[Today’s focus is on retirement investment accounts. I will create a future post for other investment accounts like 529 Plans, UTMA’s, and ABLE’s. Additionally, the terms pre-tax, traditional, and tax-deferred will be used interchangeably. Please note the website disclosure statement]
The ABCs of Retirement Investment Accounts: A Beginners Guide to Traditional or Roth, IRA or 401(k), Taxable or Tax Preferred Accounts
Have you ever wondered if there was an instruction manual that covered investment accounts for retirement savings? Something that you could easily read and get the basic gist of things? Well, then today is your lucky day! I will outline the different types of retirement investment accounts and how they work through today’s post!
Now to discuss investment accounts, we must start with the basics: There are two types of retirement accounts in Uncle Sam’s eyes: Tax Preferential and After-tax accounts (i.e., non-tax preferential).
Tax Preferential accounts have two primary flavors: Tax-deferred and tax-upfront accounts, which commonly are referred to as pre-tax or traditional, and Roth. With pre-tax accounts, you make a contribution that is deducted from your income (whether through your paychecks or on your tax returns). With these traditional accounts, you make contributions that you have not paid taxes on. They grow without taxes incurred (i.e., they stay tax-deferred) up until the time you withdraw them.
The second type of preferential tax account is the Roth flavor, which, when used, requires you to pay your taxes now. However, your money is then allowed to go into the account, and in exchange for giving Uncle Sam his cut upfront, he won’t tax you when you take it out. Now that is what I call a sweet deal!
To further illustrate these concepts, I now introduce the three Ds:
Deductions, Deferrals, & Dues
Deductions and deferrals relate to tax-deferred accounts. The fact that you get to deduct money from your taxable income now, paired with the ability to defer the gains until later, makes these outstanding accounts for tax purposes. Trade as frequently as you like (though you probably shouldn’t)!
For Roth accounts, you pay your dues (i.e., taxes) upfront, and then you can invest and trade however you want and never worry about taxes again.
Hence the three D’s save you the burden of dealing with taxes whenever you receive dividends, interest, or trade within your account. [Check out these articles if you need a refresher on dividends, interest, or gains]
How do you choose between tax-deferred and Roth? Simply put with tax-deferred accounts, you are betting that your tax rate will be lower in retirement. With Roth accounts, you are betting your tax rate will be higher in retirement. Do you know the answer to this question? Some people will likely be able to deduce this to a certain degree, but no one will ever know unless they have a crystal ball. Why do I say this? Well, it is because the wild card at play is that the government can and may change our tax rates down the road; thus we will never know! Now this doesn’t mean that we cannot make an educated guess, which is the topic for our next post! [Link]
You now know the fundamental differences between the two significant types of preferential tax accounts, so what about non-tax preferential accounts? Well, the name after-tax may be misleading when it comes to taxes, but we will get that later! So let us start with the basics first.
Tax non-preferential accounts are most commonly referred to as (non-retirement) brokerage accounts. Simply put, whatever you do in these accounts will be taxed during that year. How does this work?
When putting money into an after-tax account, you must first pay your taxes on these dollars, hence why it is called an after-tax (see the play on words?). In addition to paying taxes on these monies upfront, you create a reportable tax event whenever you trade within this account. Translation: If you make money, you owe taxes. If you lose money, you write it off on your taxes. The same applies to dividends and interest payments, too. These are just another fancy way of saying the word gains, and you will owe taxes on them in the year they are received.
Who in their right mind would invest in an after-tax account then when you do not get a tax deduction, deferral, or tax-free guarantee in the future? I’m glad you asked, and the answer is simple: Everyone. Why? Preferential tax accounts have limits and rules that govern them, making them more restrictive when depositing and withdrawing your money from them.
It sounds like a list is to highlight the benefits of after-tax accounts is in order:
•No limit on how much money you can save each year
•No penalty for withdrawing your money, ever
•Dividends are always taxed as long-term capital gains, which can be a lower tax rate
•Investments held for 12 months or longer are taxed as long-term capital gains
•Losses are deductible on your tax return
Sounds pretty great, right?
Well, you likely are now wondering about the rules and limits that govern preferential tax accounts. I agree that this is in order, but rather than a list, let’s talk about the actual account types and then cover the rules and restrictions since they vary. Once done, I will consolidate everything into a list just as I did above!
Employer & Individual Tax-Deferred/Roth Accounts
401(k) & 403(b) Accounts
Employer preferential tax accounts are referred to as employer-sponsored retirement plans or defined contribution plans. These are boring names, though. You most likely know them as 401(k) and 403(b) accounts, and the chances are high that you have one! These fun names, 401(k) and 403(b), come from subsections in the tax code known as sections 401(k) and 403(b). These two subsections established the ability for preferential tax accounts to be created by for-profit and non-profit firms. Many companies did this so they could move away from offering pensions.
