The Tax Free Bucket
Today, I’m talking specifically about the tax free bucket. However, in case you haven’t read my previous blog posts, I’m going to do a quick review to make sure you understand what the three buckets are.
The first bucket is the taxable bucket. This should only contain anywhere from three to six months—my recommendation is six months of income to be available for emergencies. It’s liquid assets. The biggest problem with this bucket is if you have too much money inside of it, you’re not going to be able to keep up with inflation. If you don’t have enough money when there’s a crisis, you’re going to have an issue.
The second bucket is the tax deferred bucket, and the tax deferred bucket has the majority of most people’s retirement assets in it at this time. What we want to do is make sure we adjust that bucket down to the appropriate amount. You don’t have provisional income. You can also get your required minimum distributions out without paying tax on those that are under your standard deduction threshold. If you can do that, that bucket is filled up correctly, and then all the other assets that we have should go into the tax free bucket.
Why do we want to put money into the tax free bucket? It’s because we’re in an environment where taxes are expected to go up. In fact, we know right now, the date is set for January 1, 2026. I get a lot of kickback from other people saying if the administrations change in the government, that date may be sooner, and that possibly could be, but we know for now that the date that’s been set is January 1, 2026.
When we talk to people about whether they’ll go higher or lower after that, the majority of the people believe the taxes are going to go higher, and they could go substantially higher because of unfunded liabilities such as Social Security, Medicare and the National Debt.
I’m going to talk about the various assets that can go into the tax free bucket and why you want to use as many assets as you possibly can to create as many streams of tax free income as possible. One of the things that we found as we do our planning is it is very difficult to get any person into a completely tax free environment with just one stream of income. It’s a process that requires us to look at various assets and at several products to be able to make sure that you can get into that tax free environment with multiple streams of income as you head into retirement.
When I talk tax free, I’m talking about federal tax free, state tax free, capital gains tax free, and Social Security tax free. It’s very important that an investment meets all these criteria. There are a couple that we get asked about that aren’t tax free.
One of them is municipal bonds. Why would a municipal bond not be considered tax free? Because municipal bonds, if you move states, are not going to stay tax free. Another one that gets brought up all the time is health savings accounts. Health savings accounts can be an amazing way to start putting money aside. However, it is not a completely guaranteed tax free asset. If you’re able to put the money in and get a tax deduction, it can grow tax free. As long as you use it for health purposes, you can pull it out tax free. You get a triple benefit if it works. There are situations where people aren’t guaranteed to be able to pull it out tax free. Therefore, we do not include it in our tax free bucket.
The first asset I want to talk about in this bucket is my favorite asset, and that is the Roth IRA. The Roth IRA was brought about to allow for taxable contributions, but tax free growth and tax free distributions when you get to the end. Unfortunately, it has not become that popular.
There’s less than a trillion dollars in assets inside of Roth IRAs, where we’ve got over 20 trillion dollars of assets going into tax deferred accounts or into our traditional IRA type accounts. The Roth IRA is great, but one of the biggest challenges that it has is that your contribution amounts are limited.
In 2020, the Roth IRA contribution is only $6,000. If you’re age 50 or older, you can put an additional thousand dollars in. But that’s only $7,000 a year. This is one of the big limitations that the product has is most people cannot get enough money into it to be able to get them the money they need once they get to retirement. If you’ve got a Roth 401k at work, the limits are going to be higher. I would take advantage of the Roth 401k so that you can then put that money in now while paying taxes at historically low rates, and then be able to pull the money out tax free in the future when tax rates are much higher.
There are some other limitations the Roth IRA has, and it’s very important to understand these. One of them is you do have to have earned income to be able to contribute into a Roth IRA. If you do not have W2 earnings, or if you don’t have some form of Social Security based earnings such as a business, then you’re not going to be able to contribute into a Roth IRA.
The other issue is you may have too much income to be able to put money into a Roth IRA. If you’re a single filer, or a head of household filer, and you make over $124,000 a year, your contribution amounts are going to start phasing out. Once you get over $139,000 a year, your contribution amount is going to be completely eliminated. For a married filing joint couple or a qualifying widower, the amount is going to be $196,000 before you start phasing out, and $206,000 before it’s completely eliminated.
The group that really gets hurt here is that group that’s married but filing separately. If you’re in that group, the chance of you contributing is going to be very limited. In fact, if you make $10,000 or less, you can contribute, but the amount’s going to be reduced. If you make over $10,000, it’s going to be completely eliminated, which means it’s a great option for married couples who file separately.
