Drop in the bucket: diversifying your retirement assets with taxes in mind.

• Author: Pope, Devin
• Position: Money Talk

For most of us, having a retirement with a handsome pension and Social Security benefits to cover expenses is no longer an option. We are fully responsible to save our income and invest our assets in order to build a nest egg for retirement. This is not an easy task and many difficult decisions must be made along the way.

We have all heard that diversification is an important part of this process. When people mention diversification they discuss how to invest in domestic and international equities, bonds, real estate and alternative investments. The equity allocation can be further diversified between small-, mid- and large-sized companies. These are very important decisions as you are planning for retirement. Another type of diversification to consider is how your dollars are allocated between asset buckets. These buckets include taxable, tax-deferred and tax-free assets. Each one has advantages and disadvantages.

Taxable Bucket

Our earnings are taxed when they are earned, then those dollars are taxed again as they generate income. The taxable bucket is less tax efficient as it is subject to two taxable events: earnings and growth. But the benefit is in the liquidity and lack of restrictions. If you need the funds, they are available. When you want to add money to the taxable bucket, you are not restricted in the amount or timing of those contributions. This flexibility is important as you build assets and withdraw them in the future.

Tax-deferred Bucket

Assets in your 401(k) or IRA would be the tax-deferred bucket. You receive a deduction from income when you make contributions. The contributions grow tax deferred, but the distributions are taxed at the applicable ordinary income rates. This is the most common bucket used to build assets for retirement. The deduction received when making contributions reduces your taxable income and taxes.

Having the assets grow tax deferred is an advantage. With the taxable bucket, you need dollars to pay the taxes on the interest, dividends and capital gains you earn. With the tax-deferred bucket, you keep those dollars and they continue to grow. Albert Einstein is quoted as saying, "The most powerful force in the universe is the power of compound interest."

If you require a large cash flow from the tax-deferred bucket for expenses, you can be pushed into higher tax rates. That dream retirement vacation becomes more expensive when you have to use dollars from the tax-deferred bucket.

Tax-free Bucket

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