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

0:00So here's what you need to do. Grab yourself a bucket, maybe three, because on this show, we're talking about the tax bucket strategy.

0:07Brian Preston:And Brian, I am so excited because today we're going to talk about a wealth-building strategy that not only gives you guidance on where to deploy your next dollar today, but it has massive compounding effects that will likely be felt throughout your entire retirement. So I'm Brian, this is Bo, and we're financial advisors here to walk you through the three-bucket strategy by age. With that, let's dive right in.

0:36Brian Preston:So Brian, there are really three different distinct tax buckets that you can put money into and pull money out of when it comes to building towards financial independence. Those are the tax-free bucket, which are like your Roth accounts or your health savings accounts. The tax-deferred bucket, which is like your pre-tax 401k, IRAs, other employer-sponsored retirement plans. And then there's the after-tax bucket. Those are like your after-tax brokerage accounts or trust accounts. And each of those buckets works a little bit differently, but I would argue they're all pretty important when it comes to building your financial life.

1:12You know our favorite tradition is actually doing and preparing a net worth statement. Good news for you if you use our net worth tool. If you go to learn.moneyguy.com, you can get your own, and that's the exact same net worth tool that we use for ourselves. Actually, we tracked the three-bucket strategy right there. And this is what I love about this is this is going to, as you know, we have built the financial order of operations, so you know what to do with your next dollar. Guess what? The financial order of operations has the three-bucket strategy built into it, but that doesn't mean you're off the hook because 20-year-olds, you look at this differently than 30, 40, or even 50-year-olds, so we've built that into today's show.

1:54Brian Preston:So what we're going to talk about is what you should be thinking about at each age and stage as it relates to these three distinct tax buckets. And to do that, we are going to use a case study to kind of build throughout each of these decades. We're going to start with our favorite financial mutant. We're going to start with Manny. And let me lay sort of the groundwork for who Manny is and what this illustration is going to walk through. We're going to assume that Manny starts investing 25 % of his gross income starting at age 25, and he does it all the way until age 65. We're going to assume that starting at 25, his salary is$50 ,000 a year and he gets an annual raise of 5%.

2:31Brian Preston:He is also a true blue financial mutant. He's going to follow the FU to a T. He gets an employer match on his retirement plan contributions where if he puts in 6%, he gets an employer match of 3%. Manny's going to prioritize the Roth 401k over the pre-tax until his combined marginal tax rate crosses from 25 % over 30%. So he's going to do Roth, Roth, Roth, and then he'll switch to pre-tax. And then we're going to assume that he can use the backdoor Roth strategy, but he does not have the ability to do mega backdoor. So he's going to start pretty simple. Complexity is going to find him and he is going to follow the financial order of operations all the way from age 25 to age 65.

3:16There is one more key thing that we use as an assumption. We used his rate of return is going to change by year. For when he's 25 years of age, it's going to be 9.5%. But every year he ages, it's going to drop down by 0.1%. For example, when he's 30, it's going to be 9%. When he's 40, it's going to drop all the way down to 8 % and so on. You're catching on all the way until you retire, which it's 5.5%.

3:44Brian Preston:And remember, he's a financial mutant. So the fact that he's saving 25 % now for the future lets you know he already has a fully funded emergency fund. He has no high interest debt. He's done the things that he's supposed to be doing to be able to be at the place where he can start building towards his great, big, beautiful tomorrow. I know we're about to jump into 20s, but I think it's worth repeating that because, as you're going to see, because this is tax favored the way the financial order of operations, he is going to have access to liquidity because of what you already said. that emergency fund is going to be the margin in case life happens.

4:17With that, Beau, what happens with the three buckets in your 20s?

4:21Brian Preston:So let's start at the very beginning. In your 20s, likely the bucket that's going to get the most attention, the one that's going to get the most love and the most resources pushed towards it is your tax-free bucket. And this is an exciting decade for retirement because in your 20s, these dollars that you save at the beginning of your journey will likely be the most valuable dollars that you have in your entire army of dollar bills when you get to retirement. So as we think about that tax-free bucket, we want you contributing to a Roth IRA, even if you cannot max it out yet. We want you to think, okay, I've already gotten the employer match.

4:59Brian Preston:I'm now in step five. Brian, will you hold the thing up for me? I'm now in step five of the financial order of operations. I'm going to start doing something, just something, into my Roth IRA. Well, I even think, because we think about this, we know step two is getting that free employer matching. You already shared Manny the Mutant is going to get, he puts in 6%, he's going to get three. So he's going to put six in. You can choose. The majority of the plans out there actually allow you to choose Roth contributions. So I think it's important. Let's level set. Why do we love Roth accounts? We actually created a slide so you could see all the things we love about Roth accounts.

