Sunday, September 02, 2007

Should I add to taxable savings or a Roth retirement plan or pay down back taxes?

My financial situation is still not out of the woods since my personal bankruptcy a little less than two years ago, but now I occasionally have the luxury of worrying what to do with "extra" money. I have a fairly detailed budget that I not only stick to, but try to underspend wherever possible every month. One question keeps popping up: For every "extra" dollar I stumble across, where should I target it?

I currently have five "places" I can target "extra" money:

  1. Park it in my interest-bearing Fidelity "checking" account as a buffer against lumpy expenses. It does earn less interest there which is taxable, but gives me a  deeper buffer so that I can more trivially handle any unexpected or lumpy expenses that make a big hit on my budget in a short period of time such as trips.
  2. Park it in my rainy-day fund so that I have even greater security if I should find myself without work for an extended period of time. This does earn a higher rate of interest, albeit still taxable. I already have about fourteen months of expenses covered by my current rainy-day fund, so growing this fund is not an urgent priority.
  3. General savings for discretionary expenses. Maybe someday I might buy a house or a yacht (yeah, really) or go back to school (yeah, right) or whatever or simply have an extra cushion going into retirement. This also earns a higher rate of interest, but is taxable.
  4. Raise my contribution to my Roth retirement plan, either my company Roth 401k or my personal Roth account. This is clearly a great choice for long-term retirement savings and incurs no taxes, but it effectively precludes re-targeting of these funds at a later date should I have need for them unless I am willing to pay a asignificant penalty. Basically, I need to decide in advance that I really will not need to even think about touching this money until I start taking distributions in retirement.
  5. Pay down my lingering IRS back taxes more aggressively. Currently charging about 10.5% interest, clearly this is the best target from a raw finance perspective, but money targeted here absolutely cannot be re-targeted at a later date.

Although paying down my back taxes is clearly the best option financially, it has several disadvantages:

  1. It just doesn't feel like I am adding to my "savings". Sure, I have a Net Worth spreadsheet in which a decline in back taxes is a positive contribution to my net worth, but the "savings" simply doesn't feel tangible.
  2. A reduction in back taxes doesn't really increase my financial flexibility since in a pinch I can simply call the IRS and tell them the bad news and renegotiate a new installment plan.
  3. With cash in a rainy-day fund and savings, I can intuitively grasp how much "rope" I have left, whereas a reduction in back taxes doesn't give me any visible "rope" to grasp.

Over the past 21 months I have manages to pay down over 40% of my back taxes. That seems like a reasonable pace. Accelerating that pace has some psychic advantages, but the skimpiness of my "life" savings doesn't make me feel that much better off.

I had been paying down back taxes with a much larger than required monthly payment last year, but I cut back to only modestly more than the negotiated installment plan payment so that I wouldn't run into budget shortfalls whenever I took a trip.

Note: I currently put 15% of my salary into the company Employee Stock Purchase Plan (ESPP) and I keep that stock for the long-term. Technically this is "savings", but since I think of it as long-term, effectively none of it is available for any short-term needs.

So, here are my priorities at this time as far as any extra money:

  1. If I get a raise:
    1. At least 25% of that monthly increment will go a larger payment to the IRS for back taxes
    2. At least 25% to increase in my contribution rate for my company Roth 401k retirement plan
    3. 25% towards general savings
    4. The remainder as an extra monthly payment on my IRS back taxes
  2. If I get some other windfall of cash:
    1. At least one-third as an extra payment on IRS back taxes
    2. One-third as a contribution to my non-401k Roth retirement account
    3. Up to one-third as general savings

That is my overall best stab at a reasonable approach to targeting any "new" money I may stumble upon.

I won't say that this is my final plan, but it is my straw man plan for now that at least gives me something to benchmark other ideas against.

-- Jack Krupansky


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