One missed tax planning opportunity that many investors make includes failing to utilize their tax-efficient investment accounts fully. Our team at Bernicke Wealth Management calls the techniques discussed here the “Two Pocket Exchange Strategy©” as they require shifting assets and income sources that investors already have from one “pocket” to another.
These investment strategies may provide current-year tax benefits or future sources of tax-free income. While these strategies appear obvious and straightforward, we consistently find that investors are not getting the most out of their portfolios.
The Two Pocket Exchange Strategy© can be especially valuable for investors who want to retire before age 65 and will not have health insurance provided to them by an employer after they retire. Before considering any of these strategies, consult with your tax professional.
The Different Types of Investment Accounts
When it comes to the Two Pocket Exchange Strategy©, the first thing to understand is the three main categories of investment accounts and how they are taxed.
- Non-Qualified Accounts: Investment accounts that are taxed annually based on interest income, capital gains, and dividends. Non-qualified accounts may not be the most efficient place to save for retirement due to the annual taxes that can apply to investment earnings in this category. Typically, this includes bank, brokerage, and mutual fund accounts.
- Tax-Deferred Accounts: Investments in this category frequently receive an upfront tax deduction, and they grow tax-deferred. Distributions in retirement are taxed as ordinary income. Examples of these tax-deferred accounts include traditional IRAs, 401(k), 403(b), 457, and deferred-compensation plans.
- Tax-Free Accounts: Investments in this category receive no initial tax advantage but will grow tax-free and can be withdrawn tax-free in retirement.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 IRA, Roth 401(k), and Roth 403(b) accounts.
To successfully implement the Two Pocket Exchange Strategy©, an investor must 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.
John Smith is 55, and his wife Jane is 56. They both work full-time, and they have a combined adjusted gross income of $120,000.
Their retirement goal is to both retire when John reaches age 62. They both have saved in their tax-deferred work retirement plans throughout their careers, and their retirement savings are held in these tax-deferred accounts. They have a High-Deductible Health Insurance plan through Jane’s employer, and the plan makes them eligible to contribute to a Health Savings Account (HSA).
Jane will not be able to keep health insurance coverage from her employer after she retires beyond what COBRA insurance coverage provides. John and Jane will need to use the health care exchange for their health insurance coverage until they are eligible for Medicare at age 65.
Jane recently inherited $225,000 in non-qualified bank accounts. John and Jane share that they can afford to live on $10,000 less than their annual take-home pay, representing the current amount they are adding to their retirement accounts.
Using The Two Pocket Exchange Strategy© For Better Retirement Planning
Here are the recommendations the Bernicke Wealth Management team would make for John and Jane:
- Jane should maximize her Health Savings Account contributions to $7,300 annually.
- John should stop making tax-deferred 401(k) contributions and begin contributing to his Roth 401(k) at work. He should increase his contributions to the maximum $27,000 annual contribution limit for 2022 into the Roth 401(k), and his contributions will increase from 10% to 54%.
- Jane should stop making tax-deferred 403(b) contributions and begin contributing to her Roth 403(b) at work. She should increase her contributions to the maximum $27,000 annual contribution limit for 2022 into the Roth 403(b), and her contributions will increase from 10% to 38.6%.
- John and Jane should each open new Roth IRA accounts, making their maximum annual contribution of $7,000.
- John and Jane should continue to maximize the HSA, 401(k), 403(b), and Roth IRA contributions until the balance in non-qualified cash reaches their emergency funds level.
John and Jane will see a significant drop in take-home income through their paychecks when they implement these strategies. John and Jane could simply turn on an additional “paycheck” from the inherited non-qualified cash to offset the drop in take-home pay from work.
The Two Pocket Exchange Strategy© increases their payroll contributions from $10,000 to $61,300 annually, significantly lowering the take-home pay from their paychecks. The $14,000 in combined annual Roth IRA contributions could also come from the non-qualified inherited cash. This would give them $75,300 per year that will go into accounts that grow tax-free, and qualified distributions are taken tax-free. The HSA also provides an up-front tax break for contributions.
By implementing the Two Pocket Exchange Strategy©, John and Jane could get most of the entire $225,000 they inherited into tax-free Roth and HSA accounts over the next three years.
We recommend tax strategies for John and Jane have the potential to permanently eliminate future taxes and tax increases on the inherited funds. The recommended strategies would also provide John and Jane with much more flexibility for planning for health care costs when they retire at 62 and before they qualify for Medicare at age 65.
The increased contributions to their HSA give them an up-front tax break now and a tax-free source to pay for out-of-pocket costs for dental, health, and vision expenses now and in retirement.
Which Tax Investment Strategy is Right For You?
We understand that everyone has different retirement goals. No matter what your goals for retirement and beyond, our team of expert advisors can help you plan out the best tax investment strategy for you.
Don’t wait to start investing for your future — talk to our team at Bernicke Wealth Management. Our innovative approach to retirement planning may even help you retire earlier than you think.
Contact our team today to get started with an initial consultation and learn more about our process.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.