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By Christian Cordoba

Stock market volatility of the kind we've seen in in the past few months may be good news for investors. If you're still working and building a retirement fund, downturns have proven to be buying opportunities.

However, glass-half-full visions evaporate once people near or enter retirement. Then, a steep drop can pummel your portfolio, with unfavorable consequences for your golden years.

Take this hypothetical example: This man retires with a $1 million portfolio, largely in stocks. He plans to follow the 4% rule in drawing down his portfolio: Start with a $40,000 payout (4% of $1 million) and increase each year for inflation.

If inflation is 2% in the first year of his retirement, he'd take $40,800 from his portfolio in the second year two. And so on.

But suppose that stocks take a 2008-like nosedive and his portfolio falls from $1 million to $700,000 -- a decline of 30%. Now, his $40,800 distribution is over 5.8% of his $700,000 balance, nowhere near 4%.

From that point on, two things can happen, both unwelcome. He might restart his 4% plan, withdrawing only $28,000 from the $700,000 remaining. That might make it difficult to pay his bills and would likely restrict his retirement lifestyle.

Or, he might just keep on as if nothing had happened. He could tap his portfolio for $40,800, then $42,000 the next year, then $44,000, and so on. This path increases the chance he will exhaust his portfolio before he exhausts his life span.

And, this scenario does not show the impact of taxes. Even after an unfavorable sequence of returns, as illustrated, you still have a chance to recoup market losses if a surging bull market follows. On the other hand, (as we are reminded, today is Tax Day) once you lose money to taxes, you lose it forever.

How and when you elect to take distribution from your retirement assets can determine the tax rates you pay. Assume that our hypothetical retiree withdraws around $40,000 a year from his IRA, with an effective income tax rate of 25%. That's about $10,000 lost to taxes each year.

Such a crushing combination (a negative sequence of returns as well as an unfavorable distribution strategy from taxable, tax deferred, and tax-free assets) can be the one-two punch you don't want to take as you face retirement.

Here are some thoughts on how to protect yourself in your fight against a sudden stock market decline and overpaying taxes, both of which can have an eventual impact on your lifestyle and legacy.

Planning With Buckets

One approach to avoiding this dilemma is to adopt a bucket plan. The name indicates that a retiree's financial assets are assigned to designated buckets, via mental accounting. That is, in your mind, your shares of this fund are in Bucket A, the shares of that fund are in Bucket B, until all your holdings are placed in this manner.

Constructed carefully, a bucket plan might reduce sequence of returns risk such as that described in the example above, where a bear market that occurs around the beginning of retirement can be perilous. A bucket plan may help you keep from spending too much, depleting your assets, or spending too little, depriving you of a rewarding retirement.

In addition, bucket plans can help you execute a tax-efficient portfolio draw-down strategy, in which you decide what, where and when assets are tapped for retirement income. For instance, it is important to recognize the need for taking required minimum distributions (RMDs) from IRAs and other tax-deferred retirement accounts after age 70½. Failure to take sufficient RMDs can result in a tax penalty of 50% of the shortfall.

The Three-Bucket Plan

A common bucket plan design involves assigning financial assets to one of three buckets:

A stable bucket. A retiree can tap this bucket for money to replace the paychecks that previously were deposited into a checking account. This money then becomes a cash source for the expenses that arise early in retirement. This bucket might hold one to three years' worth of anticipated living expenses, plus some extra money for any extraordinary planned outlays and a reserve for unplanned expenses.

An income bucket. As the name suggests, this bucket often holds bonds and other vehicles that are known for delivering interest and dividends to investors, rather than taking the risk that might come from holding assets focusing primarily on capital appreciation. Periodically, retirees can move money from the income to the stable bucket, so they'll always have cash flowing into the bank for needs and wants. This bucket might hold up to 10 years' worth of living expenses.

A growth bucket. This bucket might hold stocks and other assets prized for growth potential, rather than current, income. Such assets may be volatile, but a lengthy holding period theoretically could overcome short-term weakness. When needed, the growth bucket can be a source of assets to flow into the income bucket. Assets not deemed appropriate for the cash or income buckets can be assigned here.