5:34And a lot of times we like the low fees and expenses, especially if you're using the vanguards, the Schwabs, the Fidelities, because we're big index investors. We love the tax-free growth. And then not only the tax-free growth, but the tax-free distributions. You can potentially be a seven-figure tax-free millionaire. And then a lot of people, when you're dealing with Roth IRAs, and then hopefully with even your Roth 401k, large selection of investments. If you don't have a large selection of investments, it's your 401k, you might want to talk to your plan administrator or HR. And then I like that we have flexibility with the contributions.

6:12Brian Preston:Yeah, with a Roth IRA, one of the lesser-known little tricks about a Roth is that you can always get access to your contributions tax-free, penalty-free. Now, we never want you to do that, but it is something you should know about. It's one of the reasons why if you're trying to decide, do I prioritize the Roth 401k or the Roth IRA, oftentimes will err towards the Roth IRA after you've gotten your employer match because there is that break glass in case of emergency provision. So those are your Roth accounts, but Roth accounts are not the only tax-free accounts that you might have access to in your 20s.

6:46Brian Preston:You might also have access to a health savings account, assuming that you're covered under a high-deductible health plan through your health insurance. Now, look, we love Roth, but the health savings account is pretty magical because guess what? It offers triple tax advantage. There's actually a quattro potential opportunity as well. And what do I mean when I say triple tax advantage? Look, with Roth IRAs, Roth 401ks, the big tradeoff is, yes, you get tax-free growth, but you don't get a deduction on the front end. Guess what? With health savings accounts, even your contributions create a tax deduction for you.

7:22That's pretty powerful. Second, they grow tax-deferred, meaning as the investments, assuming you don't just use it as a clearing account, if you put your money into a health savings account and then even invest that money into the health savings account, it grows tax-deferred. And then if you use it for qualified medical expenses, you get to pull it out completely tax-free.

7:44Brian Preston:But wait, there's more. There's actually a fourth advantage that if your employer allows you to deduct your HSA contributions from your paycheck, You may even be able to have contributions that are exempt from payroll taxes. So there are four distinct tax advantages to the HSA. So if you're in your 20s and you have access to a high deductible plan, we love the idea of you taking advantage of HSA. And we also love the idea of you contributing to your Roth IRA. So for most people, this is where the majority of your savings is going to happen inside of your 20s. What's likely not going to happen is a ton of tax-deferred savings, except for, remember, if you're following the financial order of operations.

8:25Brian Preston:And step two is employer match. Your employer match is likely going to come into the pre-tax side of your 401k. So that bucket may not be growing a ton at this stage, but that's okay. It is still growing and there are still dollars going into it. Yeah, this is one. Now look, it's a change. I mean, there's been tax legislation that even this could be Roth down the road, but still for the majority of you out there, you're going to see that your employer match is in traditional tax deferred type of accounts. But I don't want you to feel pressuring yourself because like I said, there's a time and a place.

8:58That's what I love about the financial world of operations. We're going to be loading up a lot of that tax-free account. The tax deferreds go get a little love. Then you notice, hey, there's a third bucket. This is the after tax. And that's why I want to remind everybody, you have emergency reserves that are outside of this, but we're not going to be giving a lot of love on after-tax because that's really going to start building when you get to step seven of the financial order of operations.

9:21Brian Preston:Yeah, don't allow yourself to go out of order of the financial order of operations. It becomes so enticing. Oh, I'm going to go open that Robinhood account. I'm going to go open that brokerage account. I'm going to start playing with individual stocks. Be very careful. We believe that there is a better way to do money. If you don't believe us, go to moneyguide.com slash resources, download your free copy of the financial order of operations and make sure you use it as a guide to make sure your dollars are going in the places where they're going. So Brian, let's go back and check out our case study.

9:51Brian Preston:Let's see how Manny is doing. And as a reminder, these are the assumptions we're using. Manny starts investing 25 % at age 25. He makes$50 ,000 a year. He gets a 5 % annual pay raise. He follows the Foo. He gets an employer match where he puts in 6 % and his employer match is 3%. So where is he at the end of this decade? Well, you can see his portfolio, because he's been diligently saving from age 25 to 29, is now worth almost$91 ,000, with the vast majority of that being in the tax-free bucket. Yeah, it's kind of amazing. If you think about it, we always say, let's give you a check or number to look for, because you really haven't had a lot of time to start building wealth.

