Roth-ificate Your Savings Buckets

Remember Ward Cleaver from yesterday’s post? What he did was to shift money from an ordinary taxable investment account into a tax-favored retirement account. He did that by increasing his tax-deductible savings up to the maximum amount available to him. Today’s post discusses another way to shift assets from a taxable savings bucket to a tax-favored savings bucket. Roth-ificate your retirement account. If you’re allowed to.

If you have assets in a taxable investment account, using some of those assets to pay the income tax cost of converting your tax-favored savings to Roth savings is very much like shifting assets from a taxable savings bucket to a tax-favored one. Just like what Ward did in yesterday’s post.

That last statement is so counter-intuitive as to be, frankly, incredible. Am I saying that paying extra income tax is like adding more to your retirement plan? Yes I am. I alluded to this already in January 15’s post. In today’s post I’ll provide a more concrete example to show how it works.

Consider Ward from yesterday’s post. He’s planning to defer $22,000 into his employer’s 401(k) plan, and he has $66,000 in a taxable savings account. (He had $75,000, but yesterday he figured it would shrink by $9,000 to increase his planned 401(k) contribution to $22,000.) It’s early in the year, and he hasn’t contributed any of the $22,000 yet. Before he does, he’s considering making the contribution on a Roth basis, which his 401(k) plan allows. Ward figures that at his 25% income tax bracket, it will cost him $5,500 more income tax to do this (= 25% x $22,000). Which will leave him $60,500 in his taxable account. Ward figures this $5,500 expenditure is financially equivalent to turning his $22,000 contribution to a $29,333 contribution (= $22,000/(1 – 25%)). So he decides to Roth-ificate his 401(k) contribution. They don’t call him Clever Cleaver for nothing!

To see how paying taxes is like adding to tax-favored saving (incredible!), consider the following: Yesterday, we figured it would cost Ward $9,000 from his taxable account, after paying income tax, to increase his traditional pre-tax 401(k) contribution by $12,000. Had he been allowed to increase it to $29,333 (a $19,333 increase over his $10,000 planned contribution), by the same reasoning his taxable account would have been reduced by $14,500, to $60,500. So his taxable account is the same whether he Roth-ificates his $22,000 contribution, or hypothetically increases a pre-tax contribution to $29,333. But what kind of annual retirement benefit do these two different contributions get him? To see that, look at the chart on the bottom of this post. They’re the same! Ward can effectively shift more savings from a taxable environment into the shelter of a tax-favored environment!

This example explains why it's simply wrong to base your Roth-ification decision solely on a comparison between today's income tax bracket and your projected future tax bracket. In fact, there was just a short-sighted statement to that effect in an article in yesterday's New York Times. In a future post, we'll explore how this effect can easily justify paying a higher tax going in than you save going out!

Roth-ification only works this well if you pay the income tax cost with dollars that are outside your retirement account, i.e., either out of your current salary or from an existing taxable investment account. And it only works, of course, if you are allowed to Roth-ificate your retirement savings. More on that tomorrow.