As discussed in our article titled “Building Tax Diversification to create flexibility”, there are three main tax buckets that individuals can save into: tax-deferred, tax-free, and taxable/non-qualified. Let’s dive into the characteristics of different accounts, given current tax laws. Tax laws are subject to change:
1) Tax-deferred accounts:
a. 401(k)/403(b)/SEP IRA/SIMPLE IRA:
- Contributions go in pre-income tax. For example, if you are in the 22% federal tax bracket and 8% state tax bracket, you will save 30% on taxes on contributions made into this bucket.
- No tax is paid while funds are inside the account. Funds are tax-sheltered.
- Typically, funds are locked up until you reach age 59.5. There are exceptions to this rule.
- If funds are distributed early and no exceptions met, you pay tax and a 10% penalty on the distribution.
- Income tax is paid when distributions are taken from the account.
- Given current tax laws, funds in here are subject to Required Minimum Distributions starting at age 73.
- Primary savings mechanism for individuals with higher income now than in the future/retirement.
b. Traditional IRA:
- Account held in individual ownership.
- Contributions go in pre-income tax.
- There are income phaseouts that change each year to determine deductibility of contributions.
- No tax is paid while funds are inside the account. Funds are tax-sheltered.
- Typically, funds are locked up until you reach age 59.5. There are exceptions to this rule.
- If funds are distributed early and no exception is met, you pay tax and a 10% penalty on the distribution.
- Income tax is paid when distributions are taken from the account.
- Given current tax laws, funds in here are subject to Required Minimum Distributions starting at age 73.
2) Tax-free accounts:
a. Roth 401(k)/Roth 403(b)/Roth SEP IRA/Roth SIMPLE IRA:
- Contributions go in after-tax.
- No tax is paid while funds are inside the account. Funds are tax-sheltered.
- Typically, funds are locked up until you reach age 59.5. There are exceptions to this rule.
- Withdrawals/earnings after age 59.5 are tax-free.
- If funds are distributed early and no exception is met, you pay tax and a 10% penalty on the distribution.
- Given current tax laws, subject to Required Minimum Distributions starting at age 73.
- Primary savings mechanism for individuals with lower income now than in the future/retirement.
b. Roth IRA:
- Account held in individual ownership.
- Contributions go in after-tax.
- No tax is paid while funds are inside the account. Funds are tax-sheltered.
- Contributions to the account are accessible penalty-free.
- Typically, earnings are locked up until you reach age 59.5. There are exceptions to this rule.
- Withdrawals of earnings after age 59.5 are tax-free.
- Not subject to Required Minimum Distributions at age 73.
3) Tax-deferred and tax-free:
a. Health Savings Account:
- Contributions go in pre-income tax and Pre-FICA tax.
- No tax is paid while funds are inside the account. Funds are tax-sheltered.
- Distributions used for medical expenses are tax-free. Medical expenses can be re-imbursed with tax-free distributions at any time.
- If funds are not used, HSA can be used as an IRA at age 65. Distributions used for non-medical expenses are taxable as income.
4) Taxable:
a. Non-Qualified brokerage account:
- Contributions go in after-tax.
- No tax shelter on this account.
- Interest is taxed when earned. Dividends are tax when paid. Capital gains are taxed when realized.
- Favorable tax treatment on long-term capital gains and qualified dividends. See “Dividends and Capital Gain Taxation" article for details.
- Funds are always 100% liquid/accessible. There are no penalties to withdrawals from this account.
- Provides opportunity for tax-loss harvesting.
- There is a step up in basis at death.
- In my opinion, it is the most overlooked account due to the flexibility it provides. Not every dollar should go into retirement accounts.
With each account, there are more characteristics that weren't mentioned above. But this provides a deeper dive into each of the major savings/investing mechanisms.
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