My Money Is Worth More Than Your Money

Contract DiagnosticsNo, Kate and Andrew, I’m not talking about your loony Canadian dollar. Nor am I referring to the measly seventy cents or so that the New Zealand and Australian dollars are now worth. This article has nothing to do with exchange rates. Although, friends, it is true that my money is worth more than yours.

Today’s post is focused on the value of the American dollar in various retirement accounts. While I have seen a few very detail-oriented people adjust their net worth based on where their money is held, most of us — myself included — just add up the value of all the accounts to arrive at the total. Is that the best approach?

 

When a Dollar is not a Dollar

 

If you’ve been earning and investing for awhile, you most likely have money in a variety of account types. Some of those dollars are inherently worth more than others, depending on the current and future tax treatment. Let’s take a look at each of those dollars, from the most to least valuable.

 

Sam Adams picture

sam adams, american.

Roth Dollars

 

Roth dollars are the most valuable dollars you can have. If they were a day of the week, they’d be Saturday. You’ve already paid tax on them, and they will continue to grow tax free until you use them. These dollars have a value of $1.00. The Roth dollars also benefit from being sheltered from required minimum distributions (RMDs).

While it may not be ideal to make large Roth investments when you are in a high income tax bracket, particularly if you anticipate a lower tax bracket in retirement, Roth dollars are sure great to have. If nothing else, contribute to a backdoor Roth for yourself and your spouse, if you’ve got one.

I made one small Roth conversion as a resident, a Mega Roth conversion as an attending, and have made backdoor Roth contributions for several years.

30% of our dollars are Roth dollars.

 

HSA Dollars

 

Dollars in a Health Savings Account (HSA) are the next best thing. They’re like Sunday; it’s still the weekend, but not as enticing as Saturday. When used for healthcare costs, the dollars in an HSA act just like Roth dollars. Even better, you received a tax deduction when you put those dollars in the account. In the year that you contribute, you could say these dollars are better than Roth dollars, but after you’ve received that deduction, the dollars remaining are at best equal to Roth, and at worst equal to tax-deferred dollars.

There a couple ways to use your HSA dollars to cover healthcare expenses. One tactic is to use the account to pay for healthcare expenses when they are incurred. A second option is to save receipts, allow your HSA account to grow tax-free for years, then take a large reimbursement for the sum of the receipts after collecting them for years or decades.

The latter approach, saving receipts, has the potential to work out in your favor. You receive the benefit of tax-free growth of dollars that are not withdrawn when the bill arrives. I’ve begun to implement this strategy, and I’m not convinced the record keeping is worth the small benefit. I’ll probably continue to save receipts until we pack up for our next adventure, and then cash in.

If you end up with more HSA dollars than you can use for healthcare (not bloody likely), you can use the account like a traditional IRA at age 65. The money can be withdrawn penalty-free for any reason, but you will pay income tax if it not used to pay for healthcare expenses. Note that HSA money cannot pay for health insurance premiums, but can cover out-of pocket costs and a lot of other expenses, like orthodontics and eye glasses.

Flex Savings Account (FSA) dollars can be viewed like short term HSA dollars, but typically must be used up by the end of the calendar year.

1% of our dollars are HSA dollars.

 

 

Swedish McDonalds

0% of our dollars are in Swedish krona

 

Taxable Dollars

 

“Taxable” sounds bad and expensive, just as “spinal” anesthesia sounds barbaric and scary. The truth is far from the implication from the off-putting word in both cases. Taxable dollars are great dollars to have, and a spinal anesthetic, given below the level of the spinal cord, is often the safest and least invasive anesthetic option.

Taxable dollars are like Friday — part weekday, part weekend. You’ve already paid taxes on these dollars once, and the worst you’ll do is pay some tax on the growth of these dollars. At best, “taxable” dollars can be treated the same as Roth dollars.

How are taxable dollars taxed? If they earn interest in a savings account, the interest is taxed as ordinary income. If you sell a stock or mutual fund that has grown in value, you may owe some taxes on the gains. The same is true for dividends. Gains on equities held at least a year are treated more favorably, as are qualified dividends (as opposed to ordinary, non-qualified dividends).

