1. Taxable Brokerage Account: In a brokerage account, you can buy and sell stocks, bonds, mutual funds, and other asset classes. You’ll pay capital gains taxes each year on any investment gains, but you can also deduct any losses. This means when you sell your investments and start taking money out of your account, no more tax is due (except on any additional capital gains since you last paid tax). Brokerage accounts are usually owned individually or jointly, and you can put in as much money as you like every year.
2. Employer-Sponsored Retirement Accounts: These types of accounts are set up by your employer for your benefit. You typically get investment options like stocks, bonds, and mutual funds. Since these accounts are ostensibly for retirement, you will pay a 10% penalty AND income tax if you make a withdrawal before you turn 59½. But there are a circumstances under which the penalties don’t apply, such as taking regular, fixed payments over time, buying your first home, dividing assets due to a divorce, or becoming permanently disabled. And if you want to roll an employer-sponsored retirement account into an IRA outside of your organization, there is never a penalty or tax.
a. 401(k): With this type of employer-sponsored retirement plan, you save for retirement with pre-tax dollars, meaning that every dollar you contribute reduces your taxable income by one dollar. Some employers even match all or part of your contributions. You don’t pay taxes on the growth in your account along the way. Instead, you will pay regular income tax on your withdrawals once you start taking money out, which can be a good deal since a lot of people fall into a lower tax bracket once they stop working for money.
There are annual contribution limits on these accounts, and they usually go up every year or two to keep up with inflation. The limits are also higher for employees who are aged 50 or older. Contribution limits don’t apply to any employer match, though, which is nice.
Some employers also offer a Roth 401(k) option (see Roth IRA below), which also has annual contribution limits. You don’t get a tax deduction when you contribute, but you can withdraw the funds income-tax free as long as you’ve been contributing for at least five years.
b. 403(b): This type of plan functions pretty much like a 401(k) but is offered by government and nonprofit organizations rather than for-profit businesses. Your contributions reduce your taxable income, employers can match your contributions, and there are annual contribution limits which increase from time to time. Contribution limits are higher for employees who are 50 or older, but an employer’s matching contributions don’t count toward that limit. The investments grow tax-deferred, and you pay regular income tax on withdrawals once you start taking money out. And yes, 403(b) plans can offer Roth options, as 401(k) plans do.
c. SIMPLE IRA: These employer-sponsored IRAs are for smaller businesses which don’t need a plan as complex as a 401(k), and there is no Roth option. A SIMPLE IRA requires employers to make contributions to the accounts for employees, either by matching the employee’s contributions up to 3% of compensation, or by contributing 2% of salary whether the employee contributes or not. For the 2% option, there are limits on how much salary can be considered when calculating the employer contribution. The contributions are pre-tax, so the funds are taxed at your regular income rate when they’re withdrawn. Growth is not taxed along the way.
d. SEP IRA: This type of plan is for small businesses and people who are self-employed, and there is no Roth option. Only the employer makes contributions; there is no option for an employee to contribute, but if you’re self-employed that’s pretty much a moot point. The big thing to note here is that if there’s more than one employee, the employer has to contribute the same percentage of employee compensation for everyone. Contribution limits are based on either a percentage of the employee’s net compensation or an annual maximum dollar amount, whichever is lower. And, of course, your funds grow tax-deferred and you pay regular income tax on your withdrawals.
e. Solo / Personal 401(k): These accounts are available to self-employed people with no employees, or who employ only a spouse who works at least part time. This kind of plan works pretty much like a 401(k) and includes both regular and Roth options. You’re allowed to contribute as both employer and employee on a pre-tax basis, so you will deduct contributions from your business and / or personal taxes as relevant. Contribution limits apply, of course, for both the employer and employee. You’ll pay regular income taxes on the funds when you withdraw them, except on Roth contributions, and your investments grow tax-deferred.
