(We’re doing Investing 101 up in here. Be sure to check out part one here.)
For today’s lesson, let’s talk about tax-advantaged accounts. When you hear about investing, you usually hear a bunch of acronym-laden buzzwords (401k! IRA!). These are not investments. They’re containers for investments to go in, that let the investments follow nicer taxation rules. Tax-advantaged accounts should definitely be your starting place for investing. Why do these accounts matter so much?
Let’s say you decide to invest, so you just open up a standard (non-advantaged) investment account and start putting money into it. You’re investing after-tax dollars (meaning dollars you’re already going to have to pay taxes on), so you’re getting taxed on the money to start. Then, assuming you hold on to the investment for more than a year (the penalties are worse, if not), you have to pay long-term capital gains tax whenever you sell the investment. Here’s a handy Wikipedia chart that will tell you what percentage that tax rate will be based on your income. For most, you’re looking at 15-25% of what you made on your investments–POOF–gone.
Tax-advantaged accounts allow you to invest for important life events, like retirement and education, without having to pay such high taxes on those investments. Because they are such a sweet deal, though, the government has imposed rules on these accounts. I’m assuming that anyone reading this is just getting started on investing, so retirement should be the first thing on your mind. (After all, you have to take care of yourself before you can take care of anyone else!) So, let’s look at a few types of tax-advantaged retirement accounts, and their advantages/disadvantages.
Behold, the Acronyms!
- IRA stands for “individual retirement account.” You open this account yourself.
- There are 2 types of IRAs: traditional and Roth.
- With a traditional IRA, you don’t pay taxes on the money you invest now, but you do have to pay taxes on the money (and its growth) when it is withdrawn.
- With a Roth IRA, you pay taxes on what you deposit now, but you are not taxed when you withdraw the money (and its growth).
- There is an annual contribution limit of $5,500 (for 2016) for individuals under 65, for either type of IRA (and between IRAs, if you had both types).
- To qualify for a Roth IRA in 2016, you must make less than $117,000 per year, or $184,000 per year for a family.
- You may not withdraw money from either type of IRA (with a few exceptions) until 59.5 without paying a heft 10% early withdrawal tax. The Roth has some rules that allow for withdrawal without penalty in the event of a first home purchase or education expenses.
- A traditional IRA requires that you take distributions at 70.5, or else face a steep penalty. A Roth IRA does not require that you take these distributions.
- The funny names for these accounts come from the portion of the tax law that makes them possible. These are only offered through your workplace (otherwise you have to open an IRA).
- Like a traditional IRA, you are not taxed on the money that you put into these accounts, but you will be taxed on your withdrawals, which includes the growth of the investment.
- A few companies are beginning to offer a Roth 401k. It follows similar tax rules to the Roth IRA, meaning you pay taxes on the money you deposit now, but do not need to pay taxes on the withdrawals, including the growth of the investment.
- 401ks/403bs are nice because they usually come with some type of company match, whereby the company gives you retirement money as part of your compensation package. In some cases (like mine), the workplace also pays some of the investing fees for the employee.
- The 2016 contribution limit is $18,000 for contributions by an individual, but your workplace can also put a lower cap on contributions. For instance, my workplace only allows me to contribute a maximum of 4% of my income (which they match two-fold).
- HSA stands for Health Savings Account. “But wait!” you may say, “What does that have to do with retirement?”
- An HSA is arguably one of the best places to house your retirement dollars. Deposits are made pre-tax, and withdrawals can be made at any time for qualified medical expenses without any tax repercussions.
- After 65, withdrawals can be made for any reason, but will be taxed as regular income (like a traditional IRA).
- Some HSAs (like mine) also receive contributions as part of a salary package.
- You can only have an HSA if you are in a qualified high-deductible health plan.
- For 2016, contributions are capped $3350 for an individual and $6750 for a family per year (including employer contributions).
How Do I Know Which Account to Put My Money In?
This seems like a simple question, but it can be complicated by the types of investments that are offered in each option. You are typically at the mercy of your employer for your investment options within a 401k/403b and sometimes the HSA. If all the investment possibilities were the same, and I qualified for all of the account types, I’d go in the following order with my investments:
- 401k/403b up to the employer match: No investment in the world is going to give you a 100% return on your money. The match is a no-brainer.
- HSA up to the annual contribution limit: The increased flexibility for medical spending with an HSA makes it trump the IRA for me. You’ll just need to remember that if you have a medical emergency that forces you to use all or most of your HSA, those are savings you don’t have anymore (obviously).
- Roth IRA up to the annual contribution limit: To me, a Roth is a no-brainer over a traditional IRA, particularly the younger you are. I’ve read many arguments that make it sound like it’s difficult to choose between a Roth and a traditional IRA, requiring you to make a guess as to whether you think your tax bracket will be lower or higher in retirement. (In the former, you’d use a Roth IRA, in the latter, a traditional IRA). What I feel like these people don’t remember is that the Roth is growing tax-free, meaning you aren’t going to be taxed on all of the delicious compound interest that you earned over thirty-or-so years. You do have to pay taxes on those earnings with a traditional IRA. That’s why, unless you’re close to retirement, a Roth is the obvious answer. (If you’re pursuing an early retirement, a 401k might be a better option, though. Check out this discussion by Mad Fientist for why.)
- Return to the 401k up to the annual contribution limit: Some tax sheltering is better than no tax sheltering.
- Regular old non-advantaged investment account: Or, if you have other savings goals (like your children’s education) and qualify, you could fund other tax-preferred accounts for those savings (because seriously, you’re knocking this retirement saving thing out of the park if you reach this point).
As I said before, though, it somewhat depends on what your investment options are. If you’re limited to really bad investment options in one of these accounts, it might make sense to skip that option and move on to the next tier. So, how do you know if the investments are good or not? We’ll (finally!) talk about that in Part Three.