A frequent, costly tax mistake our firm witnesses can easily be avoided by repositioning an investor’s assets. This means shifting your retirement savings from tax-inefficient investments to tax-efficient investments.
At our firm, we call this technique “The Two Pocket Exchange Strategy”© as it requires shifting assets that investors already own from one pocket to another while receiving a potentially significant tax benefit. The tools to accomplish this are common, and the concept is simple, yet it is rare that investors consistently exploit this strategy to its full capabilities.
Before considering this technique, consult your tax professional and make sure you understand how investments are categorized. For simplicity, it is assumed that all of your financial assets fit into one of three categories.
The first category is non-qualified. Investments in this category can be taxed annually on interest income, capital gains, and dividends. Even clients with modest incomes often have a large amount in these accounts from an inheritance or the sale of a house or property. Typically, you hold non-qualified investments in a regular bank, brokerage, and mutual fund accounts.
The second category is tax-deferred. Investments in this category frequently receive an upfront tax deduction, and they grow tax-deferred. Distributions are taxed at ordinary income rates, but there are no penalties when money is withdrawn for qualified reasons. By qualified, we mean money withdrawn after age 59.5 or in certain other circumstances that escape the 10% penalty from early withdrawal. Examples of these tax-deferred accounts are traditional IRAs, 401(k)s, 403b, and 457, and deferred-compensation plans.
The last category is tax-free. Investments in this category receive no initial tax advantage but will grow tax-free and can be withdrawn tax-free in retirement. Examples include Roth IRAs, Roth 401(k)s, and Roth 403bs.
The non-qualified category faces annual levies on dividends, capital gains, and interest. While non-qualified accounts benefit from a lower tax rate on capital gains, the annual tax pressure may severely handicap this category, compared to the others, when it comes to investments earmarked for future retirement income. The tax-deferred and the tax-free categories carry significant tax-reduction benefits, making these accounts a more attractive place to hold retirement investments. Determining which of the latter two categories is ideal for your retirement money depends on your eligibility, availability, and a variety of other factors outside the scope of this article. To successfully implement the Two Pocket Exchange Strategy, an investor must constantly examine opportunities to reposition assets from the non-qualified category to the other categories.
Here’s a hypothetical example of how this repositioning can be done:
Larry Smith is 53. His wife Jane is 51. Both work and have a combined adjusted gross income of $185,000 (Larry, $110,000, Jane, $75,000). They’ve always kept a $20,000 emergency fund in non-qualified accounts and recently received a $150,000 inheritance, bringing their total in non-qualified accounts to $170,000.
Due to their concerns over tax rates rising in the future, they are considering establishing Roth IRAs and utilizing their employers’ new Roth 401(k) option. Since they are over the age of 50, they are eligible to contribute $30,500 per person a year to their Roth 401(k)s and up to $8,000 per person to their Roth IRAs (for 2024); however, they can only afford to live on $10,000 less than their current take-home pay.
Here are the steps I recommend they take:
Establish Roth IRAs for both and immediately shift $8,000 from their non-qualified investments into each Roth IRAs.
Establish Roth 401(k)s for both and request maximum withholding from their employers of $30,500 per person (for 2024).
The Roth 401(k) contributions will result in significantly reduced paychecks. Since they can’t pay the bills with so little take-home pay, they’ll need to withdraw a comparable amount of money from their non-qualified investment accounts.
This strategy will take almost three years to fully implement due to current limitations on contributions to the tax-free Roth accounts. Once the non-qualified funds have been repositioned, they can reduce their 401(k) contributions to sustainable levels until retirement.
Once this strategy has been fully executed, they should also consider putting a portion of their emergency reserves in an investment within their Roth IRA that is conservative and provides liquidity. A Roth IRA can double as an emergency reserve since contributions can be taken at any time, for any reason, tax, and penalty-free. (Earnings in the account generally cannot be withdrawn tax and penalty-free until age 59.5.)
What has all this shuffling of funds accomplished? Larry and Jane Smith have permanently eliminated taxes on a minimum of $170,000* of previously non-qualified investments. Moreover, any Roth 401(k) or Roth IRA funds they don’t use can be left to their children, who can continue to take income tax-free distributions for up to 10 years.
The point is that with a bit of creativity and planning, you too might be able to substantially reduce taxes on your retirement savings, as well as the tax burden on your beneficiaries, simply by shifting savings that you already have from one pocket to another.
This is an updated version of Ty Bernicke’s article originally published in Forbes on October 15, 2009.
*Assuming both individuals make a one-time contribution of $8,000 to their Roth IRAs and request maximum withholding of $30,500 from their paycheck for three years.
The use of Ty Bernicke’s research or publication of articles he has written does not indicate an endorsement of his work as an Investment Advisor. The publications did not receive compensation for publishing Mr. Bernicke’s work.
The views expressed represent the opinion of Bernicke Wealth Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Bernicke Wealth Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Bernicke Wealth Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations.