The more gains you have, the lower the potential value of your taxable dollars. An equity purchased for $100 and worth $100 is currently worth more to you than an equity purchased for $10 and now worth $100. There are methods to avoid taxes on those gains, but some are not pretty (death) and some could be eliminated with a change in the tax code.

How can taxable dollars be as good as Roth dollars? A few conditions have to be met, but it is possible. First, you must have a taxable income that keeps you in the 0% long term capital gains / qualified dividend tax bracket, which coincides with the 15% federal income tax bracket, which is about $75,000 for a couple in 2016 — a feat easily achieved by an early retiree. Second, the investment must not spin off ordinary dividends or short-term capital gains. Passive index funds are good choices to meet these criteria. Growth stocks tend to pay fewer dividends, and Berkshire Hathaway famously pays none. Finally, your state of residence must treat gains the same way the federal government does. Not all of them do.

52% of our dollars are taxable dollars.

 

Tax Deferred Dollars

 

The final category contains your least valuable dollars. Monday dollars. While you have every reason to put as much as you can into tax deferred accounts when you earn a physician’s salary, the dollars won’t be worth as much as those above when it comes to retirement.

These dollars have not yet been taxed, but when accessed in retirement, you can bet your bottom dollar that they will be. These dollars can be held in a variety of numbered and acronymed accounts, each of which behaves a bit differently, but they all have one thing in common: income tax will apply.*

Unfortunately, many retirees will have most or nearly all of their dollars in tax deferred accounts. This isn’t an inherently bad problem, particularly if the balances are sufficiently large, but if you’re relying solely on tax deferred dollars to fund your retirement, your dollars won’t go as far as any of the other dollars we’ve discussed. If your total tax in retirement is 15% to 25%, your tax deferred dollar is worth 75 to 85 cents.

17% of our dollars are tax deferred dollars.

 

dr. guy harvey autographed artwork. we spent a few dollars

 

Other Dollars

 

I’ve ignored other dollars thus far, because I’ve already accounted for 100% of our retirement dollars. Other dollars would include pensions, which is a complicated topic recently covered by the Financial Samurai. He frequently discusses real estate, too; we do not own investment real estate, but there are ways to own real estate or real estate funds in all of the account types listed above. Annuities can also be held inside and outside of retirement accounts. Cash value life insurance is something I have stayed away from, and probably doesn’t deserve my attention (or yours).

Social Security is a benefit we Americans who have worked our 40 quarters can expect to collect at some point. I’m nearly 30 years away from collecting if the rules remain constant over those three decades. I have no idea how to value this benefit with so much time remaining. I expect we will receive a benefit, and will treat it like an added bonus when the day finally comes.

 

Are My Dollars Worth More Than Your Dollars?

 

Probably. With more than 80% of my retirement dollars residing in post-tax accounts, I’m in pretty good shape. If the situation were inverted, and more than 80% of my retirement dollars were living in tax deferred accounts, those dollars simply wouldn’t go as far in retirement. The latter is a common situation.

Certainly, some of you will have an even higher percentage in Roth and taxable accounts. You win! Someone will always have a higher income, a nicer home, a more ideal asset location ration, or a better behaved dog. Actually, the vast majority of you probably have a better behaved dog, if you have a dog.

 

Bear Beer

bad dog

 

So what?

 

I don’t think we need to go to any great length to devised a formula or conversion factor for the different types of dollars we have. There are just too many variables. Even if the tax laws stay forever unchanged — they won’t — our circumstances will change. I could pay between 0% and 40% on the dollars I withdraw from tax deferred accounts depending on what happens in coming years. Income can change, deductions will graduate and leave the nest, even **gasp** filing status can change.

I do think it’s worthwhile to consider where your money is, and understand the relative value of your different dollars. Sometimes, I think we should shoot for a specific dollar amount before making drastic changes in our work / life balance. When I stop and think about our 25x (or 36x = financial freedom), I realize that the absolute number isn’t all that important, anyway. So now we’re shooting for a specific date.

