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Last week, I came across a very interesting post over at physicianonfire.com about the value of money. Physician on Fire, or PoF as he likes to call himself, correctly pointed out that some money is more valuable than others. Here’s how he summed up this crucial point.
“If you’ve been earning and investing for a while, 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.”
And as I read the rest of PoF’s post and marveled at how the concept of unequal money had heretofore eluded me, I began to feel a bit uneasy. Up until I read this post, I used to look at our portfolio and assume it was all ours. But that assumption was an appalling fiction. Some of our money is in accounts that we own exclusively, and some of it is in accounts that we share ownership with the government (i.e., the money in these accounts is taxed).
So how much of our portfolio does the government own? Is it 10%? 20%? Gulp, 30%?!
To find out, I delved into our portfolio using PoF’s superb value of money analysis as a guide.
Here we go.
How Much of Our Portfolio Do We Really Own?
In PoF’s value of money post, he ranks the value of money based on the account type. Money in accounts with less tax exposure, and thus less marred by co-ownership with the government, is deemed more valuable than money in accounts with more tax exposure. Here are his rankings from most valued to least valued.
Roth IRA Dollars: Money in a Roth is tax free when it comes to dividends, capital gains, and withdrawals. This is the most valuable money to have. No government taxation = no government ownership.
Health Savings Account Dollars: Money in an HSA, like a Roth, is tax free when it comes to dividends, capital gains, and withdrawals. There’s one important caveat, though. Withdrawals are tax free as long as they are used for healthcare. If they’re not, they’re taxed as regular income. Because there is a slight possibility that the government might be entitled to some of this money, it is ranked below Roth money.
Taxable Dollars: For our purposes, there are two kinds of taxable dollar accounts: savings and brokerage. Money in savings accounts is subject to income taxes (yes, interest is considered income). Money in brokerage accounts is subject to dividend and capital gains taxes. Fortunately, money in neither a savings account nor a brokerage account is subject to a tax when it is withdrawn. According to PoF, this is the second least valuable money to have. Any time interest, a dividend, or a capital gain is derived from money in a taxable dollar account, it’s time to pay for the cost of civilization.
Tax Deferred Dollars: Money in traditional IRAs, rollover IRAs, and workplace retirement accounts (401(k) and 403(b)) is not subject to dividend and capital gains taxes. It is, however, subject to regular income taxes once it’s withdrawn. This is the least valuable money to have. Any time you take money out, the state and federal governments get a cut. And depending on where you live and what your tax bracket is, that cut could be substantial.
And here’s what the Groovy portfolio looks like according to PoF’s money rankings.
| Money Type – Ranked Most Valuable to Least Valuable | % of Portfolio | Tax % on Dividends/Interest | Tax % on Capital Gains | Tax % on Withdrawals | True % of Portfolio Ownership |
|---|---|---|---|---|---|
| Roth IRAs | 17.42 | 0 | 0 | 0 | 17.42 |
| HSA | 1.09 | 0 | 0 | 0 | 1.09 |
| Savings | 10.48 | 15.75 | 0 | 0 | 10.48 |
| Brokerage Accounts | 39.42 | 15.75 | 5.75 | 0 | 38.29 |
| Rollover IRAs | 31.59 | 0 | 0 | 20.75 | 25.04 |
| 100 | 92.32 |
At first blush, the Groovy portfolio looks a little troublesome. Only 18.51% of our money is in accounts with the most favorable tax exposure. Over 80% of our money is in accounts with the least favorable tax exposure. And, horror of horrors, over 31% of our portfolio is in an account with the harshest tax bite. Ouch!
But upon further review, the Groovy portfolio holds up remarkably well. Thanks to being in the 10% tax bracket, we own a little more than 92% of our portfolio. The government owns a little less than 8%.
Let’s see how I came to this determination.
How I Determined the Government’s Ownership of Our Portfolio
Before I determined the government’s ownership, I made three assumptions regarding our brokerage and rollover IRA accounts. Here they are.
- We will never generate a capital gain in our brokerage accounts that is large enough to trigger a federal capital gains tax.