Whoa, who knew the tax code could be so exciting! Alright, jokes aside, these employer-sponsored accounts have substantially higher contribution limits than their individual tax-preferential counterparts.
For people employed by firms offering these that are under the age of 50, they can put up to $22,500* each year into these accounts on either a pre-tax or Roth basis (or even a combination of both up to that amount). Additionally, for those 50 and above, this amount goes up by an additional $7,500* a year for a staggering $30,000* in total. Notably, company match does not factor into these limits; it is considered separate.
Okay, but what about people who do not have an employer-sponsored retirement account or are already maxing one out? Enter the many individual tax preferential retirement accounts: (The) Traditional & Roth IRA, HSA & more!
Commonly abbreviated as IRA, the Individual Retirement Account comes in the tax-deferred/pre-tax flavor known as the Traditional IRA. It also comes in the one-time, upfront tax flavor known as the Roth IRA. Now, these accounts have a combined annual limit of $6,500* that you can contribute to in any combination of traditional and Roth. Plus, for those aged 50 or older, the limit raises by $1,000* in either format; it
pays saves to age!
Now we could spend an entire article discussing the differences between the 401(k) and IRA account types, but I already have created a post on that, which you can access here if you need help choosing between them [Link].
As with anything in life, there are caveats. In the case of 401(k) and IRA accounts, if you make too much money in the eyes of Uncle Sam, then there are restrictions. These include not receiving traditional IRA deductions, being able to directly contribute to a Roth IRA, and or being allowed to contribute to your 401(k). More frequently, this applies to traditional and Roth IRA accounts. If it affects you in your 401(k), you will know (trust me).
Quick cheat sheet for caveats of 401(k) & IRA accounts:
•401(k) Bad news: You are considered a Highly Compensated Employee, and you are restricted by how much you are allowed to contribute to your company’s 401(k) plan (You will know if you are an HCE employee)
•Traditional IRA bad news: You make over $73,000*, AND you have an employer that offers a 401(k) or 403(b). You do not get to take a deduction when your money goes into your traditional IRA. Any growth stays tax-deferred, but you lose the deduction advantage. You also have to file a form each year that tracks your amounts of nondeductible IRA contributions and their deferred tax growth. Can you say ick! No one likes government forms, no one. If you are married, the limit is $116,000 for the spouse(s) that has a 401(k)
•Roth IRA bad news: You make over $138,000*. Sorry gals and guys, but you cannot contribute to a Roth IRA. Well, not directly 🤐😉. A caveat for a caveat?! Caveat-inception. Additionally this limit raises to $218,000* for married couples. [To learn more about Backdoor Roth IRA Contributions, click here]
•If you withdraw from any of these accounts before 59.5, you will pay a 10% penalty to the IRS.
For a complete list of IRA contribution income limits, please visit the IRS website. These limits actually start to phase out before being fully disqualified, but that is something the IRS covers; my purpose is to explain the basics!
Other Individual Accounts
The HSA, i.e., Health Savings Account, is what some in the finance and tax industry refer to as the retirement super account. Why is this? Because the HSA takes tax preferential and puts it on steroids!
Contributions go into an HSA tax-deferred. They then grow tax-deferred. Finally, so long as used for medical expenses at any point in your life, they are 100% tax-free when taken! This occurs even if you don’t have an HSA eligible health insurance plan any longer.
Whoa, Nelly! Hold onto your horse there, hotshot!
As you can tell, I love the HSA account but let’s lay down the facts:
•Anyone can open an HSA account
•To contribute to an HSA, you must have a high deductible health insurance plan (HDHP for short) during the year in which you make a contribution
•You do not need to have an HDHP when you use funds or to maintain an HSA
•The annual limit is $3,850* for individuals and 7,750* for families
• Add an extra $1,000* if you are over 55
•If your spouse is on your HDHP, and is over 55, they can contribute $1,000 to their own HSA account (which will be covered in my future HSA post)
•HSA contributions that come directly out of your paycheck do not have FICA or Medicare taxes withheld, saving you an instant 7.5%; no other account offers this, period
•In NJ & CA, there are exceptions to the deferred tax growth. If you live in either, I highly recommend you read up on it this subject or ask me to explain it in the comments below or in a future post
Now, if you are thinking to yourself, “But Mile High Finance Guy, I won’t have healthcare expenses in retirement!” Sure, you won’t 🙄. Jokes aside, if you somehow manage not to have medical expenses in retirement, once aged 65, funds can be withdrawn without penalty. Instead, you only pay income taxes since you are taking funds out for non-medical purposes. Now, if you want to withdraw before 65 for non-medical expenses, you can, but you will pay taxes plus a staggering 20% penalty. So don’t do it!
