One dollar is just the same as another dollar. Curiously though, our emotions do not perceive the world this way. To our emotions, our paycheck feels different from a gift card which feels different from a tax refund.
Emotionally, some money might be serious money, intended for careful budgeting and saving, while other money is play money, without rules or restrictions on its use.
For example, it is common to view a paycheck as serious money for living expenses and tax refunds as play money for fun and frivolity.
However, this fallacious method of thinking is called a “two-pocket theory of money,” and once we overcome its sentimental ways, we open ourselves to more strategies for saving.
Most savers have at least three stores of money: retirement accounts, taxable savings accounts, and paychecks.
For those who find out about a Roth IRA late in life, it can feel too late to take advantage of it. With savings amassed in taxable accounts or Traditional IRAs and paychecks needed for living expenses, funding a Roth can seem difficult.
However, the two-pocket theory of money might be getting in the way.
Imagine, for example, that Michael and Mary haven’t saved as much in retirement accounts as they would have liked. They have about $250,000 built up in their traditional 401k accounts and another $50,000 in traditional IRA accounts.
Unfortunately, they have contributed no money to Roth accounts. Instead, they have let cash build up in their checking account and then periodically moved that money into a taxable investment account.
Now at age 50, they have $1.5 million in a normal brokerage account exposed to the taxation of legislators. With an adjustable gross income of $127,000, they are toward the top of the 25% federal tax bracket and experiencing a 15% capital gains tax. Living in Virginia, they add an additional 5.75% to each of those burdens.
Even if their taxable account only appreciates at 7%, they have to pay $21,787 in capital gains taxes each year.
With only $300,000 in traditional accounts at age 50, they could use more retirement savings. A Roth conversion, while advantageous, would pay an effective tax rate of 30.75% for the first $24,200 and 33.75% beyond that.
What Michael and Mary would like to do is simply to move their taxable investments away from capital gains tax to the shelter of a Roth, but they don’t want to incur any additional tax for doing so.
Mary and Michael are both working and earning good salaries. Both their employers have Roth options on their 401k. Because of the catch-up provision for being over age 50, they can both contribute up to $18,000 to their employer sponsored Roth 401k. And because their taxable income is below $183,000 they can contribute an additional $6,500 to their Roth accounts.
Mary and Michael can contribute $49,000 a year to their various Roth accounts.
The reason why they haven’t maxed their contributions to Roth accounts is because they don’t want to decrease their standard of living by $49,000 a year.
What they haven’t realized before is that they don’t have to.
Assuming that they max their Roth contributions, they can simply supplement their lifestyle by withdrawing $49,000 a year from their taxable investment account. Intuitively, this is equivalent to simply moving $49,000 each year from their taxable account, where it is subject to ever increase rates of taxation, to their Roth account, where it will never be taxed again. Who wouldn’t want to take advantage of that opportunity?
Most tax professionals don’t think of such tax planning opportunities, because they have to focus on complying with tax accounting regulations. Additionally, tax professionals don’t normally know the size of a client’s retirement or taxable investment portfolio. But comprehensive wealth management is the practice of analyzing a client’s whole financial situation to find small changes like these to produce wealth over long periods of time.
This opportunity only exists while Michael and Mary are employed and can contribute the maximums to their Roth accounts. Once they are retired this opportunity is lost and moving that amount of money into a Roth account would require a Roth conversion taxed at ordinary income tax rates.
At a 7% return, their taxable investment account is growing at $105,000 each year, so taking $49,000 out to supplement their income while they fund their Roth accounts won’t even stop the account from continuing to grow.
With a at 7% return, the taxable account could grow to $4.3 million by age 65. When fully funding their Roth accounts and withdrawing from their taxable account, the taxable account could still grow to $2.8 million, but Michael and Mary would also amass Roth accounts worth about $1.5 million. This assumes that the funding limits remain where they currently are and do not advance with inflation. If they advance with inflation, they could shelter even more.
By age 65, they would be protecting over $102,000 from capital gains taxes each year, a savings of over $21,000 annually. All this is accomplished simply by moving a portion of their money to a new account type.
There are many creative ways like these to get money into Roth accounts. Each person’s situation requires extensive analysis to determine what the best plan is for them, but in general tax planning favors funding your Roth.
Photo used here under Flickr Creative Commons.