One of the foundational ideas in David McKnight’s Power of Zero philosophy is that future tax rates may be significantly higher than they are today. Rising national debt and growing entitlement programs may potentially impact retirees relying on taxable and tax-deferred accounts, possibly leading to higher income tax burdens in retirement.
To prepare for that potential reality, one goal of tax-efficient retirement planning is to structure your finances so that your retirement income falls into the 0% federal tax bracket. While Roth IRAs and certain life insurance policies play key roles in this strategy, there’s another often-overlooked component that’s just as important: learning how to utilize your taxable bucket wisely.
At Hanson Wealth Management, we guide clients in using each bucket of money—taxable, tax-deferred, and tax-free—with intention. Here’s how to think strategically about your taxable assets.
Understanding the Three Buckets of Retirement Savings
In the Power of Zero framework, every dollar you save for retirement falls into one of three categories:
- Tax-deferred (e.g., traditional IRAs and 401(k)s)
- Taxable (e.g., brokerage accounts, bank savings, mutual funds outside retirement accounts)
- Tax-free (e.g., Roth IRAs, Roth 401(k)s, properly structured life insurance)
Each has a different impact on your retirement income and tax liability. The goal is to shift your savings over time into the right mix—ultimately favoring the tax-free bucket while keeping strategic amounts in the other two.
The Purpose of the Taxable Bucket
While often overshadowed by the promise of tax-deferred growth or tax-free income, your taxable bucket can be a part of a tax-efficient strategy. This bucket includes:
- Bank accounts
- Taxable brokerage accounts
- Dividends and capital gains from investments held outside retirement accounts
McKnight suggests that your taxable bucket should be kept to a limited amount—often no more than about six months of basic living expenses. That’s because the taxable bucket is subject to ongoing taxes on interest, dividends, and capital gains.
However, it has one powerful advantage: liquidity. Funds in this bucket are typically accessible without age-based penalties, making them useful for funding Roth conversions or other strategic tax moves.
Using the Taxable Bucket to Support Roth Conversions
One of the primary strategies to reduce future tax exposure is to perform Roth conversions—moving money from a traditional IRA or 401(k) into a Roth IRA by paying taxes on the converted amount today.
But where do you get the money to pay those taxes?
That’s where your taxable bucket comes in.
Using your taxable bucket to pay Roth conversion taxes can be an efficient move, especially while tax rates remain relatively low. By using after-tax dollars from a taxable account, you avoid having to withhold taxes from the converted amount itself, preserving more principal in the tax-free account for future growth.
In this way, the taxable bucket serves as a bridge—helping you transition more of your portfolio into the tax-free zone.
Managing Growth in the Taxable Bucket
While you may not want to accumulate too much in this bucket, managing its growth matters. Investments here can be strategically selected for tax efficiency, such as:
- Index funds that aim to minimize capital gains
- Municipal bonds, which may offer tax-free interest at the federal level
- Investments held long-term to benefit from lower capital gains rates
These choices can help limit the tax drag from this bucket while still allowing for growth and flexibility.
Why Less Is More in the Taxable Bucket
David McKnight emphasizes that excess money in the taxable bucket can create unnecessary tax burdens over time. For example:
- You may owe taxes on dividends and capital gains even if you reinvest them.
- Capital gains could affect your adjusted gross income and increase Medicare premiums.
- Growth here may be taxed every year, unlike tax-free or tax-deferred accounts.
That’s why it’s often more efficient to shift surplus funds to more tax-efficient vehicles, such as Roth IRAs or properly structured cash value life insurance, within IRS guidelines.
Utilize Your Taxable Bucket as a Strategic Tool
To utilize your taxable bucket effectively, consider it a short-term resource and a tool to fund tax-efficient transitions. It plays a valuable role in helping you achieve the broader objective: building a plan that aligns with a low—or even 0%—tax bracket in retirement.
This approach involves coordinating your taxable, tax-deferred, and tax-free resources in a balanced way, with a forward-looking view on taxes, market performance, and future income needs.
If you’re exploring how to apply the Power of Zero principles to your retirement strategy, Hanson Wealth Management can help you evaluate your current position and create a plan that reflects your long-term goals. Reach out today to schedule a strategy session.