 

What are you aiming for? Do you discount tax deferred or other dollars when calculating your retirement assets or net worth? I’d love to hear your thoughts.

 

*Strategies exist to make Roth conversions while avoiding federal income tax. You must have low expenses and / or a substantial amount of other dollars to spend in order to employ this strategy, and will only be able to convert a relatively small amount annually, but it is possible.


80 comments

  • Good post POF. There is a definite pattern to the split between post-tax dollars vs Pre-tax dollars. Those of us who have had relatively high incomes and comparatively lower living expenses (basically, the FIRE mindset) would be in a situation similar to you where most of retirement dollars will be post-tax (Roth/Taxable). That’s simply an outcome of having recognizing early that pretax dollars alone aren’t going to save the day when it comes to our retirement planning. I agree that majority have the ratio the other way around.

    • True, TFR. Having money left over for a taxable account after maxing out all other avenues is a nice perk to earning a solid income.

      Tax diversification is a good to have in your retirement assets.

      Cheers!
      -PoF

  • We have a good mix,maybe 50-50. One of the benefits of your last line regarding conversions is the more mixed you are the easier it will be to ladder convert the remaining money on your own schedule while living on the other money. Still I discount my pre-tax accounts at my current tax rate as a proxy to stay conservative.

    • That’s a nice mix to have, FTF.

      I’m guessing you’re in a minority of people who actually deflate their net worth with a conversion factor. That is a good way to be conservative and help ensure you have Enough before retirement.

      Best,
      -PoF

  • I like it PoF.

    I agree that most people have the ratio flipped (including us)- or the bulk of their money is tied directly to their main residence.

    I need to read up on the conversions – probably not something I need to do quite yet.

    We are rocking 15% in Roth IRAs right now.

  • I’ve been thinking of adjusting my Net Worth for taxes, because you are right, not all dollars are equal.

    I was happy that you mentioned pensions in there because that’s a huge part of my wife’s military retirement plan. These are a lot of dollars as the Financial Samurai’s article details. It’s enough dollars that it can change the tax strategy of dollars we already have.

    • You were thinking about it, then remembered that would require extra math… the Lazy Man in you won out?

      A military pension is about as guaranteed as your money can get, and is often taxed favorably, although that varies by state as well.

      Cheers!
      -PoF

      • It wasn’t much extra math… and my spreadsheet makes that math trivially easy.

        It’s that the real estate investments and pension income streams should be more than enough to live on by themselves. My blogging and dog sitting income streams adds another income stream to the mix (and I don’t see myself quitting them completely). Social Security will be something as well.

        We maximize as many things as we can with tax-advantaged accounts, but they are 20-25% of our projected income in retirement. It’s probably a minimal difference in terms of the overall plan. Still, I should separate retirement accounts into Pre-Tax and Post-Tax and then try to deal with them accordingly, which I guess would be multiplying the value of Post-Tax by something like 25% to reflect that it has more value than the rest of my Pre-tax income streams.

  • Great points, Doc! Valid to considering “discounting” IRA $ in net worth calc, but I suspect no one does it (I don’t). I do track net worth by asset location, and seek to have diversified tax positions. I also do mega back door Roth’s annually, and just completed a $16k back door the week before Christmas.

    • Thank you, Fritz!

      Some do the discounting (see Full Time Finance’s comment). With the variability, and relatively small portion in tax deferred accounts, I haven’t made adjustments in my calculations. If I were heavy on tax deferred dollars, I would be hesitant to retire with exactly 25x expenses, unless the income tax due from withdrawing those dollars is included in the anticipated retirement expense calculation.

      Cheers!
      -PoF

  • Ha, ha, Pof – great analogy! I, unfortunately, have mostly Monday dollars. Let’s see, about 25% is pension, 1% HSA, 1% Roth and the balance, 73% in a 401k. I have grown to love my pension these last few years.

    My everyday 401k dollars were cheaper than your fancy-pants Roth dollars, though, so take that! 🙂

  • Great post, PoF! I always forget that HSA withdrawals can be taken at anytime based on old receipts. We need to start saving them, especially on expensive procedures (labor and delivery…spinal anesthesia)!

