Shifting Savings Buckets

Let’s say you’re working and saving a prudent amount toward retirement. Good for you. Let’s say you’ve read Wednesday’s post about the maximum amount you can contribute to a tax-favored retirement plan. Let’s say the amount you’re allowed to contribute is more than the amount you’re adding to savings this year. If you’ve got a meaningful amount sitting inside an ordinary taxable investment account, you should consider shifting some of that to a tax-favored savings bucket to take advantage of its superior earning power (as discussed in January 28’s post)

Here’s a f’rinstance. Consider Ward Cleaver. He’s figured that he should be saving $10,000 this year, out of his $100,000 salary, which he’s doing through his employer’s 401(k) plan. Ward’s allowable maximum deferral this year (2009) is $22,000 (Ward is age 50). He has an ordinary taxable investment account with $75,000 in it. So Ward increases his deferral into the 401(k) plan by another $12,000 of his salary. To make up for his reduced take-home pay, he takes some funds out of his savings account. Actually, he withdraws less than $12,000. Because of the tax deduction, if Ward is in the 25% tax bracket, his take-home pay is reduced by only $9,000 as a result of the additional $12,000 deferral, so he only has to withdraw $9,000 from his investment account. Voila! Ward has taken advantage of the $22,000 maximum allowable tax-favored saving without reducing his spending by more than the desired $10,000 amount. Clever Cleaver!

But isn’t it imprudent for Ward to be spending down his savings? No, not necessarily. He’s not spending down his savings. What he’s really doing is indirectly shifting a piece of it from his taxable savings bucket to his tax-favored savings bucket.

The main things Ward has to consider are the restrictions he’s bought into with that shift. Is the superior earnings power of the 401(k) bucket worth the additional restrictions? Assets inside his taxable savings bucket are totally flexible. They may be invested and spent when and how Ward sees fit. But there are three main restrictions Ward’s buying into with the 401(k) plan: (i) He’s limited to investments offered by the plan. (ii) He can only gain access to the assets when the plan allows—perhaps not until after he leaves his company. (iii) And if he wants to spend the money before he’s 59-1/2, he may have to pay a 10% tax penalty for the privilege of doing so.

I think I need to devote a couple of future posts to a discussion of these restrictions. I’ll get back to you.

Ward weighed the pros and cons and opted for the superior earning power of the 401(k) plan over the flexibility of the taxable investment account. If he was saving that money toward his son Wally’s college education expenses over the next few years, he might not have done the same thing.