Video - Audio - YouTube (Material for this section begins on slide 9.)
There are many types of accounts. Once the major options are reviewed, for most investors, choosing an account is usually straightforward and easily accomplished without the need of professional assistance. However, depending upon the situation, an investor may have need of competent legal professional counsel from an attorney or professional tax advice from a Certified Public Accountant or IRS-certified Enrolled Agent. Registered representatives, commonly referred to as stockbrokers, are strictly forbidden from giving any legal or tax advice whatsoever, including about how an account should be established. If the account is for an individual with special needs or who is incapable of responsibly managing their money or if the sum is substantial, then it is imperative that an attorney should be consulted. Your particular situation also depends upon your state of residence. Go talk to the lawyers. Get a good referral!
In general, for the vast majority of retail investors who won’t need professional assistance in choosing an account, there are two major types of accounts that need to be reviewed. The first type consists of regular taxable accounts. They are also called regular accounts, taxable accounts, and non-qualified accounts. The second type consist of tax-qualified accounts such as retirement accounts, educational savings accounts, and health savings accounts.
Regular Taxable Accounts Versus Tax-Qualified Accounts
Unless the investor specifies otherwise, the brokerage firm will assume that the investor wants a regular taxable account. With a regular taxable account, each year an investor will receive one or more Forms 1099. The Form 1099 is used to report taxable income such as dividends, interest, or capital gains. The investors will need to include the information from the Forms 1099 on their tax returns and pay any applicable taxes. With regular taxable accounts, there are no limitations on how much can be contributed. There are also no limits on the types of investments that can be placed in regular taxable accounts.
Tax-qualified accounts, on the other hand, are accounts that allow the investor to either defer or forgo paying taxes. Tax-qualified accounts are also referred to as tax-advantaged accounts. There are numerous types and variations of tax-qualified accounts. Examples include retirement accounts, educational savings accounts, and health savings accounts. We will concentrate on the retirement accounts. However, many of the concepts and attributes are similar in other types of tax-qualified accounts. With a tax-qualified account, there is typically a limit to how much can be contributed in any one year. There are also restrictions on what types of investments can be placed into the accountants. However, unlike a regular taxable account, a tax-qualified account investor will not receive the Form 1099 each year unless money is withdrawn. Your account is able to grow tax-deferred or in some cases, tax-exempt. (Careful! The IRS does not like the term tax-free.)
The two cylinders in the graphic above are meant to resemble bins or buckets. The taxable account bin on the left can accept all types of investments, stocks, bonds, mutual funds, short-term “cash” investments, real estate, as well as exotic vehicles such as options and futures and allow for buying on margin and selling short. Notice that with the bin on the right, the only types of investments that are accepted are stocks, bonds, mutual funds, and short-term investments. (Actually, there is a way to place real estate and some forms of precious metals into a tax-qualified account but it is not recommended. Both can result in a tax-related financial disaster if one is not careful.) Although there are many other subtle and not-so-subtle differences, the major differences are how they are taxed by the IRS, how much money you can contribute, and what you can have in the account. Let’s investigate the two major forms of tax-qualified retirement accounts, pre-tax and post-tax.
Pre-tax Tax Qualified Accounts
Pre-tax qualified retirement accounts are also referred to as before-tax accounts. The contributions that go into the account reduce your income taxable and give you a tax break now. Examples include the Traditional IRA, 401(k) and 403(b) employer-sponsored plans, and the SEP-IRA, SIMPLE IRA and Keogh plans for small businesses and the self-employed. The contributions are deducted from your taxable income which reduces the taxes you pay. The investments grow tax-deferred until retirement. When the investor money is withdrawn in retirement, the investor pays the income tax.
The most popular personal retirement plan is the IRA, now referred to as the Traditional IRA to differentiate itself from the newer Roth IRA. Although everyone believes that IRA stands for Individual Retirement Account, the acronym actually stands for Individual Retirement Arrangement. Of course, if you use the correct name, Individual Retirement Arrangement, most everyone will look at you funny. Just say IRA.
Currently, anyone with earned income can contribute to a Traditional IRA. There is some confusion because of some of the provisions that will be discussed momentarily and because their counterpart, the Roth IRA, has restrictions on contributing for high-income individuals. However, as the tax code stands now, anyone with earned income, no matter how high, can contribute to a Traditional IRA.
Traditional IRA contributions are normally pre-tax deductible contributions that reduce your taxable income and thus give you a tax break now. This is where some of the confusion we mentioned above starts to emerge. If you have an employer-sponsored retirement plan at your place of employment and make over a certain amount, then your contributions are still allowable. However, your contributions may not be allowable as pre-tax contributions. They would be designated as post-tax contributions. You would not get a tax break now on the contributions. Of course, when those contributions are withdrawn, you would not have to pay taxes again on them. This means you will need to keep tabs on how much of your balance is pre-tax and how much is post-tax. You don’t want to pay your taxes twice! Save all your end-of-year statements.