But a Roth IRA can be a great tool. If you can qualify to put money into this bucket, it’s my recommendation that you make sure you do it every year, especially during this period of historically low tax rates, where we’ve got the highest marginal tax bracket of 37%. Even in 2026, when taxes go up, that’s going to jump to 39.6%. In addition, the brackets changing is one of the other big issues that you have when taxes go up because they’re reverting back to the 2017 amounts. So you may even have a 9% jump in your tax rate even though you’re not making any additional money.
Another important asset inside of the tax free bucket is a Roth conversion. This is where you take your traditional IRA, and you roll it over into a ROTH. Well, if you’re going to do that, make sure that you get some advice, especially if you think you’re going to do it in one year’s time. Too many times we’ve had people come in, who decided to do it themselves. They heard taxes were going to go up, so they decided to make the transition. But when they did it, the conversion created so much tax that it put them into a bad situation.
Some of them did not have money in their taxable bucket to cover the tax, and others were put in such a high bracket, that it was one that they probably, even if taxes go up substantially, may not be there in retirement anyway. You want to make sure that it’s well planned out. We do have just over five years that we can do the transition with historically low tax rates, but you want to make sure that you’re getting the correct advice before you just go do this.
Another asset in the tax free bucket that’s often not talked about is the Roth annuity. What is the Roth annuity? This is where you move your annuity into a Roth account. Not only do you eliminate longevity risk by putting an annuity in place that’s going to guarantee you lifetime income, but you’re also now putting it in an environment where you’re not going to have tax on the money that comes out of the annuity.
Many people do not understand the way annuities work. As a result, they usually will discount the value that they have to your retirement portfolio. I’m here to tell you, you need to stop discounting annuities. They’ve changed substantially, and lives changed substantially, to where annuities can be a very important part of making sure you have the income that you need to last you your lifetime. You need to understand that once you get to retirement, it’s not about your assets. It’s about how much income you can create, so that you can use that income to live off of until your retirement ends.
Another asset that we need to talk about when we talk about the tax free bucket is the life insurance retirement plan. We will go into far greater detail on the life insurance retirement plan in a future blog. You need to understand with this plan that it is a permanent life insurance policy. It is set up to do a number of things with your retirement.
One of the first things is to make sure that you have another stream of tax free income. Life insurance retirement plans that are set up correctly, not only grow tax free, but they also allow you to distribute the money out tax free. You’ll also be able to get a long term care rider. That’s going to help cover your costs of long term care if you’re to have a long term care event. Which for the average couple, you’ve got a 70% chance that one of you is going to need some type of long term care if you live to your life expectancy.
There’s also a death benefit that comes with a life insurance policy, depending on what you want to pass on to your heirs or beneficiaries. This is a great benefit though, so you want to look at the option. There’s a laundry list of requirements that you’re going to want to make sure your life insurance retirement plan has.
The first one is you want it to have safe and productive growth. You need to understand that volatility is the Achilles heel. For any life insurance product, what you’re not wanting to do is have the cash value go down so far, that in retirement, especially when you’re getting into your 70s and 80s, you’re happening to buy more insurance than you should have to buy.
You also want low fees. You want to make sure that the structure is set up to where it’s not costing you any more over the length of the policy than you would pay for a traditional investment. You also want cost free and tax free distributions. Many life insurance companies do not allow for cost redistribution. When this happens, you can end up spending hundreds of thousands of dollars to borrow your own money.
The last one is you do want that long term care rider. Long term care is one of the biggest risks facing your retirement. In fact, we insure things like our house. You realize there’s only a 3% chance that you’re going to have some type of fire that’s going to burn your house down. Yet we all have fire insurance. We insure our car even though there’s only an 18% chance you’re ever going to total your car.
We have a 70% chance if we live to our average life expectancy of needing some type of long term care benefits, yet we’re not insuring for it. You do want to make sure that you have this life insurance retirement plan as an option to put in there. Again, if you want to learn more about it, get hooked up with one of our advisors. They can help make sure that it is the product that will work for you.
Another asset that’s not in this bucket, but we want to consider for tax free income is that tax deferred bucket. I wrote about this last week. I talked about needing the right amount of money in this bucket. Well, if you get the appropriate amount inside of this bucket so that your required minimum distributions do not exceed your standard deduction, and they do not cause your social security to be taxed, then what you’ve done is you’ve created a tax free asset.
The last one that I want to cover is Social Security. If you only have Social Security income, you’re not going to have tax under Social Security. But there is what’s called provisional income, which is you take your taxable income, you take your municipal bond income, even though it’s not tax, and one half of your Social Security. Once you add those up, if the amount exceeds $25,000, for a single individual, or $34,000 for a married couple, some portion of your Social Security is going to be taxed. When your Social Security is taxed, you’re going to run out of money five to seven years faster.
Why do we want to get all this money inside the tax free bucket? Well, the biggest thing is that it helps to eliminate the risk facing your retirement.