Beware the Two-Pocket Theory of Money

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We are often tempted to treat different sections of our money differently. There’s money earned, money found, and money gifted. There’s retirement money, emergency fund money, and fun money. There’s money for our future house, money from your inheritance, and money for lunch. Some distinctions are helpful, because they help us curb our impulse to spend. Wealth is built on savings and setting aside money for our future helps us save. However, such partitions are unhelpful when it comes to budgeting and in the rigor of financial planning.

My husband is a collector of books, and we boast a large and beautiful library in our house. Without a budget to curb his impulse or a finite library to limit his storage space, we could easily impoverish our savings and have every room of our house filled with books.

Thankfully for our budget, we each have a so-called frivolous budget that we are allowed to spend on whatever we want. We have our frivolous budget luxuriously set at 1% of our budgeted income to each of us.

Thankfully for our house, my husband has recently discovered the wonders of used bookstore trade-in programs. You can take used books which you no longer wish to have and turn them into either cash or store credit.

We were discussing a planned bookstore outing and looking up what his frivolous budget has when we wondered if getting store credit could offset his purchases to increase his budget to spend.

Sadly, this way of thinking is called the two-pocket theory of money. It is better to have a one-pocket theory of money where all income sources are submitted to the budget.

Otherwise, it becomes a slippery slope. If there is one pocket of money in his used bookstore trade-in which is fun money that he can spend on books and then there is another pocket in my earned income which is the serious money that we submit to a rigorous budget, then there could also be pockets in my bonus, our tax refund, and our odd jobs income which we could allocate outside of our budget to meet other impulses and desires. Suddenly, our standard of living could be quite a great deal higher than our budget says it is.

In contrast, if we use a one-pocket theory of money, then 1% of all income sources are allocated to my husband’s frivolous budget, including 1% of his bookstore trade-in. Even though this diligence is less fun, it is actually better, even for my husband’s frivolous budget. If he were to have all of his book credit but lose the 1% shares of my bonus, our tax refund, and our odd jobs income, he would have a lot less to spend overall.

If you budget well according to your values, a one-pocket theory of money enriches your life, prioritizing your financial dreams above your impulses. If you find yourself trying to justify a two-pocket theory of money a lot, it may be a sign that your budget could do with some reworking.

In my family’s case, my husband decided to combine his Frivolous, Clothes, and Eat-Out budgets into one big budget so he can spend more on books. This is in alignment with his values, allowing him to wear socks with holes in them so he can adventure with a new science fiction novel.

In our case, it might just mean that he gets socks from me for Christmas out of the Gifts budget, which makes us all happy as giving gifts is my favorite way to spend.

Other than budgeting, the two pocket theory of money can creep into investing in unhelpful ways.

The IRS has created partitions in our savings so there are his-and-hers 401(k) plans, IRAs, Roth IRAs, and Roth conversion accounts in addition to brokerage, savings, and checking. We might make more partitions by having an emergency fund separate from our long-term taxable savings separate from our vacation fund.

As I said before, if this helps you save money, then it can be okay. However, sometimes these partitions wrongly influence investing decisions. For example, you don’t want to take any risks with your emergency fund because you might need it, but with 40 years or more before you retire, you might feel fine taking risks with your retirement money. This makes you want to invest your IRAs  and long-term taxable savings in stocks and leave your emergency fund in cash.

In reality, there is a priceless asset allocation for any given withdrawal rate which should dictate how much is kept in cash or bonds, and there are a science and an art to asset location which produces real tax savings. This rigor of financial planning to mentally combine all your savings into one portfolio with one investment plan will enrich your life more than creating fake or real partitions in your savings and allowing those to dictate investing.

If you live a modest lifestyle well below your means, you may be able to afford two-pocket thinking here or there. However, if you are riding close to the edge, a two-pocket theory of money may get you in trouble.

Photo by Patrick Tomasso on Unsplash
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Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.