In any event, whether funded with pre-tax or post-tax contributions, your investment grows tax-deferred. You pay taxes on the money as you withdraw it once you are retired. Once an investor reaches 59½ years of age, withdrawals are allowable with no penalty. Mandatory withdrawals, called Required Minimum Distributions or RMDs, now begin at age 73, up from 72 and 70½ before that. There are discussions about ultimately raising the age for Required Minimum Distributions to 75. This makes sense since as we have mentioned, people are living and working longer. The penalties for not taking the RMDs are severe, 50% of the amount that should have been withdrawn. What a way to treat old folks!
The Traditional IRA has many pre-tax siblings and cousins. There are numerous types of employer-sponsored retirement plans such as the 401(k) for corporations and other private businesses. For public organizations such as schools and hospitals, there are 403(b), 457, and 401(a) employer-sponsored retirement plans. For the self-employed and small businesses, there is the SEP IRA, the SIMPLE IRA, the Solo 401(k), and the Keogh retirement plans. You may be asking, “Where do these silly names come from?” The answer is the United States Internal Revenue Code, all 70,000 pages of code and regulations.
A pre-tax contribution lowers your taxes now. The table below shows what happens when you have $100 deducted from your paycheck and contributed into a 401(k). The tables assumes you are in the 25% Federal marginal tax bracket and 8% California marginal tax bracket.
|You contribute via your paycheck:
|Your Federal tax withholding is lowered by:
|Your California tax withholding is lowered by:
|Total government subsidy:
|Your take home pay is only reduced by:
Your take home pay is only reduced by $67 but the whole $100 still goes into your account. In addition, your employer might match your contribution 50% or 100%. If your employer matched your contribution at 100%, then they would contribute an additional $100 into your account. dollar for dollar. Cool! I get $100 or maybe even $200 worth of investments for only $67. Okay, so what’s the catch?
You pay income tax on any amounts withdrawn in retirement. However, people in retirement are usually in a lower tax bracket. If you are not in a lower marginal tax bracket in retirement, congratulations! It is my sincerest desire that all our students and readers are afflicted with the horrible misfortune of taking considerable amounts of money from their retirement accounts in their golden years.
Of course, if you withdraw the funds before retirement, you not only have to pay the income tax, you normally will be required to pay a 10% penalty. (The IRS does not call it a penalty; they call it an additional tax. Whoopee.) With some types of accounts, there are exceptions for first time home purchases, higher education expenses, medical disability, and financial hardship. It is typically difficult to get the IRS to accept the financial hardship exception. Some 401(k) and 403(b) plans do allow an individual to borrow from their account. However, the amount must be paid back in an approved amount of time or the loan will be disqualified and ruled as a withdrawal. Plus, if you lose your job, the loan becomes due quickly, typically within 90 days. In general, whatever monies you put into your pre-tax accounts should be considered to be set aside until retirement.
Some individuals may balk at the idea of setting aside money that will not be touched for upwards of 40 years. However, the traditional pension plans that employers used to offer their employees are being replaced with so-called defined contribution plans such as the 401(k) and 403(b). In the traditional pension plans, the employers would set aside funds for their employees for many decades. Now it is up to you. The good news is if you invest consistently, prudently, with an eye toward long-term growth of capital and income, you will be able to create for yourself a pension that will far exceed what the traditional pension plans offered. On the other hand, if you don’t contribute consistently, or get greedy when the markets zoom ahead and chase after the next big thing, or panic when the markets fall and sell everything, well, then your retirement won’t look so rosy. But we know you won’t be guilty of those terrible transgressions, right?
Post-tax Tax Qualified Accounts
Starting in 1998, a new type of tax-qualified retirement account, the Roth IRA, came onto the scene. A Roth IRA is a post-tax account, also referred to as an after-tax account. The Roth IRA does not give you a tax break now. Instead, your contributions are taxed as normal income. However, in retirement, all the contributions and compound earnings in the account can be withdrawn tax-free. (Ooops! Sorry, IRS. We meant to say, “tax-exempt.”) This ability has since been added to 401(k) and 403(b) plans. Tax-free in retirement is a tremendous benefit.