3. Individual Retirement Accounts (IRAs): As the name implies, only individuals can hold this type of account. They can’t be held jointly, and there’s no employer in the picture. You can keep contributing to these accounts as long as you have enough earned income to qualify. As with Employer-Sponsored plans, you need to reach age 59½ to withdraw your money without a 10% penalty and income taxes, but you can avoid the penalty in the ways I outlined above.
a. Traditional Individual Retirement Account (IRA): An IRA allows you to save for retirement with pre-tax dollars, as with Employer-Sponsored accounts. The more you contribute, the less income tax you’ll pay, and you don’t pay tax on the growth of your investments each year. In exchange for this current tax benefit, you’ll pay taxes on withdrawals, based on your income tax bracket at that time.
There are contribution limits for IRAs, and those limits increase if you’re 50 or older. But also keep in mind that if you have an Employer-Sponsored Plan in play, you can only get the taxable income reduction on IRA contributions if your income falls below a certain threshold.
b. Roth IRA: With a Roth IRA, you contribute after-tax dollars, meaning your taxable income won’t be reduced. However, this means you won’t pay taxes on the money when you withdraw it in retirement. Like Traditional IRAs, Roth IRAs have contribution limits which increase if you’re 50 or older. But they also have rules about who can contribute at all: if you have income above a certain threshold, you can’t directly contribute to a Roth. As you might expect, a Roth IRA can be a good option for people who think they will be in a higher tax bracket once they stop working, because the taxes are taken care of up front.
4. Education Accounts: The government has also set up some tax-advantaged options for people who want to save for educational expenses, including K – 12 and higher education.
a. 529 Plan: People who are 18 or older can open these state-sponsored accounts for a child or for themselves. There are two flavors of 529: savings plans and prepaid tuition plans. The savings plans allow you to invest, usually in mutual funds, so your money grows over time, and you don’t have to pay tax on that growth along the way. Prepaid tuition plans are just what they sound like; you pay current tuition prices to purchase a period of time or number of credits which then cover that same period of time or number of credits once the beneficiary gets to college. In this way, you can protect against future cost increases. There is no investment component in the prepaid tuition programs.
You don’t get a federal taxable income reduction based on your contributions to a 529, but you might get a state tax deduction or credit if your state has income tax and you’re contributing to one of that state’s plans. But you’re allowed to contribute to any state’s plan, so if another state has a better offering (or Grandma lives in California and wants a tax deduction for her generous contributions) you can go with that instead.
Any funds saved in a 529 plan have to be used for “qualified” educational expenses; for K – 12 education, only tuition is considered qualified. For higher education, qualified expenses include tuition, fees, lodging, and even student loan payments. When used for qualified expenses, 529 withdrawals aren’t taxed. If you don’t use the funds for qualified expenses, you’ll pay a 10% penalty and regular income tax on just the earnings portion of the withdrawal, not on your contributions.
There are no annual contribution limits for 529s, but most states have a limit on the total amount of money which can be contributed over the life of the account. You should also keep in mind that if you contribute more than the federal gift tax threshold amount in any given year, you may owe gift tax that year. But you can get around the gift tax issue if you contribute up to 5 times the annual gift tax threshold all at once, and then don’t contribute any more for the next five years. So if you have a chunk of change to sink in there, you can avoid the gift tax and funnel more money in early, either growing investment value or battling inflation over a longer period of time.
But what if Little Lord or Lady Fauntleroy decides not to go to college? Well, the nice thing about 529 Plans is they can be turned over to another of the beneficiary’s family members, including a sibling, step-sibling, spouse, child, niece, first cousin, or parent.
b. Coverdell Education Savings Account (ESA): As with 529 plans, anyone who is aged 18 or over can open an account for themselves or a child, and a child can have both a Coverdell ESA and a 529 plan. Owners can hold individual stocks and other securities in these plans, and account growth is not taxed along the way.
As long as withdrawals are used for qualified educational expenses, they are not taxed. If a beneficiary does use Coverdell funds for non-qualified expenses, they will pay a 10% penalty and the earnings portion of that withdrawal will be included in their taxable income, as with 529 plans. Coverdell plans consider a variety of expenses to be qualified, such as tuition, books, transportation, and room and board.