    We haven’t done any Roth rollovers or conversions so I would guess we are about 50/50. I do discount the value for a tax estimate but when that day comes I hope to do tax free laddered conversions and/ or keep too low tax brackets.

    Thanks for the great post!

    • 50 / 50 is a good place to be, GS. Especially if you’re able to do some tax free conversions as a fellow early retiree. If you keep growing your blog though, you might struggle to stay in those bottom tax brackets! #firstworldproblems

      Cheers!
      -PoF

  • Terrific way about thinking about the value of dollars in different accounts. Keeping those backdoor Roth dollars open is exactly why we’re leaving our IRA accounts open and why I didn’t rollover my 401k into an IRA when I changed gigs earlier this year.

    Obviously, docs do pretty well salary wise, but for most people, most of their dollars will probably be in 401(k)s or their residence. A lot of folks out there just might not have enough to be able to throw a significant sum into taxable investments as well.

    I’ve always recommended people to max out their 401(k)s and tax advantaged accounts first, but would you suggest changing up that common wisdom?

    • You’re giving good advice, FP. I wouldn’t change it up at all.

      Between a 401(k) employee and employer contributions, 457(b), and HSA, I add about $43,000 tax deferred money to my accounts annually, and my percentage in tax deferred will creep up a bit as long as I continue working.

      One area that is a shade of gray is Roth versus traditional investments. IMHO, Roth definitely wins in the 15% and under federal income tax bracket. Tax deferred wins in the 33% bracket and up. In between, it depends… I’ve been meaning to write up a case study on this topic for a reader for many months now… I should get on that.

      Cheers!
      -PoF

      • The decision is a lot easier if you’re on a relatively lean-FIRE path. If you’re a married couple planning to draw less than ~$75k in 2016 dollars in retirement or a single income earner planning to withdraw less than ~$40k in retirement, you can be pretty certain that you benefit from tax-deferred accounts.

        Your marginal income tax rate in retirement would be 15% in today’s brackets, and I’d argue that nearly everybody who is capable of maxing out pre-tax investments is earning an income that would otherwise be in the 25% bracket or higher while working. You get a bonus 10% plus all the bonus earnings for the years the extra 25% is sitting there waiting to be taxed.

  • It’s really good to know that HSAs can be used as IRAs eventually! Mr. Picky Pincher’s employer offers an FSA account, so we haven’t signed up for it yet since it’s a use-it-or-lose-it sort of deal.

    Even though I’ve doubled my income in the last few years, I still contribute to my Roth IRA. I love the fact that the taxes are already taken out, particularly because I’m not sure what taxes will look like once I retire. Plus I enjoy the flexibility of Roth IRAs. I do wish I could max it out, but I currently deposit $200/mo, which is a healthy sum.

  • About of our stock 90% is in Roth, and the rest in the TSP. The bulk is in rentals. But they are pulling better than 4%. If we sold them and didn’t re-buy, there would be a tax bite, but similar to a taxable account. Then there is a military pension, but it is tax free. So the odds of us paying out federal taxes in the next decade are rather low. Really, we have way more deductions than we can even use. Too bad we can’t barter deductions. 😉

  • Certainly something to think about. A good bit of our savings are in pre-tax accounts, and we will have to pay taxes.

    Those ROTH dollars do look pretty, and I used to think paying taxes up front was nice. But it’s important to keep in mind, for high income earners it costs more than $1.42 (with 30% marginal tax) to buy $1 of ROTH money.

    If you put that $1.42 into a pre-tax account. Then pull the money from your 401k in retirement, it is taxed at your effective tax rate, not marginal rate. For 40k of income, that would only be 11.5% leaving you with $1.26 of your money after taxes.

    So while I love having ROTH dollars. I would rather have 26% more of the same after tax money 😉

  • Great stuff, PoF! I’d hate to think what “Wednesday dollars” might look like…maybe back taxes owed with penalties and interest or something.

    It’ll be interesting to see what kinds of tax code changes occur in the next couple years. My hope is we’ll end the death tax once and for all – which is the worst kind of double/triple/quadruple taxation imaginable.