10:34And by the time you're 30, you'd like to have one times your income. Well, if you look at Manny the mutant, his income as he closes out this decade is right there, a little under$61 ,000. But yet his investments,$80 ,000 in the tax-free bucket, close to$11 ,000 in that tax deferred because of all the employer contributions. He's got one and a half times. $91 ,000 worth of assets that are working for you, and he's only been working for four years. That's right. This is pretty exciting territory if you are a financial mutant.

11:03Brian Preston:So when you think about some of his benchmarks that he's hit, he's getting his employer match. He's maxing out his Roth IRA, and he's almost maxing out his HSA. Other than money contributed by his employer, there's nothing going into the tax-deferred account. So all of his money is going into the tax-free accounts. And even though he didn't start investing until 25, he didn't start at age 18. He didn't start at age 20. He didn't even start at age 22 when most people graduate because he had to knock out those first few steps in the financial order of operations. Even starting at 25, just four years into his journey, he is an average accumulator of wealth.

11:42Brian Preston:As a reminder, the way we want you to calculate this, you take your age times your income, divide it by 10 plus the number of years until you're 40. Well, if you do this for Manny, you can see he's already an average accumulator of wealth well on his way to becoming a prodigious accumulator of wealth. And the goal is to hopefully get you to prodigious accumulator, which means you're two times that calculation that you just shared. But well done, Manny. I mean, you've got to think about this. Crossing over the average accumulator of wealth in the first few years shows that discipline was doing a lot of work as Manny was building this journey.

12:18And I'm so excited because he is well on his way to becoming a seven-figure tax-free millionaire.

12:24Brian Preston:All right, Brian. Now let's talk about the next stage. Let's talk about what the three buckets look like in the 30s. And for most folks, the 30s are a unique time because this is likely when you are either in or might be entering into the messy middle. This is a financial stage where life looks a little bit different. All of a sudden, you have neither disposable income left over or disposable time. You feel like you're being stretched a thousand different directions in a thousand different ways, and it's hard just to make sure that you're doing the things you're supposed to be doing from a financial planning standpoint.

13:00Those commitments, because you think about all the things with the family planning, the buying the house, you're going to feel somewhat overwhelmed. And a lot, look, we're an optimist type. We give optimistic advice, but I think it's important to show these stages of life so that you can know that you're not having to face this alone. We're all in this together. A lot of other people, you're not unique. A lot of other people have gone through the exact same, you know, messy middle journey. Stick with it. Don't let this serve as a distraction where you say, you know what? I can let my foot off of discipline.

13:33I can quit worrying about margin because it's okay just to give a no. I want you to stay the course. Know it's going to be hard. Yes, the days are long, but I promise you the years are short. Respect the foo and you will come out the other end that much better.

13:47Brian Preston:And so if you can keep your focus, if you can continue to keep your eyes on what you're supposed to be doing, there are things you can be thinking about as you are thinking through your tax buckets in the 30s. One of the unique things that might be happening is as you get into 30s, as you get into some of the better earning part of your career, you may no longer be eligible to make direct contributions to a Roth IRA. The income phase outs in 2026 are$153 ,000 to$168 ,000 for a single person or for married filing jointly, it's$242 ,000 to$252 ,000. If you make over those income thresholds, you no longer can contribute directly to a Roth IRA.

14:27Brian Preston:But assuming your account structure will allow you, meaning you don't have any other outside IRA assets, you can do backdoor Roth IRA contributions where you contribute to a non-deductible traditional IRA. You then convert that money to Roth and you have thus put $7 ,500 in your tax-free account. And that's exactly what we're going to be doing for Manny in the case study. Well, and also this might be the decade, especially in your latter 30s, when you, as you said, you start getting some traction on your career. If you blow through the tax rates, it might make sense to transition from making Roth contributions on your employer plan to traditional.

15:05Well, more to come on that, but it's definitely important. And then the other thing that's life planning was when you think about tax-free accounts, we think about those health savings accounts. We love the health savings accounts, but remember you have to have access to a high deductible health plan. Well, when you're looking at your employer benefits, when it's open enrollment time, if you know you're doing family planning, like you're going to have a kid this year, or you have other things coming your way, it might make sense to hit the pause button on that high deductible plan and also the health savings account and go with the Cadillac options of a PPO or other things.

