You Can Save in Three Different Tax “Buckets.” What Are They, and Why Should You Care?

I’m violating one of the cardinal rules of content marketing here by writing about something I want you to know about, instead of something that you want you to know about.

I do it because it’s important. And slightly nuanced. And even most people who are attentive to personal finance won’t think about it. And you’ll be better off if you do.

I’m talking about making sure you’re saving money in three different tax “buckets,” or three kinds of accounts (if you can), differentiated by tax treatment:

1. Tax-deferred accounts
2. Tax-free accounts
3. Taxable accounts

Sexy, I know.

Having money in each bucket gives you more flexibility in your financial life, now and through the end of your life. I think flexibility, a close cousin of choice, is extremely important for women in tech.

I will now don my corduroy jacket with leather-patched elbows and start the lecture.

How Each Kind of Account Works

Let’s get Buckets 101 out of the way first.

Tax-Deferred Accounts

“Tax-deferred” means that

1. When you make your contribution, you get a tax deduction,
2. The investments inside the account grow tax-free year after year, and
3. When you withdraw money from this account in the future, every dollar is subject to ordinary income tax, just as your salary is now.*

For example, if you have $1M in tax-deferred accounts, you really only “own” about $600k or $700k of that, because you’ll pay 30% to 40% in taxes when you take the money out. The IRS and your state tax board “own” the other $300k to $400k.

People in tech usually get money into tax-deferred accounts in one way: Make pre-tax contributions to your 401(k).

While you can probably choose between making pre-tax and Roth contributions to your 401(k) (most tech-company 401(k)s offer both contribution types), if you’re high income—and especially if you live in a high-tax place like California or New York City—you likely should and already are contributing pre-tax.

While tax-deferred IRAs exist, the only way you get pre-tax money into one is if you don’t have an employer retirement account at work or your income is below a certain threshold. If you’re working in tech, those two conditions are unlikely to be true for you: you’re likely to have an employer retirement account (aka, 401(k)) and your income is likely high. (Do note: If you take a sabbatical, then you’re much more likely to qualify for making pre-tax contributions to an IRA!)

*It is possible to get after-tax money into tax-deferred accounts, usually in IRAs. If that happens, the portion of the withdrawal from the tax-deferred account that is after-tax will avoid taxation. This is called the pro rata rule. This is pretty rare, and even in cases where there is after-tax money, it makes up a small percentage of the total balance.

Tax-Free Accounts

“Tax-free” means that:

1. When you make your contribution, you might or might not get a tax deduction,
2. The investments inside the account grow tax-free year after year, and
3. When you withdraw money from this account in the future, it comes out tax free.

For example, if you have $1M in tax-free accounts, you “own” $1M of that. You’ll pay $0 in taxes when you take the money out. The IRS and your state tax board “own” $0.

People in tech get money into tax-free accounts in three ways that I see:

1. Make after-tax contributions to your 401(k), and ideally convert the contributions to the Roth sub-account immediately afterwards. That way, both contributions and any earnings on those contributions are in a Roth (tax-free) account.
2. Make backdoor Roth IRA contributions. You might also have made direct contributions to a Roth IRA in earlier years when your income was low enough that you were eligible to make them. (In 2022, for example, if your income is < $144,000 [single] or < $214,000 [married filing jointly], you may contribute directly to a Roth IRA.) As of the writing of this blog post, it is still unclear if/when backdoor Roth contributions will be outlawed going forward.
3. Contribute to a Health Savings Account (HSA). Now, of course, with HSAs, you can get this tax-free withdrawal only if you withdraw the money for health expenses…but I don’t see aaaaaany problem assuming your healthcare expenses will be big enough in your later life.

Taxable Accounts

“Taxable” means:

1. When you make your contribution, you do not get a tax deduction,
2. The income the investments generate each year is subject to capital gains tax in that year, and
3. When you sell an investment, you owe capital gains taxes on the gain—not the original invested amount, aka “cost basis”—in the investment right then and there.

For example, you invest $600k in a taxable account, and it grows to $1M. If you sell everything, you owe capital gains taxes on $400k. (The range of capital gains tax rates is literally 0% to your ordinary income tax rate…close to 50% in places like CA and NYC if your income is really high.) And along the way, year after year, if the investments generate $10,000 of investment income each year—interest, dividends, capital gain distributions—you owe taxes on that income, too.

People in tech get money into taxable accounts in two way that I usually see:

1. Your company stock plan deposits company stock into a brokerage account in your name, typically at Fidelity, Schwab, eTrade, or Morgan Stanley. For public companies, this is RSUs when they vest, ESPP shares when the shares are purchased at the end of the purchase period, or when you exercise options. For private companies that have just gone public, it’s really the same thing except Everything Kinda Happens at Once, instead of regularly over time.
2. You invest your cash money in a brokerage account, at a “roboadvisor” (ex., Wealthfront, Betterment, Ellevest), a crypto account (ex., Coinbase), through a stock-trading app (ex., Robinhood), via an increasing variety of kinda unusual ways of investing money (thanks, fintech!), and at a traditional custodian (Schwab, Fidelity, Vanguard, TD Ameritrade) where you choose stocks or funds.
   
   A variation on this theme is that you’ve worked with an investment advisor before, and they invested your cash money in a brokerage account.

Why You Should Care

So far I wouldn’t blame you if this seems just like an academic exercise in personal finance. Possibly interesting, but likely not, and certainly theoretical. I’d love for you to understand how these three buckets can help you.

You Want Tax Savings Now.

