As retirement approaches, one of the most critical financial preparations, alongside healthcare planning and winding down work activities, is establishing a substantial cash cushion. This vital reserve serves a dual purpose: it provides a reliable source of funds throughout your retirement years and, crucially, offers a protective buffer if unexpected events force an earlier-than-planned exit from the workforce. When developing a "Bucket portfolio," individuals should carefully consider the appropriate amount, origin, and placement of these essential liquid assets.When developing a "Bucket portfolio," individuals should carefully consider the appropriate amount, origin, and placement of these essential liquid assets (Getty Images)Rightsizing Bucket 1Retirement planning often focuses on accumulating wealth, but strategically managing withdrawals is equally crucial. Experts suggest that your immediate cash reserves, or "cash bucket," should cover one to two years of portfolio withdrawals, rather than total living expenses. This distinction is vital because other income streams, such as Social Security or a pension, will likely contribute to your overall spending, and these sources can fluctuate throughout retirement.To establish your initial cash bucket, consider your anticipated income sources for the first few years post-retirement. For instance, imagine a 66-year-old aiming to retire in two years, expecting to draw $80,000 per year, in total, from his $1.5 million portfolio. This individual plans to defer Social Security benefits until age 70, meaning their entire spending will initially come from their investment portfolio. After age 70, approximately half of their spending needs will be met by Social Security.A conservative approach for this individual would involve allocating $160,000—his years 1 and 2 portfolio withdrawals. His Bucket 2—high-quality bonds—would consist of eight years’ worth of portfolio withdrawals, which at that point will be $40,000 per year (his $80,000 total spending less Social Security income). The remaining $1 million and change could go into a globally diversified equity portfolio.Where to put the money?Beyond simply accumulating enough cash for retirement, a crucial question arises: where should you store your liquid reserves? The decision between holding funds in taxable or tax-sheltered accounts hinges significantly on your planned sequence of withdrawals once you stop working.Taxable accounts are often prioritized for early retirement withdrawals, largely due to their higher ongoing tax costs compared to tax-sheltered options. While appreciated assets held for over a year in taxable accounts benefit from long-term capital gains rates, ordinary income faces higher tax brackets. Yet, a different strategy might suit some retirees: drawing from tax-deferred accounts earlier. This approach aims to reduce future required minimum distributions (RMDs) and subsequent tax bills. Given these intricate considerations, seeking guidance from a financial or tax adviser is highly recommended. Ultimately, a clear understanding of your initial retirement spending plan will illuminate the best place to keep your vital liquid reserves.Where to get the money?Once you’ve determined how much of a cash bucket you plan to set aside and where you’ll hold it, the next step is figuring out how to build it up. Ideally, you’d give yourself a couple of years to enlarge your cash position rather than having to find the money just before retirement. Many people moving into retirement will have a few options.Additional savings: For preretirees who are still saving, a logical way to begin bulking up cash is to direct new contributions into cash. Say, for example, the aforementioned retiree is making the maximum allowable 401(k) contribution of $32,500 and putting another $8,600 into an IRA. By directing two years’ worth of contributions to cash in those two accounts, he could arrive at nearly half his target cash allocation ($82,200 of his $160,000 target) by the time he reaches his retirement.Bonuses and inheritances: If you’ve recently received a surprise cash injection, the assets are a logical source for bulking up cash reserves. They’re probably already in cash and in a taxable account.Rebalancing: Trimming equities and adding those assets to cash and bonds provides a twofer for people closing in on retirement: It reduces risk and helps cover cash flows for the first few years of retirement. This kind of selling can trigger a tax bill, so get some tax advice and/or concentrate rebalancing in tax-sheltered accounts to lessen the impact.Reducing risky positions: Even if your portfolio’s asset allocation doesn’t need adjusting, you may still have problematic holdings in your portfolio: the employer stock you know you should scale back on, the individual-stock portfolio that’s duplicative of what’s in your mutual funds, or the costly active fund that hasn’t earned its keep relative to an inexpensive exchange-traded fund.Such holdings can be ideal sources when building up your cash reserves, just mind the tax consequences if you’re selling them from a taxable account.