15:39Make sure you're not skipping that financial mutant step of looking at your health insurance options and choosing what fits in this upcoming year.

15:47Brian Preston:Yeah, even though we love the tax benefits of the HSA, we don't want to let the tax tail wag the financial planning dog. We want to make sure that we're still making the most sound decisions available, even if it means walking away from a specific tax benefit. Now, Brian, you've already alluded to this. One of the things that might also be changing in your 30s is that your tax-deferred bucket might become a bigger planning tool where you were in your 20s and you were in a lower tax bracket and it made tons of sense to go Roth, Roth, Roth, tax-free, tax-free, tax-free. As you get into your 30s and as your income increases, now you may want to consider pre-tax 401k contributions.

16:26Brian Preston:If you're someone whose marginal tax bracket, when you add up your marginal federal and marginal state bracket is greater than 30%, every dollar that you put into the 401k and the pre-tax side could save you 30 cents in taxes. You can think about that like a 30 % imputed rate of return. That becomes so attractive of a benefit that it's difficult to walk away from. So you're going to want to make sure that you reassess this in your 30s to make sure that you are putting your money when it relates to your 401k in the right tax bucket. And then that last tax bucket is the after tax. Now, look, I don't want you to get discouraged.

17:01This one might not get filled up, but it might have a little bit. You might actually get a piece of this in your late 30s because remember, to get beyond into the after-tax, you need to be having a savings and investment rate that's exceeding 25%, and you need to build this up. That's not going to be the easiest thing to accomplish, but you might catch a portion of it right here in the after-tax. More to come on that as you're going through. And it's okay if you don't reach this bucket in your 30s. There's going to be time in your 40s. That's why I think you're going to see we catch a lot of traction, and start thinking about what does it look like when we retire.

17:37And that three-bucket strategy really starts to focus on filling all three buckets up.

17:42Brian Preston:Okay, so let's check in with Manny and see where he's at. As a reminder, Manny started investing at 25, saving 25 % of his gross income. His salary when he started was$50 ,000, and he's gotten a 5 % pay raise every year. He follows the financial order of operations, and if he puts in 6 % to his 401k, his employer will match 3%. So when we check in here at the end of the 30s, he has now, through consistent and disciplined saving, accumulated a portfolio of almost$530 ,000. Do you see the magic of compounding growth and then just being consistent early and often really does create a reward? Because here's somebody that their income is right under six figures,$98 ,997, but they They have investable assets that are right under$530 ,000.

18:33Now look, yes,$466 ,000 is in those tax-free buckets. Oh, whoa. That is going to be awesome down the road as compounding growth keeps building. And then, yes, those employer match contributions are going to be a little under$64 ,000. Still impressive. Early and often wins.

18:50Brian Preston:Yeah, and what's wild is if you think about his income, he started at$50 ,000. He's gotten these pay raises. his income by the end of his 30s is right at$99 ,000, almost$100 ,000. And you know, when we think about our checkpoints, by the time you get to 40, we want you to have three times your annual income saved in investment. So for Manny, that'd be$300 ,000. You can see he is now well above that. He's maxing out his Roth IRA. He's maxing out his HSA, and he's contributed even more to his Roth 401k now. So he's not quite maxing it out, but he is rapidly approaching hyperaccumulation. He's still not yet hit the tax bracket where it makes sense for him to shift into pre-tax, but that's okay.

19:32Brian Preston:Those dollars are still gonna be growing based on the employer match. And then now he is beginning to get close to being a prodigious accumulator of wealth. That's when you take your age times your income, and when you're 40, you just divide by 10. You can see that where he started the decade with a portfolio of just over$90 ,000, as he closes out the decade, he has almost$530 ,000 saved up. Powerful decade. I mean, a five-fold increase is just wowser. You can start to see that discipline, giving yourself the margin of living on less than you make and just giving it that component of time really is powerful in the long term.

20:13Brian Preston:Brian, I love being a business owner, but I think people underestimate how fast things move from, I've got an idea to, all right, now we actually have to build this thing. That's right. The idea is the fun part, but then you've got logistics, operations, marketing, all the stuff that actually makes the business run and work. And that part can really slow you down and it might even keep you from starting at all. Exactly. Which is why having the right tools and the right partner can make all the difference. That's where Shopify comes in. Shopify is the commerce platform behind millions of businesses around the world and 10 % of all e-commerce in the U.S., from startups to popular brands like Chubbies and Allbirds.