- We will never withdraw money from our rollover IRAs until we’re 59½.
- We will never withdraw enough money from our rollover IRAs to push us into the 25% tax bracket.
Okay, with these assumptions in mind, here’s how I determined the government’s ownership of our portfolio.
Roth money. This was easy. No taxes on dividends, capital gains, and withdrawals. The government has no claim on any of this money. Its ownership is zero percent.
HSA money. Again, easy. Because our HSA money is such a small amount (only 1.09% of our portfolio), it’s safe to say this money will only be used for healthcare in the future. The government will therefore have no claim on any of this money. Its effective ownership is zero percent.
Savings account money. This money generates very little interest, and the taxes on this interest is so trivial, it’s fair to say the government has no real claim on any of this money. Its effective ownership is zero percent.
Brokerage account money. This money generates roughly $10K a year in dividends. Again, the combined federal and state tax on these dividends ($470) is so trivial, it’s almost fair to say the government has no real claim on any of this money. And I say almost because unlike our savings account, our brokerage account money is subject to a capital gains tax.
The capital gains tax makes things very complicated. At the federal level, it’s highly unlikely that we will ever pay a capital gains tax on this money. Why? Because as long as our taxable income plus our capital gain is less than $75,900 (the top of the 15% tax bracket), the federal tax on this capital gain is zero. Right now, we have about a $65K spread between our taxable income and $75,900 threshold. In fact, if we sold every stock and bond fund in our brokerage accounts right now, we would realize a capital gain of about $30K. Well below the $65K spread.
At the state level, however, capital gains are treated like ordinary income. So if we sold a portion of a stock or bond fund and realized a capital gain, we would owe North Carolina 5.75% of that gain. Again, however, there’s very little capital gain potential in our brokerage accounts right now. But let’s say half of what we ever sell from our brokerage accounts is a capital gain. This would then mean that North Carolina owns 2.875% of our brokerage accounts. But since our brokerage account money is only 39.42% of our portfolio, North Carolina effectively owns 1.13% of our portfolio.
Rollover IRA money. We’ll make this simple. Even though some of the money taken from this account will face a 10% federal income tax, most will face a 15% tax. So we’ll just say any money taken from this account will incur a 15% federal income tax. Add to this the 5.75% North Carolina income tax, and any money withdrawn from this account will be hit with a 20.75% combined income tax. The federal government and North Carolina effectively own 20.75% of our rollover IRAs. But since our rollover IRA money is only 31.59% of our portfolio, the federal government and North Carolina combined own an additional 6.55% of our portfolio.
What Percentage of the Least Valuable Money Should Be in Your Portfolio?
Whew! That hurt.
Making reasonable assumptions about future withdrawals from our brokerage accounts and our rollover IRAs, and then using those assumptions to gauge the overall tax liability of our portfolio was freakin’ hard. Too many damn variables. And don’t forget, my analysis didn’t consider future Social Security payments and the oodles of money (haha!) this blog will soon be earning. Throw those two money streams into the picture, and the extent of our portfolio’s tax liability becomes even more complicated.
So what’s the takeaway? How much of the least valuable money should be in your portfolio?
If you’re going to be in the 10% or 15% tax bracket in retirement, try to keep your traditional and rollover IRA money to a third or less of your portfolio. Do that and you’ll be in good shape. You’ll own roughly 90% of your portfolio.
If you’re going to be in the 25% tax bracket or higher in retirement, try to keep your traditional or rollover IRA money to a quarter or less of your portfolio. PoF, for instance, has 17% of his portfolio in traditional or rollover IRA money. Failing to abide by this guideline will likely cede too much ownership of your portfolio to the government.
Final Thoughts
Okay, groovy freedomists, that’s all I got. How much of your portfolio do you really own? What percentage of your portfolio is comprised of PoF’s least valued money? And what do you think about my traditional and rollover IRA money guidelines? Is keeping this kind of money to a third of your portfolio or less a reasonable goal? I’d love to hear your thoughts. Peace.
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