There are three basic tax buckets: taxable, tax-deferred, and tax-free. Another way to think of them is as “tax me now,” “tax me later,” and “tax me never.” It’s important to contribute to each bucket strategically to optimize your financial growth and long-term financial wellness.
What’s in your Taxable Bucket?
Accounts in your taxable bucket require you to pay taxes on their growth (but not the original investment) every year. In this bucket, you will find common investments that you are probably already familiar with, such as:
- savings accounts
- money markets
- mutual funds
The money you are putting into these accounts has already been taxed, so you don’t initially get any tax advantage from them. Indeed, you might never receive a tax advantage in some of the accounts in this bucket. However, taxable accounts have benefits, too! These funds have greater liquidity, so you can access them in an emergency or when planning a large purchase. It’s therefore important not to disregard them in your financial planning.
Double Compounding Effect
One reason to limit how much you invest in your taxable bucket is the “double compounding effect,” which David McKnight introduced in his book, The Power of Zero. The double compounding effect works by these steps:
- You increase the balance in your taxable bucket and experience growth in the account
- Therefore, your tax bill on your taxable bucket grows as well
- Tax rates on both your taxable bucket and tax bill rise
- Your overall tax bill increases at an accelerating rate each year
The bottom line: since the double compounding effect causes taxes to increase on your taxable bucket and your ever-increasing tax bill, the overall amount of taxes you owe increases more quickly each year. It’s important to offset these costs by prudently investing in other types of accounts as well.
Plan Ahead: Effects on Social Security Taxation
In the absence of good financial planning, the taxable bucket can also have unintended consequences with regard to your Social Security benefits. The IRS has set income limits on what they call “provisional income” that determine whether or not you are taxed for your Social Security benefits. Any provisional income above that limit leads to Social Security taxation. Growth in your taxable bucket is categorized as provisional income, so an increase in your taxable bucket could cause your Social Security benefits to be taxed. This is especially important to consider for individuals planning for or entering into retirement to prevent incurring unnecessary taxes.
It is essential that you reach out to speak with a trusted financial advisor, regardless of your current stage of financial growth, to ensure that you are using your taxable bucket to its full potential.