The Three-Bucket 401(k) Withdrawal Strategy That Can Save Retirees Six Figures in Taxes

Many people spend their entire working lives contributing to a 401(k) retirement plan in hopes of retiring one day. However, very few people consider their withdrawal strategy once they're actually retired. Even if they have multiple streams of income, many retirees default to withdrawing everything from their 401(k) first, without considering the consequences.

Charles Schwab explains that there are many ways to withdraw money from your retirement accounts. One strategy is the bucket approach. This is also called the three-bucket strategy. Here is more information about it and how it could potentially save retirees six figures in taxes.

What retirees need to know about 401(k) withdrawals

Every time a retiree withdraws money from a traditional 401(k), it's taxed as ordinary income. Depending on the amount you withdraw, it can make your Social Security benefits taxable. If you push your income high enough, it could also trigger IRMAA, which is the surcharge high earners have to pay for Medicare. That's why retirees need to carefully plan how they withdraw money from their accounts.

The three bucket withdrawal strategy

The three-bucket withdrawal strategy is a plan to spread your retirement withdrawals across different types of accounts. The goal of doing this is to be in control of how much taxable income you have in any given year. That way, you can avoid paying higher taxes or higher Medicare costs.

Another option with the three-bucket strategy is to withdraw from one type of account until it's gone, then move to a different type of account. There are pros and cons to both options.

The first bucket: pre-tax money

The first bucket in this strategy is your pre-tax money. That includes your contribution to traditional 401(k)s and traditional IRAs. Because you were able to lower your taxable income when you contributed to these accounts, you now have to pay taxes on them in retirement.

This is the bucket that retirees need to be most careful with, since withdrawing money from it counts as ordinary income. You also must be above age 59 and a half to avoid paying a 10% penalty.

The second bucket: Roth money

The second bucket is Roth IRA and Roth 401(k) money. Because you contributed to these accounts with after-tax money, you do not have to pay taxes on your withdrawals (as long as you meet specific requirements).

Many people use their Roth accounts to make large purchases, such as paying for a major home repair or buying a car in cash. There are also no Required Minimum Distributions (RMDs) with Roth accounts, which means you can leave your money in one as long as you like. This makes Roth accounts very valuable from a tax perspective.

The third bucket: taxable brokerage money

Finally, the third bucket is taxable brokerage money. This is money you've invested in a regular brokerage account versus a retirement account. When you sell an asset in your brokerage account, you're taxed on the gain. For many people, that is more tax advantageous than withdrawing from a 401(k).

Many people also consider money in savings, such as an emergency fund, savings bonds, or a high-yield savings account, as part of this bucket.

Why a specific sequencing order makes sense for retirees

Some financial experts recommend withdrawing from your three buckets in a specific order to minimize taxes. Others recommend taking a small amount from each every year. The best route for you will ultimately depend on the type of accounts you have, the amount you need to withdraw, and your retirement goals.

A financial planner can help you make a withdrawal plan that helps you minimize taxes while also having enough money to maintain your ideal retirement lifestyle.

The critical planning window is below age 73

At age 73, you're required to make Required Minimum Distributions (RMDs) from your 401(k). That means that, by law, you have to take out a certain amount of money. For that reason, the years before you turn 73 are a critical planning window. Use this time to decide how you will withdraw money from your 401(k), keeping in mind that your balance will likely grow due to compound interest over time.

Bottom line

Having a well-thought-out withdrawal strategy can help you to have a stress-free retirement in the future. Deciding which accounts to use for your income and the order to withdraw from them can have a big impact on your taxes each year. For that reason, it's important to speak with a financial planner and an accountant if you're not sure the best route to take for your personal finances. Also, stay up to date with retirement policy news to ensure you're staying compliant with all laws, especially ones pertaining to 401(k)s and RMDs.