Avoid Selling Low

If retirees have a stable bucket that regularly flows into their checking account, they can be confident of meeting their daily financial requirements, regardless of what happens in the markets. They may not be tempted to sell potential growth assets at depressed prices, during a bear market for stocks, just to meet current expenses. Furthermore, cash positions held outside of a retirement account will have already been taxed, so any distribution from, say, a bank account or stable investment should not generate an additional tax.

Assets in the income bucket typically are chosen for their expected low volatility because their primary objective is to generate income to cover expenses, or both. If necessary, the less volatile positions among these assets might be tapped for transfers to the stable bucket without having to incur severe losses.

You also should consider the tax impact when choosing which accounts to use to fund this income objective. After-tax investments, such as bonds or income funds from a non-retirement account might go into the income bucket. Other strategic choices here might include using qualified dividends and maximizing tax-loss selling by taking offsetting gains and losses.

You also could acquire cash by taking some dollars out of a traditional IRA before RMDs begin at age 70 ½. Sometimes, withdrawing a portion of your IRA earlier than required can be a thoughtful move from a long-term tax planning perspective because you might:

-- Take advantage of years where you are in a lower bracket. The Tax Cuts and Jobs Act of 2017 has lowered tax rates from 2018 through 2025, so this may be an opportunity for you;

-- Spread the locked-in tax debt over several years and thus avoid higher tax brackets on future withdrawals;

-- Reduce tax on eventual RMD income that you may not need;

-- Defer -- and therefore increase -- Social Security benefits, which are partially tax-exempt;

-- Coordinate annual income to avoid the thresholds that may push your modified adjusted gross income into higher Medicare Part B premiums after age 65.

From Growth to Income

Once you have decided on how to fill your income bucket, considering both asset "location" and "tax diversification," remaining financial assets will start in the growth bucket and later flow to the income bucket. This could mean, say, selling a stock fund to raise money for investing in a bond fund.

If your income bucket holds several years' worth of your cash needs or generates much of your needed income from dividends, you won't be forced into selling that stock fund at a perceived bad time, such as after a market decline. Savvy timing and account selection may help you move money from mental bucket to bucket without being clobbered with additional tax just to use your own money for basic living expenses.

For instance, imagine yourself going to an ATM machine for cash, but the ATM is tied to the stocks within your IRA, your only account option. When you go to withdraw $100, the machine tells you that because the market has moved down recently, you will have to withdraw $130 worth of shares, just to get your $100.

But there's more. The IRA has not been taxed yet, so you now must pay, perhaps, $30 in tax. Congratulations, you have just exhausted $130 of your savings to take out $70 for dinner. At least the ATM will probably say "thank you," something the IRS won't do. With proper planning you can reduce this type of unnecessary risk from both sequence of returns and taxes.

Putting the Bucket Plan Together

To get an idea of how a proper bucket plan might be structured, consider a hypothetical couple. They're in their early 60s and ready to retire, with $1 million of financial assets.

She plans to retire at 62 and begin taking Social Security. He will leave his employer but do some consulting work, so he defers Social Security to increase the eventual monthly inflows.

This couple tabulate their expected monthly expenses in retirement. They feel they'll need $3,500 a month, pretax, in addition to her Social Security and his earnings. That's $42,000 a year.

They also are looking forward to taking a cruise that might cost $8,000. With a $25,000 emergency fund, they'd like to have a total of $75,000 in their stable bucket ($42,00 + $8,000 + $25,000).

They want to have 10 years' worth of monthly expenses in their income bucket, for a total of $420,000 ($42,000 x 10). Because they won't quite have $500,000 in their stable and income buckets, they would have just over $500,000 in their growth bucket.

Filling the Buckets

Which assets go into which bucket? For now, assume that they have done virtually all their saving through their employers' 401(k) plans. They'll roll over those accounts to traditional IRAs, continuing the tax deferral. Otherwise, their only financial asset is a modest bank account.

