Do you ever get the sense that you’re being forced to take more and more risk to earn a reasonable rate of return on your low-risk investments? If you do, you’re not alone.
I read recently that savers must take four times more risk in 2017 than they had to in 1985 to make a measly 5% return on their investments. Wow, that’s a bunch of risk to take for a small amount of return. Part of this is the result of the risk-free rate of return continuing to hover near zero. As you know, the risk-free rate of return is a theoretical rate of return of an investment with zero risk. As our parents headed towards retirement many years ago, the risk-free rate was much higher. Currently, even though the Federal Reserve has raised interest rates a bit recently, rates are still extremely low. Strangely, in what seems like a cruel twist of fate, every April taxpayers must give a share of their paltry returns to the Internal Revenue Service.
Do you want to keep the tiny amounts of interest you’re currently earning in your checking, savings, and money market investments?
If you’re vigorously shaking your head up and down and muttering “YES,” then keep reading. The sad reality is that many savers are unintentionally sabotaging their portfolios by having too much money in taxable accounts.
The Three Buckets Analogy
Let’s assume there are three types of accounts (or buckets) where all your money goes.
Taxable Bucket: Earnings are taxable each year (Savings accounts, checking accounts, traditional brokerage accounts, etc.
Tax-Deferred Bucket: Money is taxable when you take it out (401(k) accounts, IRAs, etc.)
Tax-Free Bucket: Money is no longer on IRS’s radar (Roth accounts, certain types of carefully created cash-value life insurance policies.)
Financial experts don’t agree on much. However, one concept with uniform consensus is that you should always have at least six months of income on hand in the taxable bucket for life’s unexpected expenses and emergencies. Yet in spite of the agreement of the experts, many people have much more in their taxable bucket than is necessary. Money in these accounts is often in low-interest investments such as savings, money markets, conservative bonds, etc. Ignoring the scenario of paying too much tax for a moment, remember that inflation will reduce your purchasing power over time at ultra-low rates of return.
You may be thinking, “Ok, then what can I do?”
You could invest in a Roth IRA. Those who have work wages, but don’t make too much money are eligible. It makes great sense to contribute to a Roth IRA. There are several reasons to love Roth accounts.
The tax-free nature of Roth accounts is a plus. Once money is placed in a Roth account, as long as laws stay the same, it will never be taxed again. Further, Roth accounts don’t figure into the calculation for Provisional Income, which determines whether or not your Social Security gets taxed. (Hint: You don’t want your social security taxed.)
By keeping more than you need in your taxable bucket, you are ultimately paying a (figurative) penalty. Interest rates are rising, which is a good thing for savers, but remain at historically low levels.
Imagine for a moment that you have $100K in a money market account. Even if you are only earning 1/2 of 1% or something similarly appalling, you’re going to pay tax on that interest each year. This adds insult to injury. If rates continue to rise, you’ll earn more interest, but you’ll also pay more tax.
So start moving some of that money into the tax-free bucket. Of course, there are limits to who can make a Roth contribution because a Roth account is a product for Main Street, not Wall Street. Unfortunately, if you earn too much, Roth accounts won’t be an option for you.
However, a Roth IRA allows cases where you can contribute for a non-working spouse and there are provisions that let you contribute more as you get older.
The bottom line is that Roth accounts should definitely be part of your race plan!
That’s just the way it works!