The 3 Tax Buckets Every Pre-Retiree Should Build
Most people approaching retirement have their savings sitting in just two places. Their 401(k) and possibly a Roth IRA.
Those are great accounts. However, if you want true flexibility in retirement, especially during the important years between age 55 and 65, you need a third tax bucket that many retirees overlook.
This third bucket gives you something retirement accounts cannot provide.
Complete control.
No penalties.
No withdrawal restrictions.
No required distributions.
It can also help you reduce taxes significantly over the course of retirement.
What Are the Three Tax Buckets in Retirement?
The three retirement tax buckets are:
- Tax-deferred accounts such as 401(k)s and traditional IRAs that are taxed as ordinary income when withdrawn.
- Tax-free accounts such as Roth IRAs and Roth 401(k)s that provide tax-free withdrawals in retirement.
- Taxable brokerage accounts that offer flexible withdrawals and are taxed at capital gains rates.
Using all three tax buckets can help retirees control taxable income and reduce lifetime taxes.
Understanding the Three Tax Buckets for Retirement
One of the easiest ways to understand retirement tax planning is by thinking of your savings as three different tax buckets. Each bucket is taxed differently, which affects how and when you should withdraw money in retirement.
Using multiple tax buckets allows retirees to control their taxable income and reduce lifetime taxes.
Bucket 1: Tax-Deferred Retirement Accounts
The first bucket is your tax-deferred bucket.
This includes accounts such as:
- 401(k)
- Traditional IRA
- 403(b)
When you contribute to these accounts, you usually receive a tax deduction upfront. Your investments grow tax-deferred, meaning you do not pay taxes while the money compounds.
The trade-off happens when you withdraw the money.
Every dollar withdrawn from a tax-deferred account is taxed as ordinary income. Depending on your tax bracket, that can range from 10 percent to 37 percent at the federal level according to the IRS.
Another important rule involves Required Minimum Distributions (RMDs). Once you reach age 73, the IRS requires you to begin withdrawing money whether you need it or not.
2026 Retirement Contribution Limits
For 2026 the contribution limits are:
- 401(k): $24,500 per year or $32,500 if age 50 or older
- IRA: $7,500 per year or $8,600 if age 50 or older
Tax-deferred accounts are extremely valuable, but relying on them alone can create large tax bills later in retirement.
Bucket 2: Tax-Free Retirement Accounts
The second bucket is the tax-free bucket, typically made up of:
- Roth IRA
- Roth 401(k)
With Roth accounts, contributions are made with after-tax dollars. You do not receive a tax deduction when contributing.
However, the benefits come later.
Your investments grow tax-free, and withdrawals in retirement are also tax-free as long as the rules are followed.
This means:
- No tax on investment growth
- No tax on qualified withdrawals
Another advantage is that Roth IRAs do not have Required Minimum Distributions during your lifetime.
Because of these benefits, Roth accounts are often the most valuable retirement assets you own.
Many investors stop here. They build a tax-deferred bucket and a Roth bucket and assume their strategy is complete.
Unfortunately, that leaves out a critical piece of the retirement tax puzzle.
Bucket 3: The Overlooked Taxable Brokerage Account
The third tax bucket is the taxable brokerage account.
At first glance, this account may seem less appealing because it does not offer an upfront tax deduction. That is why many investors overlook it.
However, this bucket offers something the other two do not.
Flexibility.
Taxable brokerage accounts have several advantages:
- No contribution limits
- No early withdrawal penalties
- No required minimum distributions
- Favorable capital gains tax rates
If investments are held longer than one year, profits are taxed at long-term capital gains rates, which are currently 0 percent, 15 percent, or 20 percent depending on income.
These rates are often lower than ordinary income tax rates.
But the real benefit appears during one of the most important stages of retirement.
The Retirement Gap Problem
Many people hope to retire before age 65.
This creates a period often referred to as the retirement gap. It is the time between retirement and when Medicare begins.
During these years, retirees must generate income while managing taxes carefully.
Consider this example.
A retiree leaves work at age 62 with:
- $1,000,000 in a 401(k)
- $200,000 in a Roth IRA
They need $80,000 per year to live on, and Social Security provides $30,000.
That means they must withdraw $50,000 annually from savings.