If they have $20,000 in their bank account, that money could be designated as part of their stable bucket. The remaining $55,000 (of the desired $75,000) would be held within their traditional IRAs, in funds that focus on asset preservation.

Possibilities include money market funds as well as high quality, very short-term bonds or bond funds. Once that $55,000 is in place, they can arrange for $3,500 to move from these cash or bond positions into their checking account each month, if necessary.

You should realize that planning for future bucket withdrawals may require funding increases to meet your after-tax needs as well as inflation, especially if you're tapping an IRA or another tax-deferred retirement plan. I have not done so in this article's examples, for simplification.

Keep the Cash Flowing

In this example, the couple keeps $420,000 in their income bucket. A bond ladder could be used here. That is, their IRAs could hold $42,000 worth of individual bonds scheduled to mature in 2019, $42,000 in 2020, and so on, out to 2028.

As those bonds mature each year, the redemption proceeds as well as the accumulated interest income could flow into the stable bucket. Then $40,000 from the growth bucket could be used to buy bonds that become the new rung on the ladder. If the timing is unappealing for selling growth assets, these sales can be deferred until prices are more attractive, and money from the stable or income buckets can be used in the meantime.

I've used laddered bonds as a simple example of how this may work, although this may not be the best solution for the entire income bucket during today's low-interest-rate environment. Other possibilities for the income bucket may include short- and intermediate-term bond funds, a managed bond or balanced dividend strategy, and single-premium immediate annuities or certain fixed-index annuities.

With those holdings in the income bucket, almost anything with appreciation potential could be designated for the growth bucket. Stocks and stock funds would largely go here; they might be augmented by hedge-type funds, real estate, private equity, managed equity accounts, and perhaps some types of growth-oriented annuities.

Note that they start RMDs as they each reach age 70-1/2. That won't be a problem if distributions from the stable bucket to their checking account exceed the RMD amount each year.

They must be aware, however, that RMDs from IRAs are truly "individual." That is, he must withdraw at least his RMD amount each year from his IRA and she must do likewise from hers. If one spouse takes the couple's RMDs, the other spouse may owe a 50% penalty on the amount not withdrawn, even though the income tax payments are sufficient.

Multiple Choices

Above, I presented an example in which this couple had virtually all their financial assets in tax-deferred traditional IRAs. In another scenario, let's assume their $1 million portfolio is $600,000 in traditional IRAs and $400,000 in regular taxable accounts, held jointly.

In that situation, they could fill their $75,000 stable bucket from their taxable account. In addition to their bank accounts, any money market funds could be designated as stable bucket assets.

To bring the total to the desired $75,000, they could sell any taxable account investments they no longer wish to own. If the sales trigger losses or small long-term gains, the tax impact could be modest.

Depending on their joint income, the couple in this example would owe the IRS only 15% (or even 0%) on long-term capital gains. Capital losses can offset those gains, leaving them untaxed. In fact, up to $3,000 of net capital losses can be deducted each year, and excess losses can be used in the future.

If they hold tax-exempt municipal bonds or muni bond funds in their taxable account, they could be assigned to the income bucket. The balance of the income bucket (which holds $420,000, in our example) could be held inside Ian's and Pam's traditional IRAs, in interest- or dividend-paying investments.

Retirees willing to take on some risk in their income bucket might use a dividend-oriented stock fund in a taxable account. Many such funds pass through qualified dividends, which are taxed as lightly as long-term capital gains.

Note that the feasibility of taking on the additional risk will depend not just on tolerance of volatility, but the percentage draw-down from financial assets needed to cover your income gap. Thus, if your income gap is only 2% of those assets, instead of 4%, there is a good argument and justification to say that you can afford to take on more volatility risk.

Finding the Right Mix

When it's time to replenish the stable bucket from the income bucket, a mix of holdings from both the couple's taxable account and their traditional IRAs can be used, with an eye to keeping the tax bill at moderate levels. Keep in mind that traditional IRA withdrawals must at least meet RMD amounts, for each traditional IRA after age 70½.