    As for us, the overwhelming majority of our holdings are in straight-up taxables, which isn’t totally optimal for us from a tax perspective. But it’s basically an artifact of how we accumulated most of our wealth while running our own biz.

    That neighbor’s dog looks sorta familiar by the way… You don’t happen to live down the street from Borat, do ya?

    Happy holidays, and nice work.

    • Gracias, FL!

      I thought we were celebrating Humpday, no? The camel?

      Taxable dollars are really good, actually, especially for an early retiree. If you can engineer your taxable income to the 15% tax bracket, gains can be had tax free.

      Borat! A British friend of mine introduced me to the Ali G show back in 2002. I’ve got the whole series on DVD. Kinda jumped the shark eventually, but some of that stuff is pure gold.

      Cheers!
      -PoF

  • TJ

    Not much tax deferred for me.

    Roughly 65% taxable, 20% ROTH, 15% tax deferred

  • Great post, PoF!

    This is the single biggest problem that Mrs. Vigilante and I ran into while preparing or prenup. We know that a dollar in one account is not necessarily worth a dollar in another account, but it is very difficult to put a precise equation to how much of a difference there might be. I agree 100% with how you explain it in present-day terms (“If your total tax in retirement is 15% to 25%, your tax deferred dollar is worth 75 to 85 cents,” for example), but obviously any future changes to the tax code would force an amendment to that kind of blanket statement.

    When we drafted our prenup, we thought about this a lot. Mrs. Vigilante has a pension in which each dollar is really worth more than a dollar, in all likelihood. We’ll both have plenty of tax deferred savings, but hers is ever-so-slightly easier to access because she has a 457(b) – no early withdrawal penalty no matter what. (We assume I won’t be paying those, either, but it will take planning to avoid it with my accounts.) And finally, I have slightly more valuable dollars in my HSA than she has in her tax-deferred accounts.

    With all the variables, we decided it was best to leave this up to future us. Basically, our prenup speaks in terms of the value of investment accounts “with consideration of tax effects” or something like that. That way, it’s flexible for changes, rather than simply saying “Discount the value of X account by Y percent.” So, if we were to divorce today and our assets were $500 cash (mine) and $500 in a tIRA (hers), we would discount hers by future taxes of 15-25%, and I would have “more” than her (to be distributed however the prenup says).

    That also makes this the single most dangerous part of our prenup: If we ever get divorced, this is the one section of the prenup that is ripe for litigation. I have seen a lot of divorcing couples dispute the value of accounts by hiring CPAs to appraise things like her pension or a large 401(k). It’s possible we could end up there, as well.

    Guess we’ll just have to make this marriage thing work!

  • Great post as always! It’s very important to know the appropriate conversion factors between the different accounts. For example, if someone’s 20% bond allocation is in the tax-deferred account and 80% stocks in the taxable account, the effective bond allocation may be much less than 20%. But then again, who needs bonds anyways? I hate bonds! Bad example, bad example. 🙂

    • The White Coat Investor has a good way of looking at this issue. Consider your tax deferred account as 2 accounts — a Roth account that belongs to you and a Roth account that belongs to the government.

      If half your money is in the IRA, and 100% of your REITs (better example?) are there, and you have a 25% total tax in retirement, your REIT exposure is 25% lower than you think / calculate.

      It was a novel way to look at it, but it makes sense.

      Best,
      -PoF

      • That’s a great point. It reminds me of an excellent paper I read a while ago:

        “A tax-deferred account is best viewed as a partnership. A TDA is like a limited partnership in which the individual investor is the general partner and owns (1 – t) of the partnership interest, where t is the marginal tax rate when the funds are withdrawn in retirement. The government is effectively a limited partner and owns the remaining t of the partnership.”

        Uncle Sam is (literally) a shareholder in the tax-deferred account! That has all sorts of interesting implications for asset allocation and withdrawal timing.
        Cheers!
        ERN

  • Great point on a dollar not always being worth a dollar, depending on where it is. I’ve been thinking lately I need to boost my after-tax investments, being heavily weighted in pre-tax or tax advantaged accounts. Need some more Fridays in my life!

