We've all heard of bucket lists. Many of us have created them for retirement: where to travel, try new activities, and maybe even have a new place to snowbird. But you may not be familiar with this type of bucket list: the bucket system of money management. I have found this is critical to successful investment planning.
One of the most basic parts of any financial plan is the amount of risk you should take in your investments. This involves some sort of risk assessment and is used by the vast majority of investors and investment professionals to determine an investment policy statement or the risk level of their portfolio.
As a Certified Financial Planner™ Practitioner, I also conduct these assessments for my clients. Unfortunately, many people stop here and ignore everything else that needs to be considered when planning an investment strategy. I use the simple concept of bucket-of-money theory as a system to visualize the difference between short- and long-term goals.
The 4 buckets of money
My experience is that most people do not dramatically change their risk tolerance even when they reach retirement age or beyond. What really changes is the time they have to get to the goal. Someone who was a long-term aggressive investor might become a growth investor as they get older, but they are unlikely to suddenly become ultra-conservative, nor should they be. What you need to do is have the right money in the right buckets.
1. Short term funds
Monthly spending
Your short-term bucket should include all the money you plan to spend over the next 2 years, as well as your emergency funds. These are all your essential expenses such as rent or mortgage payments, groceries, utilities, car payments and the like. This includes your discretionary spending like eating out, hobbies and vacations.
Budget
Add to that any major purchases you plan to make in the next 2 years. This money is practically spent already. No, I don't expect you to have that much liquid cash, so let's 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 a clear spending plan. Knowing your budget and sticking to it is a key factor to a successful retirement. Clear goals can contribute more to this success than almost any other aspect of retirement planning.
Emergency fund
Let's look at the need for an emergency fund. This is money you need when you need it, and you can never know when that need will come. You can't afford to worry about bad market conditions or unexpected tax payments; it must be readily available cash. YouGov reported that only 49 percent of Americans could afford $400 for an emergency. My goal is for you not to 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 have net after-tax income, but even that might be more than we need. The correct amount I suggest is 3 to 6 months of net expenses. Some people will want more just to feel comfortable, but this is the right choice to add to the first bucket.
The second bucket is the intermediate bucket. This is the money you plan to spend over the next 3 to 5 years. This target is far enough away that inflation can and will affect how much this target will cost. This is where you need to take enough risk to limit that impact so you can afford that trip to the Maldives.
In this area, you should use long-term CDs, short- and intermediate-term bonds, or portfolios with a conservative allocation. Aggressive growth stocks are probably not a good idea for this category. The goal here is not to hit it out of the park, but just to offset inflation over the next 5 years. If the goal is within the 2-year mark, you should convert those funds to 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 more than 5 years away – usually long enough to last 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 depends on your risk tolerance. More moderate investors can only slightly exceed inflation. Aggressive investors may see significant net gains, but also volatility that may not be acceptable to most people.
4. Retirement savings
Tax deferral accounts
The difference between long-term money and retirement depends on taxation. Retirement is tax-deferred. These can be your 401k, 403b or IRA accounts, to name a few, that are available to you. These are the accounts you put your money into pre-tax. While the funds are there and hopefully growing, no tax is due. This means that trading activities that generate profits (or losses) are not reported. You will pay taxes only if you take out the money as a distribution.
This is a big difference between these two types of accounts. You see, with a long-term account, you should think about how much you pay in taxes. The more you pay on the investment gains along the way, the less net. This means that good asset managers treat these accounts differently and use tactics and strategies that reduce the current taxation of gains.
With a pre-tax retirement account, everything you take out of the account is taxed. There are some exceptions for charitable distributions, but money you want to spend on yourself from these accounts is always taxable, and there's the catch. Since everything is taxable when you make withdrawals from these accounts, you don't want to make large distributions from them.
If you do, the IRS will be your best friend because you will give them so much. These accounts are really meant to be spread out over your lifetime, taking a small percentage each year. The reality is that these accounts are forced to be long-term investments for this reason.
Too often I see people have their retirement money in savings or short-term CDs; that completely misses the point of this type of account. You want a portion of it in a short-term retirement bucket when you take distributions. This way you can weather any volatility and stay invested for the long term, but not have to worry about selling out in a down market.
Roth IRAs
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 spans the two long-term buckets. It has the tax deferral like a retirement account (which it is), but all distributions are tax-free and can be used in a lump sum. I think it really depends on how you want to use that money. Is it tax-free for living expenses or giving to others? Go to Australia for a month or use the money for your annual beach trips?
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 this out. As a financial planner, I'm biased, but professional advice can lead you in the right direction. A professional can help you figure out your risk tolerance, but there are free do-it-yourself tools available. This is one case where "free" can end up costing you a lot. No matter how you develop your plan, make sure you stick to it. Emotional investing almost never works and can cause you to 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 the bear should make it easier to stay the course and have a successful retirement.