In 2020, for example, they might want to move $42,000 from the income bucket to the stable bucket. They could take $20,000 from his IRA, if that's the amount that would keep them in a low tax bracket.

The $22,000 balance could come from their joint taxable account. A combination of capital gains and capital losses might produce the desired $22,000 from the income bucket without triggering any tax.

This approach may lead to most of the income bucket assets being in their traditional IRAs. Then the growth assets would be held in the taxable account.

One strategy is for them to retain their most highly appreciated assets in the growth bucket. This will avoid paying what might be steep capital gains tax on possible sales.

Under current law, when either dies, the assets remaining in taxable accounts will pass to heirs with a basis step-up to market value. Then even the assets that grew the most, during the couple's lifetime, could be sold without owing income tax on previous appreciation. The step-up in basis is still one of the best deals in the tax code, yet people often lose it by selling assets in the wrong order, upon needing to raise cash.

Reasoning for Roths

Taking this example one step further, assume that either or both has/have a Roth IRA or a Roth 401(k) or a similar account. Ultimately, assets held there might qualify for completely tax-free gains. To qualify, the original owner must be at least age 59½ and have held the Roth account at least five years.

Roth assets could be assigned to the growth bucket and held as long as practical, hoping to maximize the appreciation potential. Roth IRA owners never have RMDs. (RMDs do apply to Roth 401[k]s, however.)

Tax-free income eventually may be paid out to the account owner or to beneficiaries, after the owner's death. Equities generally have enjoyed long-term gains over long holding periods, so equities and equity-like holdings could be appealing investments inside Roth accounts, for the growth bucket.

What's more, any potentially tax-free payouts that become available inside Roth accounts could be tapped if a need for tax-free income should arise.

In any of these scenarios, RMDs may grow to the point that they're throwing off more income than needed. In such a case, the money left after income tax could be used for charitable gifts. Or, such spare dollars might be used for paying premiums on life insurance for the IRA owner, funding an income tax-free bequest to policy beneficiaries.

Consider designing your own bucket plan to help be a good steward of your money for yourself and your family, even in the face of unavoidable market volatility, death and taxes.

Bucket Plan Checklist

-- Educate yourself on sequence-of-returns risk and sequence of taxes on distribution opportunities for retirees. Or, work with a knowledgeable financial adviser.

-- Conduct a cash flow analysis to determine your income gap.

-- Evaluate your asset "location," not just your asset "allocation," to determine if you're holding the right investments in the right accounts. (What types of accounts you have and where.)

-- For tax diversification, determine how much you have in taxable, tax-deferred or tax-free assets that can be used for income at different times, to replenish each bucket efficiently.

-- Conduct a tax projection with "what-if" scenarios to determine how much, if at all, filling out your income tax bracket might save you over the years.

-- Learn the rules pertaining to IRAs, 401(k)s and other tax-deferred accounts to avoid making costly mistakes and potentially use tax savings opportunities.

-- Consider inflation and cost-of-living estimates based upon your actual needs and wants and expenses, rather than relying upon headline CPI rates.

-- Plan the estimated amounts necessary into each bucket.

-- Review regularly to reload the first and second buckets as necessary, preferably at opportunistic times during market cycles and moderate tax rates.

-- Enjoy retirement with confidence knowing you've become a thoughtful steward of accumulated wealth for yourself and your family.

Got questions about the new tax law, Social Security, retirement, investments, or money in general? Want to be considered for a Money Makeover? Email

About the author: Christian Cordoba, CFP®, RFC®, CFS is president and founder of California Retirement Advisors, a full service and independently owned retirement consulting firm and a member of Ed Slott's Elite IRA Advisor Group. Cordoba is a registered instructor with the Financial Educators Network, a member of the HS Dent Advisors Network and a member of the Mastermind Group. Additionally, Cordoba is a licensed financial consultant affiliated with First Allied Securities, Inc., a registered broker/dealer and member FINRA/SIPC. CA License #0B09076.