Let’s revisit the same $100 monthly contribution, but this time with a Roth IRA.
|You contribute to a Roth IRA:
|Your Federal tax withholding is lowered by:
|Your California tax withholding is lowered by:
|Total government subsidy:
|Your disposable income is reduced by:
As you are explaining the Roth IRA to a family member or friends, they exclaim, “What? No help from the government on your taxes? Why would anyone contribute to a Roth IRA?” Here’s the answer you will give them, “Because a Roth IRA is so cool!” Tax-free in retirement is a golden opportunity. No other investment account option comes close. Eventually, I believe that they will probably be gotten rid of or have severe constraints put on them. From time to time, there is talk about limiting the benefits of a Roth IRA, especially for high-income investors.
Another major benefit of the Roth IRA is that you can withdraw the contributions at any time without taxes or penalties. You have already paid tax on the contributions. This makes the Roth IRA also an excellent intermediate-term investment account. You can use it for the down payment of a house or other high-ticket item. They are great for college expenses since currently the monies in a Roth IRA are not taken into account when you apply for public financial aid using the FAFSA form. (Some private universities do take Roth IRA monies into account when calculating financial aid.)
However, the Roth IRA was not meant for everyone. Unlike the Traditional IRA, there are limits on who can contribute to a Roth IRA. Only single taxpayers with an AGI of $138,000 or less in 2023 and married couples with an AGI of $218,000 or less in 2023 can fully contribute to a Roth IRA. After you earn over these amounts, the amount you can contribute is lowered until it phases out entirely. If you don’t qualify, congratulations!
As is the case with our tax system, there is often a loophole. You can still contribute to a Roth IRA anyway. If you already knew you earned over the limit or if it turns out you find that you have earned over the limit, you can “recharacterize” ‒ that’s the verb that the IRS uses ‒ the contributions into a Traditional IRA which does not have the same limitations before you file your taxes and then you convert the Traditional IRA back into the Roth IRA. It is called the Roth IRA Backdoor. I know. I know. Who voted for these bozos? Oh, yeah. We did.
Contribution Limits on Retirement Accounts
Tax-qualified accounts typically have yearly contribution limits. The limits increase with inflations. Here are the contribution limits for 2023 for the Traditional IRA and Roth IRA. Note that these limits are cumulative. You can contribute to multiple Traditional IRAs or Roth IRAs but the total contributions in all your accounts must not exceed these amounts.
|Age 50 and Over
For the Traditional and Roth IRA, contributions are limited to the lesser of your gross salary or the maximum yearly contribution. If you make at least $6,500, you have until April 15th of 2024 to put the maximum into an IRA or Roth IRA for 2023. Your spouse is also eligible for contributions even if he or she does not work. The contribution limits are raised from time to time because of inflation.
The contribution limits for 401(k), 403(b), and 457 employer-sponsored plans are much more generous.
|Age 50 and Over
Again, contributions are limited to the lesser of your gross salary or the maximum yearly contribution. In other words, in 2023, if you make $22,500, you could put your entire income into a 401(k) or 403(b) or 457. As noted above, these amounts are now indexed to inflation and go up over time. There is a loophole in the law that allows those in the public sector to contribute $22,500 into both a 403(b) and a 457 – or $30,000 into both if you are 50 or over!
The Roth 401(k) and Roth 403(b)
Starting in 2006, employers were able to offer the Roth option for their 401(k) and 403(b) plans. Similar to a Roth IRA, Roth 401(k) and Roth 403(b) contributions can be made post-tax. However, any monies matched by your employer continue to be pre-tax contributions. This means you must keep good records of how much is pre-tax and how much is post-tax. You don’t want to be taxed twice on the post-tax contributions! This is a great option for those who do not need the tax break now. However, unlike the Roth IRA, contributions are not able to be withdrawn without penalty or taxes until retirement. Unless your employer offers matching contributions, Your Humble Author prefers the Roth IRA because of its flexibility as an intermediate-term account. Of course, if your employer offers matching contributions, the Roth 401(k) or Roth 403(b) is the winner. Never turn down free money, Dear Readers!
Tax Credits for Retirement Savers
Retirement savers may be eligible for tax credits. A tax credit is a dollar-for-dollar reduction of income taxes. The tax credit amounts range from 10% up to 50% of your contributions with a maximum of $2,000 per individual. The tax credit is based upon how much you contribute and your Adjusted Gross Income (AGI). If your Adjusted Gross Income is below these amounts for 2022, you should be eligible for the tax credit:
- $36,500 or less – single filers
- $73,000 or less – married filing jointly
- $54,750 or less – head of household
There are some other restrictions. You must be at least 18 years old, not be a full-time student, and not be claimed on someone else’s tax returns as a dependent. If you are eligible, then, for example, $50 per month contributed to a Roth IRA for a total of $600 per year could result in a $300 tax credit. That is a strong motivation to contribute. If you do your own taxes, do not forget this. If you have someone do them, make sure to tell them you put money away in a retirement account. Tax software programs such as TurboTax or TaxSlayer handle these well.