxes, Austin has $31,200 to live off of. Austin lives 25 years until he is 90 and essentially runs out of retirement assets to live off of.

Meanwhile, Alexa draws on each of her "buckets" in such a way that the money in each also lasts 25 years. She takes $14,800 out of her IRA-type bucket, $10,400 out of her investment bucket and another $10,400 out of her Roth IRA bucket. The money coming out of the Roth IRA bucket is completely tax free (and is not counted towards income) so she gets to use ALL of that. The investment income is taxed at long-term capital gains rates (current 5% or 15%) so she keeps most of that ($9,800 per year after taxes). The income coming out of the IRA-type bucket is taxed as regular income, but her Adjusted Gross Income is much lower than Austin's ($15k vs $44k) so she is in a lower tax bracket. After taxes, Alexa gets to enjoy $12,600 of that income.

The end result is that Austin has $31,200 per year to live off of ... and Alexa has $32,800 to enjoy ($1600 more per year or about 5% more).

Summary - What This Means to Your Wealth Health

Regardless of what happens to tax rates in the coming years, avoiding the temptation and advice to save all your retirement income in your 401(k) or IRA-type, qualified, tax-deffered retirement account will add up to 5% to your overall net wealth.

If you believe (as I do) that income tax rates are going to go up in the future ... or that your retirement income needs will be greater than your taxable income during your working years (as I also do), then the net effect of the "3 Bucket Strategy" will be even greater. It could easily mean hundreds of thousands of dollars in additional net wealth in your future - creating a more secure future for your family ... and the opportunity to enjoy a richer and more fulfilling life every day.

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Comments (4)
1 Friday, 04 December 2009 04:26
OK, so wouldn't Alexa come out even better off if she put the entire $6500 into just one bucket, a Roth IRA?
2 Friday, 04 December 2009 04:31
John D. Buerger, CFP
Great question Greg ... That was what I thought at first, but it actually doesn't work that way. The improvement of a 100% Roth IRA contribution over a 100% regular IRA contribution is only about 1/2% where the 3 Bucket approach can improve net wealth by 5%.

The reason all three buckets works better is that the strategy maximizes the tax advantages in each one. Remember the cardinal rule - save the greatest amount of taxes (period) ... regardless of when you take the tax hit.

An additional benefit - not having all your wealth in any one basket protects you from law changes regarding that type of account. If you had all your money in Roths and Congress decided they wanted to change the rules regarding their tax treatment (maybe taxing gains inside the Roth when you take the money out), that could prove to be hugely problematic.
3 Friday, 04 December 2009 05:45
Bill Winterberg
John, the bucket strategy gets even better with the progressive nature of the marginal tax brackets combined with the deductions, exemptions, and credits taxpayers receive.

I've seen cases where taxpayers in 2008 realized long-term capital gains and received Social Security income, Traditional IRA distributions, and Roth IRA distributions and paid $0 in Federal tax.

All of the taxpayer's AGI was subtracted by deductions, exemptions, and credits for which the taxpayer qualified, resulting in nearly $0 in taxable income.

So as you said, having a diversified source of income ("buckets") allows individuals to take advantage of the various ways taxable income can be subtracted off the return.

Bill @ FPPad.com
4 Friday, 04 December 2009 15:34
John D. Buerger, CFP
Thanks Bill. Everyone should read that 3rd paragraph again ... "resulting in nearly $0 in taxable income."

The only thing I would add to Bill's comment is that good tax planning would, in the 2008 case Bill cites, favor taking more income from the IRA bucket to use up the headroom in the lowest tier(s) of the progressive tax system ... at least if there is any possibility that in future years you might have to declare taxable income.

You might as well pay a 15% marginal tax rate this year on some money. It's better than paying a higher marginal rate in the future if/when they raise taxes. The cardinal rule still stands - "the objective is to pay the lowest rate in taxes regardless of when they get paid."

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Last Updated on Thursday, 17 December 2009 00:59