The majority of financial commentary revolves around which investments to pick. After all, calling the hot stock of the year or debating crypto versus green energy makes for great conversation at a cocktail party. However, the first decision any rational investor should make is not which investment, but which investment account.
I have counseled thousands of clients across the country on financial planning since the Great Recession, and one of the most common questions I hear goes like this, “Well, which has a better rate of return, a 401(k) or an IRA?” Or, “Do you think I’ll make more money in a 529 college savings plan or by investing in the stock market?” The terms change, but the confusion remains the same.
A simple analogy might help illustrate the difference. Investments, whether they be stocks, bonds, mutual funds, exchange-traded funds, or any other security can be likened to “ingredients.”
The account type that holds these ingredients can be thought of as the “dish” on which they are served. Before measuring out the ingredients, it is always best to know what type of meal to cook. A chef might have the best cheese in the world sitting on his counter, but it is of little value baked into a pizza pie if his guests are looking for a sweet desert.
Determine Your Goal
So not unlike deciding on the meal, then the dish, and then the ingredients, the rational investor must first decide on the purpose of his investment, then the appropriate account to match said goal, and lastly the assets that fit best. No account or investment is ultimately good or bad on its own, but, rather, is perceived as such by meeting or not meeting an investor’s expectations.
The easiest way to begin distinguishing between account types is by segregating them into pre-tax and post-tax. Pre-tax accounts are investment accounts that have yet to be taxed, meaning the funds that go into the account are deducted against current-year income and are considered pre-tax dollars.
The most common of pre-tax type of account is the employer-sponsored retirement plan, such as a 401(k), 403(b), 457(b), or TSP (Thrift Savings Plan). Each of these accounts allows the employee to defer up to $20,500 annually, or $27,000 if one is over the age of 50.
The funds may be invested in a variety of options depending on the plan sponsor, with many employers today offering a default target-date retirement fund based on the employee’s age. The acronym for these is TDFs, and the date at which you intend to retire, such as 2030, 2040, 2050, etc., is called the vintage.
Individuals who are not eligible for such a plan at work can opt for funding a traditional individual retirement account (IRA), which allows for a $6,000 annual deferral, or $7,000 if over age 50. When an employee retires or separates service from their employer, they will be eligible to rollover their pre-tax funds into an IRA and continue deferring the tax on interest and capital gains.
Contractors and other self-employed persons may be able to set up a SEP IRA (Simplified Employee Pension) that can allow up to $61,000 of deferrals in 2022.
It is very important the investor realize these accounts do not provide a “tax-savings,” but rather a “tax-postponement” that creates a compounding unknown future tax liability. These funds cannot be accessed before Age 59-1/2 without incurring a 10% premature distribution penalty (unless certain exceptions apply). No matter when the funds are withdrawn, penalized or not, they will always be subject to income tax, both the investor’s basis and gains.
The Roth option in many ways can be seen as the opposite of a pre-tax retirement account. Contributions go in post-tax, offering no current-year deduction, but then grow tax-free and can be accessed tax-free in retirement after age 59-1/2 and after a five-year holding period.
The tax-free benefit applies to 100% of the account balance, including the investor’s basis and gains.
The Roth IRA allows an investor to contribute up to $6,000 annually, or $7,000 if over Age 50 (same as a Traditional IRA). However, there are income restrictions to funding a Roth IRA. In 2022, single filers with a Modified Adjusted Gross Income (MAGI) over $144,000 are not eligible, nor are those Married Filing Jointly with MAGI over $214,000, or Married Filing Separately with income over $10,000.
Fortunately, each of the workplace retirement plans aforementioned are allowed to offer a Roth contribution option. The same higher contribution limits apply ($20,500 and $27,000) and there are no income restrictions to being able to fund a Roth option on a workplace retirement plan. Investors who do not have a Roth option at work and make an income above the IRS allowable limit may utilize the “backdoor Roth IRA” strategy, although provisions in the Build Back Better bill may prevent the necessary Roth conversions in this strategy in future years.
529 College Savings Plans
A 529 college savings plan is comparable to a Roth account in that it allows an investor to contribute money after-tax, with the opportunity for tax-free growth and tax-free distributions if used towards qualified expenses, such as college tuition or room and board. 529 plans do not have contribution limits. However, contributions are considered as completed gifts for federal tax purposes. In 2022, up to $16,000 per donor per beneficiary qualifies for the annual gift tax exclusion. Some states allow a portion of annual contributions to be deductible against state income taxes. If the funds are not used for a qualified expense, the investor may realize income taxes and a 10% penalty on any gains that are withdrawn.
The last type of post-tax account popular with investors are called taxable accounts. These lack the tax deferral provided by the qualified plans mentioned previously, but provide much greater flexibility in the form of unlimited contributions and withdrawals without IRS penalty. These type of accounts generate Tax Form 1099 annually, which reports interest, dividends, short-term capital gains, and long-term capital gains that can create a tax consequence each year. Individual investment accounts, joint accounts, Transfer on Death (TOD) or Payable on Death (POD), and savings and checking accounts all fall into this category.
Understanding all of these various investment account types is critical to building a sound financial plan. Just as an ingredient can be used in many different ways for different recipes, so can the same growth fund be found in a Roth IRA, 403(b), 529 college savings plan, or individual brokerage account.
However, the applicability, liquidity, and tax consequence of using such a fund can be greatly different in each of these accounts.
Bryan M. Kuderna, CFP®, MSFS, RICP®, LUTCF is the host of The Kuderna Podcast and founder of Kuderna Financial Team, a NJ-based financial services firm. He is also the author of Anoroc and Millennial Millionaire.
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