When Retirement Bucket Portfolios Meet Multiple Retirement Accounts

Note: The following is part of Morningstar.com's Retirement Matters Week special report. A version of this article appeared on Sept. 14, 2015.

On the surface, Bucket retirement portfolios look straightforward and easy to maintain, and that's a big part of their appeal. Simply segment your portfolio by your expected time horizon, choose your cash flow extraction method (income, total return, or both), and then sit back and enjoy your retirement.

But retirees and soon-to-be-retirees know that it's not quite so straightforward. Investors typically accumulate assets in multiple silos--company retirement plans, IRAs, taxable accounts, and/or various vehicles for self-employed folks--and those accounts are frequently multiplied by two for married couples. These retirement-savings wrappers vary in their tax treatment upon withdrawals, and some carry mandatory distributions post-age 70 1/2.

Given all of those variables, the once-simple-seeming Bucket strategy can become not so simple in a hurry. What further complicates matters is that the composition of retiree portfolios varies widely, making it difficult to provide meaningful one-size-fits-all guidance. Some retirees have few taxable assets; others hold nothing in Roth. Moreover, retirees might approach withdrawal sequencing from their various accounts in completely different--but equally legitimate--ways. Thus, it's too simplistic to say that taxable assets (often first in the queue under standard withdrawal-sequencing advice) should equate to Bucket 1, tax-deferred to Bucket 2, and Roth to Bucket 3.

That said, there are a few key concepts that retirees and pre-retirees can use to make bucketing work across multiple accounts.

Basic Withdrawal-Sequencing Guidelines: A Starting Point While imperfect, standard guidance about which accounts should go first in the retirement-funding queue--and which should go last--is a good starting point to help you determine which account type should house which bucket. The conventional wisdom is to hang on to those investments with tax-saving features--whether traditional (tax-deferred) or Roth assets--until later in retirement. Taxable accounts, meanwhile, can go earlier in the distribution queue. And it goes (almost) without saying that retirees who are older than age 70 1/2 will want to prioritize required minimum distributions before all other distribution types so that they can avoid penalties. (This article goes into greater detail on tax-efficient withdrawal sequencing.)

Thus, a retiree employing these guidelines would want to maintain ample liquidity (Bucket 1) in his or taxable accounts, while saving Roth accounts for the higher-risk/higher-return assets (stocks, Bucket 3). Assets the retiree expects to tap in the intermediate years of retirement (Bucket 2, mainly bonds) could be housed in tax-deferred accounts.

A Simplified Example To illustrate how this could work with a real portfolio, let's assume Sam and Emily, both 65 years old, are positioning their $1.5 million portfolio for drawdown. Let's further assume that they're targeting a $60,000/year annual spending target with an annual inflation adjustment, and a 25- to 30-year time horizon. (They're employing the 4% guideline.) For the purpose of this illustration, I'm also assuming their three accounts--taxable, tax-deferred, and Roth--are of equal size.

Here's how the Bucket strategy would overlay their multiple accounts.

• Taxable account ($500,000): Houses Bucket 1 ($120,000 in cash instruments to fund two years' worth of living expenses) and part of Bucket 2 ($380,000 in short- and intermediate-term municipal-bond funds)
• Tax-deferred account (traditional IRA) ($500,000): Houses remainder of Bucket 2 ($100,000 in intermediate-term bond funds) and part of Bucket 3 ($400,000 in equities/equity funds)
• Roth account: Houses remainder of Bucket 3 ($500,000 in equities/equity funds, aggressive bond funds, commodities)

On an ongoing basis, Sam and Emily could periodically spill dividend and income distributions from their taxable and tax-deferred accounts into the cash portion/Bucket 1. If those income distributions were insufficient to refill Bucket 1, they could periodically rebalance their stock and bond positions in their taxable and tax-deferred accounts, steering the rebalancing proceeds into Bucket 1 as well. (This article discusses the logistics of Bucket maintenance.)

Customization and Flexibility Are Essential Of course, that scenario is highly simplified. For starters, it's a rare retiree who has equal amounts of assets in all three account types; most of today's retirees will hold relatively less in Roth accounts and relatively more in tax-deferred and taxable accounts. That may make it easier from a planning standpoint, however. For many retirees, their taxable accounts can house Bucket 1/cash, while their tax-deferred accounts can house most of Buckets 2 and 3. The Roth account can serve as a growth "caboose," holding the tail-end of Bucket 3.

It's also worth noting that while the sequence of withdrawals discussed above is a good starting point when determining in-retirement cash flows, retirees' situations will vary widely; a sequence that makes sense for one retiree may not be a good fit for another. And even for the same retiree, the "right" accounts to pull cash from will tend to vary from year to year.

For example, a retiree who would like to minimize RMDs later in life might decide to spend from his or her tax-deferred accounts before RMDs kick in--thereby reducing the amount that will later be subject to RMDs--rather than tapping his or her taxable portfolio early in retirement as standard withdrawal sequencing would dictate. Retirees may also choose to put tax-deferred distributions ahead of taxable distributions in years when they know they'll have lots of deductions to offset the income tax hit associated with the IRA distribution. In both situations, the retiree might choose to hold more liquid assets/Bucket 1 inside the tax-deferred account to help facilitate those distributions.

Alternatively, some retirees may want to tap their Roth IRAs for at least part of their living expenses, even in their early retirement years--especially in years when their tax bills will be on the high side. Because Roth distributions are not taxable, taking distributions from Roth accounts would help keep them in the lowest possible tax bracket. In that instance, they'd want to retain at least some liquid assets in their Roth accounts, to help ensure that they're not withdrawing stock assets when they're depressed.

This article discusses some of the instances when it's sensible to override the standard advice about withdrawal sequencing. Retirees who aren't comfortable determining their most tax-efficient sequence of withdrawals--which, in turn, can inform each of their accounts' positioning--can get a lot of bang for their buck by consulting with a tax-savvy financial advisor or an investment-savvy tax advisor.

Stay Diversified, Don't Overcomplicate As is clear from the aforementioned exceptions to withdrawal-sequencing guidelines, there are many instances when investors will benefit from maintaining asset-class diversification--or at least a bit of liquidity--in each account type.

But rather than maintaining three distinct Bucket portfolios in three separate account types, it's worth remembering that the Bucket strategy is designed to help retirees simplify--not complicate--their plans. Thus, if certain pools of assets are a fairly small piece of the overall plan, it's wise to skinny down the number of holdings in it even as you stay diversified.

For example, if you intend to draw most of your living expenses from your taxable account, you might populate that account with an online savings account and a high-quality short- or intermediate-term municipal-bond fund. In a similar vein, if a Roth IRA account is but a tiny piece of your overall IRA assets, you can hold a total stock market index fund as well as some cash assets to facilitate withdrawals when you need them; there's no need to manage each subportfolio as a well-diversified, multibucketed whole with many individual funds.