  • I’ve only recently realized that just like other ways of diversifying your portfolio, diversifying between taxable and tax-free or tax-deferred is also important. We have over 90% in our tax-deferred accounts with the rest in a Roth and HSA accounts. I’m working on increasing our Roth and HSA funds to to give us the option of early retirement without penalties as well as being able to draw from several accounts to manage the amount of tax we pay each year (drawing from Roth to make sure we don’t exceed the marginal rates in each year).
    I do love the HSA! Another great thing that makes those funds cheaper are that they aren’t subject to FICA tax when withheld from an employer. It doesn’t help high income earners as much overall, due to the social security 6.2% cap, but will help everyone with the 1.45% Medicare Fica tax.

    • Great point about the HSA withholdings, MYMM. Most physicians & high earners will max out the SS “contribution” but decreasing the Medicare portion is worth something.

      Good luck in altering your ratios!

      Best,
      -PoF

  • This is a very interesting take on retirement planning. I’m glad I’m prioritizing my Roth IRA right now!

    Now the only problem is ramping up my income and decreasing my debt expenses. I’m only able to contribute $50/month to me and my husband’s Roth IRA right now, sheesh… Luckily, I just picked up a couple of high-paying writing clients, and the husband is working to start his own freelance business right now too (his THIRD job while also going to school full-time), so I’m hoping we’ll be able to boost our savings even more.

    Should have gone to medical school instead of wildlife biology school …. 😉

  • I haven’t done the math yet but I instinctively inflate our Final Number for retirement to adjust for the dollars that will be taxed later on. That’s enough to give me a general benchmark until I want to commit more time and brainpower to organizing it. That might be my fun 2017 money project – reorganizing our money strategies for retirement.

    • There are lots of pretty good reasons to overshoot for retirement, an early retirement in particular. Accounting for more taxes from a preponderance of money in tax deferred accounts is one of them.

      All the best in 2017!
      -PoF

  • We are in the traditional 401K pool for most of our money. I thought about contributing to Roth 401Ks now but the reality is that I can use the money now to pay down school debt, etc. I am planning for a big conversion (Traditional to Roth) when I go down to 60% in the future (unfortunately not near future). That way the tax burden won’t be as bad.

    • Good choice, EJ.

      I would stick with traditional contributions to the 401(k) indefinitely unless the tax code / brackets change significantly. In your field, you’ll probably be in the 28% to 33% bracket even at 60%. It’s a ways off, so you can wait and see.

      Hopefully, you’re able to do the backdoor Roth annually. I plan to take some screenshots to share when I make our contributions next week.

      Cheers!
      -PoF

  • Well played PoF! With 52% of your hoard in “taxable” dollars you’d succeed at FIRE wherever you were, even the extra difficulty locales like the UK or Australia.

    It is scary how the conventional wisdom “go big on your own home, is the biggest asset you’ll ever own” and “put all you can into your company pension” skews the deck against most folks even thinking about early retirement. Your post provides a great counter argument to those urban myths.

    Keep up the great work!

    • Thank you, Slow Angry-looking Dad!

      Homes sure are expensive, aren’t they? If you get in and out at the right times, big gains can be had, or you can do what I did and lose a bunch. Either way, the carrying costs (property tax, maintenance, improvements) can be massive.

      Cheers!
      -PoF

  • I agree, that net worth is not so cut and dry, which is why I personally don’t keep close track. I do like Roth dollars, because what you see if what you get. I am a real estate investor and four of our properties are owned free and clear. If you were to compare our rental cash flow to the 4% withdrawal rate of a retirement account, then some of these properties are equivalent to being worth 4 times what we actually paid for them, or what they are currently worth. So, what would I use?

    Additionally, someone may include their car in their net worth, but a car costs the average person $6k per year just to maintain. Since I went car-free, I can eliminate needing to cover those costs in my retirement.

    On a similar note, I live in a paid-off tiny condo with my husband in a great area. Our total housing expenses, including taxes, HOA and utilities is less than what my brother and his partner pay in just taxes alone. So, after they pay off their big mortgage over 30 years, their yearly holding costs are still twice as much as our costs.

