Three Buckets of Money
Friends – A common theme when talking to clients is the struggle to balance competing priorities for their investments. There is a push and pull between near-term needs and longer-term goals. Balancing risk and return. Giving their money a chance to grow while not having a pullback in markets reduce their savings right when they need it. To help manage this challenge, we use a concept called bucketing – managing your savings and investments within different buckets, with different timelines and risk profiles, all working toward different goals as part of a broader plan. Most often this takes the form of three main buckets – short-, intermediate, and long-term savings. I’ve described each in more detail below.
- Short-Term / Spending (Under 2-3 Years) - The first bucket is often the simplest. This is money set aside for known needs or expenses within the next two to three years. This is money for day-to-day cost of living, emergency funds or known near-term expenses (vacations, down payments, home improvements, tuition payments, insurance, taxes, etc.). Because these goals are so close, I always recommend taking as little risk with this money as possible, suggesting it be held in cash, money market funds or short-term individual bonds or CDs. That way you limit the risk of a decline in value without time to recover before the money is needed.
People often have trouble determining how much money to hold in this short-term bucket. To start we set aside 3-6 months’ of living expenses as a baseline emergency fund (depending on the number of incomes in a household and the stability of those incomes) and then we add on any known additional near-term expenses. For example, if a family typically lives on $10,000 a month and knows they will need $20,000 next year for some home repairs, we might allocate anywhere from $50,000 – $80,000 in their short-term bucket, freeing up the rest for investment.
NOTE: Cash-on-hand can have a powerful psychological effect on savers. In the end, I always encourage my clients to err on the side of more vs. less. Being able to sleep at night is far more important than earning a slightly higher rate of return, so if rounding up and having a bit more cash is important to them, we always lean in that direction. - Intermediate-Term / In Between (3-20+ Years) - The middle bucket is what I refer to as intermediate term. This is where you save for goals more than a few years out but before retirement. This can be anything from college tuition, a second home, a new car, boat, renovations, weddings or any other significant expense. This is often the last bucket investors formalize, as inertia often leads to automating retirement contributions and letting the rest of your savings build up in cash. Having a discipline around investing the money you set aside for these types of intermediate-term goals is essential to give it more of a chance to grow. These are often more balanced investments, more aggressive than cash but less aggressive than your longest-term retirement savings. These investments are often held in fully taxable accounts, so understanding how to invest tax-efficiently is critical.
- Long-Term / Retirement (20+ Years) - This is often the largest bucket for investors. Saving for retirement is typically done through 401(k)s, IRAs and other qualified plans and done automatically from month-to-month. Because this is the longest-term money for investors, these are often some of their most growth-oriented investments, with plenty of time to weather the ups and downs in markets in exchange for higher return potential. Rules of thumb for how much to save for retirement typically start at 10-15% of your gross pay, with many seeking to maximize the annual limits on their retirement accounts (up to $22,500 in 401(k)s in 2023 plus a $7,500 catch up contribution if you’re over 50). Add in the ability to contribute to IRAs, HSAs and additional after-tax retirement contributions, and it’s not uncommon for a couple to be able to contribute $50,000 or more across their various retirement accounts, if they so desire. The challenge here is often balancing the desire to fully utilize these tax-advantaged savings options each year with locking up too large a proportion of your savings in long-term accounts where withdrawals are more restricted until age 59 ½.
Finding the right balance as you allocate your savings between these three buckets is difficult. And it is important to understand the strategies available to optimize to investments in each – selecting the right account types, taking appropriate levels of risk, mitigating taxes and managing liquidity are all critical. If you have any questions at all about how to optimize your own savings around these three buckets, please don’t hesitate to reach out. I’m always happy to help.