If that entire withdrawal comes from a 401(k), the full $50,000 becomes taxable income.
Depending on the tax bracket, this could create $8,000 to $12,000 in taxes every year.
Alternatively, they could withdraw from their Roth account to avoid taxes. However, Roth money is usually the most valuable long-term asset because it grows tax-free.
Using it too early can reduce long-term tax benefits.
This situation illustrates the two-bucket problem.
Retirees must choose between paying higher taxes or spending their most valuable tax-free assets too quickly.
How the Third Tax Bucket Changes Retirement Planning
Adding a taxable brokerage account changes the strategy completely.
Imagine the same retiree also has $500,000 in a brokerage account.
Now they can withdraw their living expenses from that account.
Instead of paying ordinary income tax, withdrawals may only trigger long-term capital gains taxes, which could be 0 percent or 15 percent.
Because their taxable income is lower, they enter a period often called a tax valley.
During this time, retirees can strategically convert money from a traditional IRA into a Roth IRA while remaining in lower tax brackets such as 12 percent or 22 percent.
This strategy can potentially save tens or even hundreds of thousands of dollars in taxes over a lifetime.
Are Taxable Brokerage Accounts Tax Inefficient?
One of the biggest misconceptions about brokerage accounts is that they are tax inefficient.
In reality, taxation often depends on how the account is invested.
Actively managed mutual funds with frequent trading can generate higher taxes. However, many investments are extremely tax efficient.
Examples include:
- Total market index funds
- S&P 500 index funds
- Low-cost ETFs
These investments have low turnover, which means fewer taxable events.
Dividends are usually qualified dividends, which are taxed at favorable capital gains rates rather than ordinary income rates.
Additional Tax Benefits of Brokerage Accounts
Taxable brokerage accounts also provide additional planning opportunities.
Tax-Loss Harvesting
If investments decline in value, you can sell them to realize a loss.
These losses can offset capital gains and even reduce ordinary income by up to $3,000 per year.
Step-Up in Basis
When brokerage assets are inherited, beneficiaries receive a step-up in cost basis to the current market value.
This means unrealized gains accumulated during your lifetime disappear for tax purposes.
Your heirs could sell the investments and pay no capital gains tax.
This benefit does not apply to traditional retirement accounts.
How to Build the Third Tax Bucket
If you are approaching retirement, building a brokerage account can significantly improve your financial flexibility.
A simple approach looks like this.
Step 1: Capture the Full Employer Match
Always contribute enough to your 401(k) to receive the full employer match.
Step 2: Contribute to a Roth IRA if Eligible
Roth accounts provide valuable tax-free income later in retirement.
Step 3: Build a Retirement Bridge Account
After those priorities are covered, consider directing additional savings into a taxable brokerage account.
Think of this account as a retirement bridge fund.
This provides flexibility during early retirement and creates opportunities for tax planning.
Using Asset Location to Reduce Taxes
Another powerful strategy is asset location. This means placing investments in the accounts where they are most tax efficient.
A common structure looks like this.
Tax-Deferred Accounts
- Bonds
- High-income investments
Roth Accounts
- Growth stocks
- Long-term appreciation assets
Taxable Brokerage Accounts
- Broad market index funds
- Low-turnover ETFs
Using proper asset location can help minimize taxes while maximizing long-term growth.
Why Three Tax Buckets Create a Better Retirement Strategy
Having all three tax buckets provides important advantages:
- Greater control over taxable income
- More flexibility for withdrawals
- Opportunities for Roth conversions
- Reduced lifetime tax burden
Without a taxable bucket, retirees often pay more taxes than necessary.
With the right strategy, you can create a retirement income plan that is more flexible, tax efficient, and sustainable.
Final Thoughts
Retirement planning is not only about how much money you save. It is also about where your money is saved and how it will be taxed later.
Building all three tax buckets can give you greater control over your retirement income and potentially save significant taxes over time.
If you want help building a tax-efficient retirement strategy, working with a qualified financial planner can help you make the most of these opportunities.
At Eagle Financial Planning, we help pre-retirees create clear strategies for retirement income, tax planning, and long-term financial security.
You can schedule a complimentary Retirement Strategy Session to see how these strategies might apply to your situation.