This is the reason to put money into tax-deferred accounts (and HSAs). You get a tax deduction on the contributions now, which lowers your tax bill. If you didn’t get a tax deduction, there’d be little reason to put money into an account that turns every dollar of withdrawal into fully taxable income.

You’ll Live on Your Investment Portfolio in the Future, and You’ll Want to Control Taxes.

When you get older, you’ll be living mostly on your investment portfolio. This is the definition of financial independence.

(“Mostly” on your investment portfolio because you’ll be getting Social Security income by the age of 70. Yes, despite all the doom and gloom stories. It’s a pay-as-you-go program, meaning that as long as there are still people working, and therefore paying into the system, retirees will still be receiving some money out of the system.)

One thing you might not know about (and by “might not” I mean “if you do, I will eat my sock”) is that once you’re in the “I receive Social Security and Medicare” age range, your income—technically, your Adjusted Gross Income (AGI)—level dictates how much of your Social Security income is subject to tax and how much you pay for Medicare Part B premiums. It also affects things like the tax rate applicable to capital gains income and ordinary income, which of course are things that affect you even now.

Some years you might want a lower AGI to minimize all the various tax rates and surcharges affected by your income level. Some years you might be okay with having a higher AGI.

You can control your AGI each year if you have money in each kind of account, by withdrawing different amounts of money from each type of account:

• tax-deferred accounts (these add a lot to your AGI)
• your tax-free accounts (these don’t add to your AGI)
• and your taxable accounts (these add a bit to your AGI)

I think this requires a leap of faith from you. None of us is good at identifying with our future selves. So, you just gotta kinda take me at my word that this will be useful. Sort of like saving to your 401(k). You can’t actually imagine being 65 and taking this money out to live on, but intellectually you know it’s true, and you’ve drunk the “Just Save To Your 401(k)” kool-aid. Delicious!

You Need Money for Stuff Between Now and Then, and You’ll Want Easy Access to Money.

I wrote a whole blog post about this. The short of it is: If you’re in your 20s, 30s, or 40s, you got a lotta life between now and retirement (not just financial independence, but literally not earning money anymore). And where are you going to get the money to support that life if you need a whacking good amount of it (i.e., more than your income can cover)?

How will you buy your home in 5 years?

How will you fund that graduate degree in 10 years that isn’t even a glimmer in your eye right now?

How will you pay your bills when you take a year off from work when you have your first child…at some point in the future?

That’s right: by withdrawing money from a taxable account. You can use that money any time, for any thing, no penalty. (Yes, taxes on the gains. You can hope that the tax bill will be big, because that means your investments grew a lot!)

Your pre-tax and tax-free accounts have way more restrictions (how old you are, what you’re using the money for) attached to them.

Strategies to Fill Each Bucket

Being able to put money in each “bucket” is, to be sure, a privilege. It means you have enough money to save meaningfully to three separate accounts. Most people are delighted if they contribute to their 401(k) and stop there.

Let’s assume you have the financial wherewithal to save so abundantly.

Automate as Much as You Can Through your Paycheck

Your paycheck from your employer is probably the best way to automate your savings, for two reasons:

1. Automating savings is easy, through deferrals and direct deposits.
   
   You can set up automatic savings on your 401(k) portal to a tax-deferred account (through pre-tax 401(k) contributions) or a tax-free account (through Roth 401(k), after-tax 401(k), and HSA contributions).
   
   You can set up automatic savings on your payroll portal to a taxable account through direct deposit to a taxable account, or even by way of ESPP participation (because those shares will eventually be purchased and put into a taxable brokerage account).
   
2. Many savings opportunities are tied to your paycheck.
   
   You cannot get money into your 401(k) other than by saving from your paycheck. And while sometimes you can save to your HSA outside your paycheck, why would you? You’d have to pay FICA (Social Security + Medicare) taxes on it, whereas you can avoid those taxes if save via your paycheck. Additionally, you only get to participate in your ESPP through paycheck deduction.
   
   And yes, all these savings opportunities can make your take-home pay very tiny. Don’t worry, we got you covered.

Habitually Sell RSUs and Push that Money into a Taxable Brokerage Account

Your “direct from paycheck” savings are going to mostly fill tax-deferred and tax-free accounts. So, how can you fill up the taxable bucket, too?

Aside from going through an IPO and having a bunch of money just drop into your lap (so nice when that happens), if you work at a public company, the simplest way is to make a habit of selling RSU shares as they vest and moving that cash into a taxable brokerage account. (You can do the same with ESPP shares. But because they’re often worth far less than your RSU shares and because there are tax advantages to holding ESPP shares—unlike RSU shares—I’ll focus here on RSU shares.)

Put a reminder in your calendar that recurs according to the frequency of your RSU vest, monthly, quarterly, or semi-annually:

1. A day or two after your RSUs vest (because the RSU shares usually take a business day or two to actually show up in your account), sell the shares. Don’t just let the RSU shares accumulate simply because you don’t know what to do with them. Note: This is not an investment recommendation! Simply a tactic you can consider.
2. Transfer the resulting cash to your taxable investment account. Some custodians make this transfer easy. Some don’t.
3. Invest. Don’t just keep it as cash (unless, of course, you need cash).

Repeat steps 1-3 every time RSUs vest.

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I hope I’ve opened your eyes a bit to this nuance of saving and investing. It’s certainly not nearly as important as how much you save, and usually not as important as how you invest your money.

But it can add some optimization to your tax planning and flexibility to your financial life before retirement.

If you want to learn about these kinds of technical nuances of personal finance…and also have a good sense of how much they are essential “cake” versus optional “icing,” reach out and schedule a free consultation or send us an email.

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Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.