    My point is that net worth isn’t as relevant as how far your money will go for each person’s particular desired lifestyle. ERE does this kind of calculation. Instead of net worth, he has calculated that he has enough money to last him something like 90 years from now. However, a slight change in his particular lifestyle, could cut that in half pretty quickly.

    I did a different calculation from him, even. I determined what my basic monthly needs were, and then created enough residual income to cover that amount so that I knew that I could have the basics like safe housing, healthy food and medical insurance covered. That was what I considered my ‘break-free’ point from the corporate world. After that point I was free to pursue work on my terms and any income I make goes toward travel and more investing.

  • 40% is in Roth dollars or taxable. That percentage has been increasing as my income increases and I’m able to funnel more money into my brokerage account than I’m allowed to contribute to my pre-tax 401k. I still without a doubt think it’s the best move for me to max out my pre-tax 401k, Roth IRA, and HSA, and then everything else goes into taxable brokerage account.

  • My dollars are structured 20% pre-tax, 13% Roth, 0.5% HSA, 2% taxable, 3% savings bonds, 8% cash, and 54% primary residence. I’m working on reducing the primary residence allocation. Hopefully I should get it down to 35% in the next few years and that 19% into taxable – then things would be a bit more balanced. That’s unfortunately what happens when you live in a HCOL area and your real estate appreciates quickly – if my condo hadn’t appreciated, it would only be 40% of my net worth. I’ve maxed out my pre-tax 401(k) for six years, Roth IRA for seven years and the Mega Backdoor Roth IRA for two.

  • Thanks PoF! This is one of the most helpful articles I’ve seen. It really helped me grasp the long term implications of taxable, tax deferred and Roth dollars.

    Mrs. G. and I were just looking at our buckets last night and many of the questions we had, you answered. We have 36% in taxable, 7% in Roth, and the rest in tax deferred. Oh, and a small amount in HSA that we will continue to add to. Our income is too high to effectively do Roth conversions yet, but we just set our FIRE date for early 2018, so we’ll work on that when our income is lower.
    Thanks again.

    • Those taxable dollars will come in handy after you FIRE, won’t they? It’s good to have available money while you make those Roth conversions and wait for them to “season” for five years.

      Cheers!
      -PoF

  • Aw man, I’ve been trying to ignore this and pretend like it’s all actually our money, not partly the IRS’s.
    We do think about this sometimes, but prefer to continue ignoring the tax implications AND ignoring our potential social security income. Hopefully it will be pretty much a wash and our taxes owed will be less than or equal to what we collect from social security.

  • Awesome post! You’re right that too often we simplify our savings to just one big number and don’t consider how much of that number is actually”ours”.

    Really cool perspective

  • Nice post, and great analysis! We’re in the same camp as Mr. Crazy Kicks in that most of our funds are in pre-tax accounts. However, like him, at our 33% tax rate, we felt pre-tax was better because our effective tax rate would be ~half of that or less, when we need those funds.

    That’s a main reason we don’t have much at all in a Roth. Taxes just seem too high right now. 🙂

  • Enjoyable post PoF! As someone who hasn’t always had 401k’s available during my career it’s refreshing to see another blogger not pooping on taxable dollars!

    We have roughly 60% of our net worth in taxable accounts. Over time, I hope to continue to add to my Roth accounts!

    Happy New Year!

  • Interesting thought process here, and definitely one that should be considered. I have about 40% in a roth, although that number will shrink now that my contributions all go towards a traditional 401k. I then have 50% in tax-deferred and 10% taxable. I’m currently focusing on growing my taxable accounts so I can reach FI faster.

    I do agree with you that roth dollars are valuable since they won’t be taxed again and have no minimum distribution rules, but it can be more costly to obtain those roth dollars. Many people will be in a lower tax bracket when they retire. The house is most likely paid off so there goes your biggest expense. Also, if you’re getting your retirement income from dividends and capital gains, you’re getting much more favorable tax treatment on those dollars. I racked up a lot of roth dollars early in my career when I wasn’t making as much money, but I fully expect to be in a lower tax bracket in retirement, so I’ve since cut off my roth contributions.

