The majority of financial commentary revolves around which investments to choose. After all, calling the hot stock of the year or debating crypto versus green energy is great conversation at a cocktail party. However, the first decision any rational investor should make is not which investment, but which investment account.
I’ve advised thousands of clients across the country on financial planning since the Great Recession, and one of the most common questions I hear is, “Well, who has a better rate of return, a 401(k) or an IRA?” Or, “Do you think I will 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 in stocks, bonds, mutual funds, exchange-traded funds, or any other security, can be thought of as “ingredients.”
The type of account that contains these ingredients can be thought of as the “dish” on which they are served. Before measuring ingredients, it’s always best to know what type of meal to cook. A chef may have the best cheese in the world sitting on his counter, but it’s of little value cooked in a pizza if his guests crave a sweet dessert.
Determine your goal
So, much like deciding on the meal, then the dish, then the ingredients, the rational investor must first decide on the objective of his investment, then the appropriate account to match this objective, and finally the assets which he are best suited. No account or investment is ultimately good or bad per se, but rather is perceived as such by meeting or not meeting an investor’s expectations.
The easiest way to start distinguishing between account types is to separate them into pre-tax and after-tax. Pre-tax accounts are investment accounts that have not yet been taxed, which means that funds paid into them are deducted from current year income and are treated as pre-tax dollars.
The most common type of pre-tax account is an 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 carry over up to $20,500 per year, or $27,000 if they are over 50.
Funds can 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 age of the employee. The acronym for these is TDF, and the date you intend to retire, such as 2030, 2040, 2050, etc., is called the vintage.
People who don’t qualify for such a plan at work can opt to fund a traditional Individual Retirement Account (IRA), which allows for an annual carryover of $6,000, or $7,000 if over age 50. When an employee retires or leaves the service of their employer, they will be able to transfer their pre-tax funds into an IRA and continue to defer tax on interest and capital gains.
Entrepreneurs and other self-employed people may be able to set up a SEP IRA (Simplified Employee Pension) that can allow up to $61,000 in carryovers into 2022.
Tax deferral
It is very important for the investor to realize that these accounts do not provide a “tax saving”, but rather a “tax deferral” which creates an unknown compound future tax. These funds are not accessible before the age of 59.5 without incurring a 10% early distribution penalty (unless certain exceptions apply). Regardless of when the funds are withdrawn, penalized or not, they will still be subject to income tax, both on the investor’s base and on the gains.
The Roth Option in many ways can be considered the opposite of a pre-tax retirement account. Contributions are paid after tax, providing no deduction for the current year, but then grow tax-free and are accessible tax-free upon retirement after age 59½ and after a holding period of five years.
The tax-free benefit applies to 100% of the account balance, including the investor’s base and earnings.
The Roth IRA allows an investor to contribute up to $6,000 per year, or $7,000 if over age 50 (like a traditional IRA). However, there are income restrictions for funding a Roth IRA. In 2022, single filers with a Modified Adjusted Gross Income (MAGI) greater than $144,000 are not eligible, nor are married filers jointly filing with MAGI greater than $214,000 or married filing separately with income greater than 10 $000.
Fortunately, each of the aforementioned workplace pension plans is allowed to offer a Roth contribution option. The same higher contribution limits apply ($20,500 and $27,000) and there are no income restrictions on being able to fund a Roth option on a workplace pension plan. Investors who do not have a Roth option at work and who earn income above the limit allowed by the IRS can use the “backdoor Roth IRA” strategy, although the provisions of the Build Back Better Bill may prevent the necessary Roth conversions in this strategy in the years to come.
529 Education savings plans
A 529 college savings plan is comparable to a Roth account in that it allows an investor to contribute after-tax money, with the possibility of tax-free growth and distributions if used for eligible expenses, such as tuition or room and board. 529 plans have no contribution limits. However, contributions are considered completed gifts for federal tax purposes. In 2022, up to $16,000 per donor and recipient is eligible for the annual gift tax exclusion. Some states allow a portion of annual dues to be deductible from state income tax. If the funds are not used for an eligible expense, the investor may be subject to income taxes and a 10% penalty on any gains withdrawn.
The final type of after-tax account popular with investors is called a taxable account. These lack the tax deferral provided by the previously mentioned qualified plans, but offer much greater flexibility in the form of unlimited contributions and withdrawals without IRS penalty. These types of accounts generate the 1099 tax form each year, 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, transfers on death (TOD) or payable on death (POD), and savings and checking accounts all fall into this category.
Understanding all of these different types of investment accounts is essential to developing a solid financial plan. Just as an ingredient can be used in different ways for different recipes, the same growth fund can be found in a Roth IRA, 403(b), 529 college savings plan, or individual brokerage account.
However, the applicability, liquidity and tax consequences of using such a fund may be very different in each of these accounts.
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Bryan M. Kuderna, CFP®, MSFS, RICP®, LUTCF is host of The Kuderna Podcast and founder of Kuderna Financial Team, a New Jersey-based financial services company. He is also the author of Anoroc and Millennial Millionaire.
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