Self Employed Accounts
In addition to the HSA, the SEP-IRA and Self Employed 401(k) accounts exist for entrepreneurs. These accounts work similar to their standard counterparts mentioned above but have different contribution limits and finer nuances. Since most people do not fall into this category of self-employed, we will not cover these details in today’s post. However, if you want me to explain them, let me know in the comments below!
Alright, so we have covered the benefits and drawbacks of contributing to tax-preferred accounts. Anything further you should know? I’m glad you asked!
Uh oh, that doesn’t sound good.
Do you like giving away your money to the government? If you do, skip this section, but if you don’t, then the elephant in the room is the early withdrawal penalty. Basically, the IRS wants you to keep your money in a 401(k) or IRA-like account until you turn 59.5. Otherwise, they will slap a 10% penalty on top of ANY taxes you will owe when funds are withdrawn to discourage you from doing this.
As we covered early on, there are always caveats, and penalties are no different. There are several ways to access your money without giving Uncle Sam 10%. However, we will cover those in a future article on withdrawing from a retirement account without penalty. Tune in early retirees, those with kids, and those whose lives throw them curve balls!
So as covered above, there are various reasons to contribute to tax preferential and non-preferential retirement accounts. Generally, what I would implore you to consider is to start with a 401(k) to get any company match of your contributions if one is provided. Company match, when provided, is free money. From there, save in whichever type or combination of types that fit your specific needs. For some people, withdrawal flexibility matters if they plan on early retirement and don’t want to be penalized. These folks should use non-preferential tax accounts AND tax-preferential accounts. Others may want the flexibility to buy a house with their money or help their kids out instead of just using them for living on in retirement. Situations can vary, but the chances are you should be using both types of accounts! Thanks for joining today; below are the points that I feel matter most.
•Non-preferential accounts (regular brokerage/investing accounts) have more flexibility for withdrawing from but incur taxes before the money may be needed
•Non-preferential accounts have no savings limit
•Non-preferential accounts allow investments to be taxed as long-term capital gains (this may be more preferential depending on your income and tax situation)
•Non-preferential accounts can be used for additional purposes other than retirement if your plans change
•Tax preferential accounts (those with deferrals, deductions, or dues) take the stress out of repeatedly incurring taxes. You are taxed once on the front or back end, rather than continually
•Tax preferential accounts can save you substantial money if you trade frequently or have lower/higher tax rates in retirement compared to now
•Tax preferential accounts have more rules and nuances since Uncle Sam is providing you these benefits. These include penalties if you don’t follow them
•You can save in a 401(k), IRA, HSA, self-employed, and non-preferential tax account all at the same time
•Using one does not disqualify you from using the other, so use both depending on what you need
Need more help deciding which type of tax preferential account to contribute to? Check out this article on choosing between traditional/pre-tax and Roth accounts and this article that compares 401(k) and IRA accounts
List of Retirement Accounts & Annual Limits from IRS.gov as of 2023 Tax Year. For a guide as to what order to use these accounts, check out this article!
|401(k) or 403(b)||$22,500 as pre-tax or Roth|
|Catch-Up for those 50+ in 401(k) or 403(b)||$7,500 as pre-tax or Roth|
|401(k) or 403(b) maximum limit w/ standard limit, co contributions, & after-tax||$66,000 or $73,500 for those 50+|
|401(a) – Pre-tax or after-tax, growth is tax deferred||$66,000|
|IRA or Roth IRA||$6,500 as pre-tax, after-tax, or Roth|
|Catch-Up for those 50+ in IRAs||$1,000 as pre-tax, after-tax, or Roth|
|SEP-IRA or Self Employed 401(k) – Always pre-tax||$66,000 but depends on business revenues|
|HSA – Always pre-tax||$3,850 individual or $7,750 family|
|HSA Catchup for those 55+||$1,000 per 55+ spouse|
|457(b) for gov or non-profits – Always pre-tax||$22,500|
|457(b) special catchup those within 3/yrs of retiring||$22,500 or amount not used prior years|
|457(f) – Always pre-tax||No limit – can be forfeited|
|Non-Gov 457 Top Hat Plans – Always pre-tax||No limit – can disappear if company goes bankrupt|
|Non-tax preferential accounts – Always after-tax||No limit|
|Whole Life Insurance or Deferred annuities||No limit|
Note: For 401(k), 403(b), and SE-401(k) accounts, they are inclusive of a single $66000/$73,500 limit. This single limit is separate of the SEP-IRA $66,000, meaning one could do both limits if they have the financial means
*As of 2023 tax year contribution limits, this figure can and will change in the future, and I will do my best to update when it does, but this information is provided as-is.
Mile High Finance Guy
finance demystified, one mountain at a time