    Very interesting post. Thanks for sharing!

  • just a thought

    Don’t forget about state income taxes (or lack thereof). This can swing the analysis and advice drastically.

  • You give tax deferred accounts way too little credit. Not only do you get the upfront tax break ( especially useful if future tax law changes, like a new Roth IRA tax) but you get tax-protected compounding, arbitrage between your tax rate at contribution and withdrawal and significant asset protection. If taxable is Friday tax-deferred is at least Thursday afternoon. Monday dollars would be like earned income in your peak earnings years.

    • You make some great arguments for contributing to tax deferred accounts, and I contribute the max to every tax deferred account available to me, which is a 401(k), 457(b), and an HSA. The only Roth contributions I make are the personal and spousal “backdoor Roth” contributions. It’s great to make tax deferred contributions because you get a lot of value back right away – up to 50% or more depending on your marginal tax bracket. That is why the tax deferred dollars are worth less later on; you’ve already received a portion of those dollars back.

      In this post, I’m talking about the value of the dollars in your various accounts today. A net worth of $2 Million largely in a 401(k) or any tax deferred account has less value than $2 Million that is mostly in Roth and taxable accounts. It could be in the neighborhood of 20% less, which is huge for people making retirement decisions based on “The Number.”

      I can agree that current-year earned income that you haven’t yet paid tax on is worth even less, but I would never consider all of those dollars in my net worth calculation if I knew some of it belonged to the government. Yet that is exactly what many (including me) do when we calculate our nest egg including tax deferred accounts.

      Thank you for your thoughts!
      -PoF

  • Great post! I’ve always been wondering how US people aiming to live off of the 4% rule would consider their pre-tax money. Considering them at their 100% face value is a lie.

    I’ve done a similar analysis for Swiss situation and currently took into account my expected tax on my Tax Deferred Accounts.

  • Great post. I really enjoyed it. My feeling on HSAs is that, if you have the means, you should contribute the max each year but pay for health care costs from other funds until retirement. This will give you the maximum benefit of the tax deferral. Most estimate show that we will probably spend 200k to 300k on health care costs in retirement. I like to think of HSAs as Health Care IRAs that will be just as valuable as Roth dollars, but not until retirement.

  • Andrew S

    I enjoyed reading this post but it left me wondering if you are right on valuing taxable $ higher than tax deferred $. I get that you have to pay taxes at the ordinary rate on your IRA/401K $ but you get the benefit of compounding over many years without paying any taxes. Are you suggesting its not worth putting $ into your retirement plan?

    • No, No No. I should have been more clear in the post. See my response to WCI above.

      I’m talking about the value of dollars that you have today. You get a tremendous value for your dollar when you put it into a tax deferred account. You might get fifty cents back, and if you do, I suggest you invest that fifty cents in a Roth or taxable account.

      But you’ve already realized the biggest advantage of that tax deferred dollar. Yes, tax-free growth is nice, but those dollars and the growth will eventually be taxed like ordinary income. Your taxable dollars have already been taxed once, tax drag in a taxable account can be kept to a minimum (0.3% to 0.6% or less) and capital gains taxes and dividends can be realized tax free if you play your cards a certain way.

      Best,
      -PoF

  • GXA

    Great post. Thanks for the information.

    We are at approximately 30% roth thanks to a 2009 mega conversion, 25% tax deferred and 45% taxable.

    We are very comfortable with this mix, and as I have at least 3-5 more years of work prior to ER, the taxable and tax deferred with continue to grow relative to the Roth. The plan after ER to to fill up the lower tax brackets with serial roth conversions from a tax deferred account.

    Thanks for sharing your wisdom on your site!!

  • Although not the same structure in Canada, we keep most of our money in RSP (similar to a 401k) and the rest in our TFSA (similar to Roth) so all our investments are tax sheltered 🙂

  • Great refresher on the benefits of tax diversification. I like the days of the week analogy…. Monday dollars, hehe. Particularly ironic for the FIRE crowd because who cares if it’s Monday right?

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