We’ve all heard of bucket lists. Many of us have created them for retirement: where to travel, new activities to try, and maybe even a new place to snowbird. But you might not be familiar with this type of bucket list: the bucket system of money management. I have found this crucial for successful investment planning.
One of the most basic parts of any financial plan is what amount of risk you should take on your investments. This involves some form of risk assessment and is used by the vast majority of investors and investment professionals to determine an investment policy statement or what the risk level of their portfolio should be.
As a Certified Financial Planner™ Practitioner, I also do these assessments for my clients. Unfortunately, many people stop there and ignore everything else that needs to be considered when planning an investment strategy. I use the simple concept of the buckets of money theory as a system to visualize the difference between short- and long-term goals.
The 4 Buckets Of Money
It’s been my experience that most people don’t dramatically change their risk tolerance even when they get to retirement age or beyond. What really changes is the amount of time they are facing until the goal. Someone who was a long-term aggressive investor might moderate to a growth investor as they got older, but it’s unlikely they will suddenly become ultra-conservative, nor should they. What you need to do is have the right money in the right buckets.
1. Short-Term Funds
Your short-term bucket should contain all of the money you plan to spend in the next 2 years and your emergency funds. This is all your essential expenses like rent or mortgage payments, food, utilities, car payments, and the like. It also includes your discretionary expenses such as dining out, hobbies, and vacations.
Add to this any large purchases you plan to make in the next 2 years. This money is, for all practical purposes, already spent. No, I don’t expect you to have this much money liquid, so we add to this bucket how much you have in income. The word here is budget. Having a written budget so you can keep income and expenses in check is key to retirement success.
Pro Tip: Have a written budget and clear spending plan. Knowing your budget and sticking to it is a key part of having a successful retirement. Having clear goals can do more to ensure this success than almost any other aspect of retirement planning.
Let’s look at the need for an emergency fund. This is money that you need when you need it, and can never know when that need is coming. You can’t afford to worry about bad market conditions or having to pay taxes unexpectedly; it must be readily available cash. YouGov reported that only 49 percent of Americans could come up with $400 for an emergency. My goal is for you to not be one of them.
Conventional wisdom says an emergency fund should be 3 to 6 months’ income — I disagree. First, no one gets to keep their gross income; you have to pay Uncle Sam. Now we’re at net after-tax income, but even that may be more than necessary. I suggest 3 to 6 months of net expenses as the correct amount. Some people will want more just to be comfortable, but this is the right range to add to the first bucket.
2. Intermediate Funds
The second bucket is the intermediate bucket. This is the money that you have plans for in the next 3 to 5 years. This goal is far enough away that inflation can and will affect how much that goal will cost. Here you need to take enough risk to limit that impact so you can afford that trip to the Maldives.
In this bucket, you will want to use long-term CDs, short- and intermediate-term bonds, or conservative allocation portfolios. Aggressive growth stocks are probably not a good idea for this bucket. The goal here is not to hit it out of the park but just to match inflation over the next 5 years. As the goal gets within the 2-year mark, you will want to transition these funds into cash in the first bucket.
3. Long-Term Funds
The third and fourth buckets may sound the same, but there are key differences. The Long-term bucket is self-explanatory. Here, your goal is longer than 5 years away — typically, long enough to get through a full market cycle. In this bucket, you want to beat inflation to get a real return on your investments.
The idea here is that you can buy and do more with your money later on. How much you beat inflation is decided by your risk tolerance. More moderate investors may only exceed inflation by a small margin. Aggressive investors might see significant net gains but might also see an amount of volatility that may not be acceptable to most people.
4. Retirement Funds
The difference between long-term money and the retirement bucket comes down to taxation. The retirement bucket is tax-deferred. This may be your 401k, 403b, or IRA accounts, to name some that may be available to you. In these accounts, you’ve put your money in on a pre-tax basis. While the funds are there and hopefully grow, no tax is due. This means any trading activities that make gains (or losses) are not reported. You only pay taxes when you take the money out as a distribution.
This is a big distinction between these 2 types of accounts. You see, in a long-term account, you should be concerned about how much you pay in taxes. The more you pay on the investment gains along the way, the less you net. This means that good money managers will treat these accounts differently, using tactics and strategies that reduce current taxation on gains.
In a pre-tax retirement account, everything you take out of the account is taxed. There are some exceptions for charitable distributions, but money that you want to spend for yourself from these accounts is always taxable, and there’s the rub. Since everything is taxable as you take withdrawals from these accounts, you won’t want to be making huge distributions from them.
If you do, the IRS will be your best friend because of how much you’re going to be giving them. These accounts are really meant to be distributed over your lifetime, taking a small percentage each year. The reality is that these accounts are forced into being long-term investments because of this.
Too often I see people have their retirement money in savings or short-term CDs; this completely misses the point of this type of account. You will want a part of it in a retirement short-term bucket if you are making distributions. That way you can ride out any volatility and stay invested for the long term but not have to worry about selling out in a down market.
A quick word about Roth IRAs: they’re great! Never having to pay taxes on your investments again is a good thing. This type of account straddles the two long-term buckets. It has the tax deferral like a retirement account (which it is), but all the distributions are tax-free and can be used in a lump sum. I think it really comes down to how you plan to use this money. Is it for living on or leaving to others tax-free? Are you going to Australia for a month or using the money for your annual trips to the beach?
Pro Tip: While you’re working, contribute as much as you can to a Roth IRA and invest it for the long term. It can help make those big once-in-a-lifetime vacations possible.
Budgeting and planning are the keys to figuring all of this out. As a financial planner, I’m biased, but professional advice can guide you in the right direction. A professional can help you figure out your risk tolerance, but there are free DIY tools available. This is a case where “free” may end up costing you a great deal eventually. No matter how you develop your plan, make sure to stick to it. Emotional investing almost never works and can make you do the wrong thing at the worst possible time. Using the bucket system of money will help tame the emotional beast. Knowing you have enough money available to ride out the bear should make it easier to stay the course and have a successful retirement.