How to Build Wealth with the 3 Bucket Strategy (By Age)

This discussion introduces the "tax bucket strategy" for wealth building, emphasizing its impact on current financial decisions and long-term retirement planning. The strategy involves three distinct tax buckets: tax-free (like Roth accounts and Health Savings Accounts), tax-deferred (pre-tax 401k, IRAs), and after-tax (brokerage or trust accounts). Each bucket functions differently but is crucial for financial health. The Financial Order of Operations (FOO) incorporates this three-bucket strategy, with different approaches recommended based on age. A case study of "Manny," a "financial mutant," illustrates this strategy from age 25 to 65. Manny starts investing 25% of his gross income at age 25, with an initial salary of $50,000 and a 5% annual raise. He follows the FOO, receives a 3% employer match on his 6% retirement plan contributions, and prioritizes Roth 401k until his combined marginal tax rate exceeds 30%. He also uses the backdoor Roth strategy but not mega backdoor Roth. His rate of return decreases by 0.1% each year, starting at 9.5% at age 25 and reaching 5.5% by retirement. Manny has a fully funded emergency fund and no high-interest debt, ensuring liquidity. **The 20s: Prioritizing the Tax-Free Bucket** In the 20s, the tax-free bucket receives the most attention. Dollars saved early in life are the most valuable due to compounding. Contributions to a Roth IRA are prioritized after securing the employer match (Step 2 of FOO). Roth accounts are favored for their low fees, tax-free growth, tax-free distributions, and flexibility, including the ability to access contributions tax-free and penalty-free in emergencies. Health Savings Accounts (HSAs) are also highlighted for their "triple tax advantage" (tax-deductible contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses) and potential fourth advantage (payroll tax exemption for direct payroll deductions). If an individual has a high-deductible health plan, HSA contributions are highly recommended. The tax-deferred bucket, primarily funded by employer matches, grows slowly in the 20s. The after-tax bucket is generally not a focus until Step 7 of the FOO, after other priorities are met. It's crucial to avoid opening brokerage accounts and investing in individual stocks out of order. By age 29, Manny's portfolio is nearly $91,000, with the vast majority in the tax-free bucket ($80,000) and almost $11,000 in the tax-deferred bucket from employer contributions. His income is just under $61,000, meaning his investments are 1.5 times his income. He maxes out his Roth IRA and almost his HSA, and is an "average accumulator of wealth." **The 30s: Navigating the "Messy Middle" and Shifting Strategies** The 30s often bring the "messy middle" of life, characterized by increased family and financial commitments, leading to less disposable income and time. Despite these challenges, maintaining financial discipline is crucial. As income rises, individuals may no longer be eligible for direct Roth IRA contributions. The backdoor Roth IRA strategy (contributing to a non-deductible traditional IRA and converting it to Roth) becomes a viable option. For Manny, this means putting $7,500 into his tax-free account. The decision to use an HSA may be paused if family planning or other health needs make a high-deductible health plan less suitable, even if it means foregoing tax benefits. The goal is to make sound financial decisions that align with life circumstances. The tax-deferred bucket gains more importance in the 30s. If a combined marginal tax rate (federal and state) exceeds 30%, pre-tax 401k contributions become attractive, offering a 30% imputed rate of return through tax savings. Manny will consider this shift in his late 30s. The after-tax bucket might see some initial contributions in the late 30s if savings rates exceed 25%, but it's acceptable if this bucket isn't significantly filled yet. By the end of his 30s, Manny's portfolio reaches almost $530,000, demonstrating the power of compounding and consistent saving. $466,000 is in tax-free accounts, and nearly $64,000 is in tax-deferred accounts. His income is around $99,000, and his investments are well over three times his annual income, exceeding the target for a 40-year-old. He maxes out his Roth IRA and HSA and contributes significantly to his Roth 401k, nearing "hyper accumulation." He is close to becoming a "prodigious accumulator of wealth." **The 40s: Peak Earning and Strategic Accumulation** The 40s are often peak earning years, and for those who maintained discipline earlier, this decade brings the rewards of past efforts. Even late starters can still achieve significant growth. The tax-free bucket strategies (Roth IRA, HSA) are generally established. The key decision point becomes the 401k contributions: Roth versus pre-tax. Manny continues prioritizing Roth because his combined marginal tax rate is still 24%. The tax-deferred account, initially funded by employer contributions, now also receives pre-tax contributions as income rises. It's important to balance retirement savings with current financial needs, such as paying cash for large purchases like cars, avoiding unnecessary debt. The after-tax account starts to gain traction in the 40s, providing a bridge of liquidity for early retirement or lifestyle needs. The focus shifts from pure accumulation to considering how and when these dollars will be used. By the end of his 40s, Manny's portfolio is almost $1.7 million, with nearly $1.5 million in tax-free accounts, under $200,000 in tax-deferred, and a small sliver ($6,700) in after-tax. His income is $161,000. He is maxing out his Roth IRA, HSA, and 401k, and is in the "hyper accumulation phase," saving to the after-tax account. Manny has become a "prodigious accumulator of wealth," hitting millionaire status in his 40s. **The 50s and Beyond: Fine-Tuning for Retirement** In the 50s, the focus is on fine-tuning the plan for retirement. There's a common sentiment among retirees that they wish they had more in their tax-free bucket. This stage involves considering strategies like Roth conversions, especially for those planning early retirement, and reassessing whether to switch to Roth contributions in the 401k, even if pre-tax was beneficial earlier. The ultimate use of the money and the desired tax rate in retirement dictate these decisions. The tax-deferred bucket, now at "critical mass," becomes a prime target for Roth conversions, particularly for those in the FIRE movement whose earned income will drastically drop upon retirement. However, accessing these funds before age 59 and a half (or 55 for 401ks) incurs penalties and ordinary income taxes. The after-tax bucket becomes highly valuable in early retirement as a source of accessible funds. The "LIFO method" (Last In, First Out) is recommended for de-accumulation: after-tax funds are drawn first, followed by pre-tax (with optimized Roth conversions), and finally Roth accounts, which are preserved for their tax-free growth and legacy building potential. By age 65, Manny retires with a portfolio of almost $6.4 million: $4.6 million in tax-free, over $1 million in pre-tax, and $635,000 in after-tax. His income at retirement is $352,000, which, adjusted for 40 years of inflation, is equivalent to someone making $107,000 in today's dollars. This demonstrates that starting with a modest salary and consistent saving can lead to substantial wealth. Manny's $6.4 million portfolio can replace 72% of his final salary with a 4% withdrawal rate. With social security, this rises to 98% of pre-retirement income, effectively giving him a "pay raise" in retirement. The large portion of tax-free assets allows him to control his tax rate in retirement. Manny is a prodigious accumulator of wealth. **Key Elements of Success for Manny:** 1. **Discipline and Margin:** Manny consistently lived below his means, creating financial margin. 2. **Early Start:** Starting at 25 allowed compounding to work its magic over a long period. 3. **Following the Financial Order of Operations (FOO):** The FOO provided a "better mousetrap," guiding his financial decisions through various life stages and challenges. The FOO is described as an "all-terrain vehicle" system, designed to navigate life's ups and downs. The overall message is that consistent saving, early action, and adherence to a structured financial plan like the FOO can lead to significant wealth accumulation and a comfortable, tax-optimized retirement. For those who achieve financial success, the increasing complexity of their financial lives may necessitate professional guidance.