Coverdell funds must be used by the time the beneficiary turns 30. If not, they can’t be transferred to anyone else, and the beneficiary will pay regular income tax on the earnings potion of the withdrawal. Transfers to family members are allowed, though, before the beneficiary turns 30.
Coverdell ESAs have an annual contribution limit of $2,000 per beneficiary, and only families whose Adjusted Gross Income (AGI) falls below a certain threshold can make contributions at all. There are no income tax credits or deductions available for these accounts, at either the federal or state level.
5. Achieving a Better Life Experience (ABLE) Act Account: ABLE plans function a lot like 529s. However, ABLE accounts are designed for people who have disabilities, so they can save in a tax-beneficial way without impacting any government benefits they are receiving. Most people who get Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI) are eligible, but other disabled people might qualify. Check online at the ABLE National Resource Center for details.
ABLE accounts allow people with disabilities to hold investments which grow in value over time. This growth is not taxed along the way, and withdrawals aren’t taxed if you use them for qualified, disability-related expenses. The first $100,000 in an ABLE account doesn’t count toward the $2,000 SSI individual resource limit, but even if the account value goes higher than that the beneficiary won’t lose Medicaid benefits. The details of how these accounts work vary depending on which state the beneficiary lives in, and some states don’t even have active programs, so be sure to check out all the rules for your state using the ABLE National Resource Center’s state search tool.
Please also check out my previous post, “Special Needs and ABLE Accounts,” if you’re interested.
6. Health-Related Savings Accounts: The federal government has set up some ways for us to save for healthcare costs in a tax-beneficial way. When these accounts are set up via an employer, sometimes employers will contribute along with the employee.
a. Health Savings Account (HSA): HSAs are available to individuals and via employers, but the individual controls the HSA and can bring it with them if they leave their employer. To contribute to an HSA, you have to be participating in a high-deductible health plan. What counts as high-deductible is defined by the IRS, but if you qualify you can make pre-tax contributions and any earnings in the HSA grow without being taxed along the way. As long as you spend the money on qualified healthcare expenses you don’t have to pay taxes on the withdrawals, either. You can also invest in mutual funds within your HSA, and sometimes in stocks and bonds. There are annual contribution limits, as you would expect, and if your employer contributes it does count toward the limit.
You don’t have to spend all the money in your HSA every year, which makes it a great way to save for medical expenses over the long haul. Just remember that if you don’t use the funds for qualified medical expenses, there’s a 20% penalty and you will also pay taxes on those withdrawals. On the plus side, if you wait until you’re 65 or older, the 20% penalty goes away and you can use the money like you would any IRA or 401(k) money. You’ll just pay income tax on the withdrawals, and hopefully you’ll be in a lower income bracket once you’re 65+.
b. Flexible Spending Account (FSA): FSAs are for people who want to save for healthcare costs on a pre-tax basis but aren’t participating in a high-deductible health plan. They are only available through employers and are owned by them, so if you leave that employer your FSA funds revert back to them. One of the big advantages of an FSA is that you can spend all of the money even before the funds have been contributed to the account. It’s ALL yours at the beginning of the year.
As with HSAs, withdrawals aren’t taxed as long as you spend them on qualified healthcare expenses. Stocks and other investments aren’t available, and you may be required to spend all of the funds in your FSA each year. Some plans do allow you to carry over a limited amount of money to the next year, or they offer a grace period at the beginning of the next year when you can spend any remaining funds. FSAs also have contribution limits, and they are lower than those for HSAs.
c. Dependent-Care FSA: These plans are similar to regular healthcare FSAs, but they cover qualified dependent-care expenses. These qualified expenses include daycare, nannying, preschool, nursery, babysitting, before- and after-school programs, and anything else relating to the physical care of a kid. Food and education aren’t considered qualified expenses here. The funds can be used for any child under 13, or for older dependents who aren’t able to care for themselves.
Whew! This post got pretty long, so thank you for sticking with me until the end. That said, there are a lot of nuances I couldn’t cover in this short summary, so it behooves you to educate yourself about the ins and outs of investment accounts before you get going. Contribution limits and other rules also change frequently, so it’s worth looking for updates every so often. Stay geeky, my friends.