Most of us think about our savings by account. There’s the IRA from an old job, the Solo 401(k) you set up for the business, the checking account, maybe a rental property or two. It’s a natural way to keep track, but it doesn’t tell you the thing that matters most over the long run: how much of that money you’ll actually get to keep.
At a recent MidAtlantic IRA National Strategy Call, Jack Kiley, CPA, offered a different lens. Instead of sorting your money by account, sort it by how it’s taxed. When you do, everything you own falls into one of three buckets.
Bucket One: Taxable
This is money you’ve already paid tax on, or will pay tax on every year. Your paycheck, your savings account, your personal brokerage account, rental income from property you own in your own name. Growth in this bucket is generally taxed as you go.
Bucket Two: Tax-Deferred
This is where Traditional IRAs, SEP IRAs, SIMPLE IRAs, and pre-tax 401(k) dollars live. You typically get a deduction when the money goes in, it grows without annual tax, and you pay tax when it comes out. For most people, this is the biggest retirement bucket by far.
Bucket Three: Tax-Free
This is the Roth bucket. You pay tax on the way in, and qualified withdrawals come out tax-free, growth included. For most investors, this is the smallest of the three.
The Real Question: How Do You Move Money Between Buckets?
Here’s the shift Jack encourages investors to make. The goal isn’t to pick the “right” bucket and pour everything into it. It’s to move money from one bucket to another on purpose, at the right time, and at the lowest tax cost you reasonably can. There are four main paths.
From taxable to tax-deferred. When you make a pre-tax contribution to a Traditional IRA, SEP, or Solo 401(k), you’re moving money out of the taxable bucket and into the tax-deferred one, usually with a deduction today. For business owners in a high-income year, that deduction can be meaningful.
From taxable to tax-free. A Roth contribution moves money you’ve already paid tax on straight into the tax-free bucket. Depending on your income and the type of plan you use, there may be limits on how much you can contribute this way, so it’s worth checking your options before you assume you do or don’t qualify.
From tax-deferred to tax-free. This is the Roth conversion, and it’s where a lot of the strategy lives. When you convert, you pay income tax on the value you move from a Traditional account into a Roth, and from then on that money (and its future growth) sits in the tax-free bucket. The key word is timing. A slower year in your business, a gap between jobs, or the years before required distributions begin can all be windows where converting costs less than it would otherwise.
From tax-deferred to taxable. Eventually, money leaves the tax-deferred bucket as distributions, and at a certain age the IRS requires it. This is the one move everyone makes sooner or later. The question is whether it happens on your schedule or on the government’s.
Where Alternative Assets Change The Math
For self-directed investors, that third path has an extra dimension. When you convert, you’re taxed on the fair market value of what you move. With stocks, that’s just the market price. With real estate, private notes, or a partial interest in an LLC, value is determined by appraisal, and it isn’t always the same as what you expect the asset to be worth down the road.
That means the value of an alternative asset at the moment you convert can matter a great deal. We walked through a few examples of this in our earlier article on Roth versus Traditional accounts, and it’s a big reason why investors who hold alternatives inside their IRA often have more flexibility in how they move between buckets than they realize. It’s also an area where a qualified, independent valuation and good professional advice are essential.
Why Fall Is A Good Time To Look At Your Buckets
Roth conversions count toward the tax year in which they’re completed. That makes the last few months of the year a natural time to step back, look at how your income is shaping up, and ask whether this is a year to move some money into the tax-free bucket, or a year to hold steady. You don’t have to make a decision today, but having the conversation with your tax advisor now gives you room to act thoughtfully instead of rushing in December.
Thinking Beyond Your Own Retirement
There’s one more reason the tax-free bucket deserves attention. Under current rules, most non-spouse beneficiaries who inherit a Traditional IRA have to empty it within a set number of years, often while they’re in their own peak earning years. Roth dollars generally pass to heirs without that income tax burden. For families thinking about legacy, building up the third bucket over time can mean leaving behind more of what you built and less of a tax bill.
A Few Questions To Start With
If this framework is new to you, start simple. Roughly how much of your money sits in each bucket today? Which bucket do you expect your income to come from in retirement? Are there years ahead when your income may dip? And do you hold assets inside your IRA whose value today may not reflect where they’re headed? You don’t need all the answers. Just asking the questions puts you in a stronger position than most.
The Bottom Line
There’s no single right mix of buckets. The best balance depends on your income, your tax bracket, the assets you hold, and what you want your retirement (and your legacy) to look like. The three bucket framework simply gives you a clearer way to see where you stand and where you have room to be strategic.
If you’d like to go deeper, join us on an upcoming National Strategy Call, or reach out any time at hello@midatlanticira.com. We’re always happy to walk through how self-directed accounts work alongside you and your advisors.
MidAtlantic IRA, LLC is a self-directed IRA administrator and custodian, not an investment advisor. This article is for educational purposes only and is not tax, legal, or investment advice. Please consult your own tax and legal professionals before making decisions about your accounts.