Investing in Retirement Accounts

This article is part of a 15-part series aptly titled How to Become a Better Investor in 15 Days. In the most recent lesson, Fred Leamnson taught us about tax-efficient investments and how your investments and their earnings may be taxed.

Today, we’ll follow up by talking about some of the most common retirement accounts available to many Americans.

 

The IRA: Individual Retirement Arrangement

 

An IRA is an Individual Retirement Arrangement (or Account — the IRS uses the terms interchangeably).

The account is Individual. There are no joint IRAs.

It is for Retirement. The money in your IRA will grow tax-free as long as it remains in the account. If you want to access the money prior to retirement (age 59.5), there can be penalties, although there are a few different workarounds.

There are several limitations. For every dollar contributed to an IRA, you or your spouse must have a dollar of earned income. You can only contribute $6,000 per calendar year per person in 2020, and the 50-and-older crowd can contribute an additional $1,000 per year.

If you earn “too much,” you can be subject to additional limitations, and we’ll discuss those below.

IRAs come in two varieties: traditional and Roth.

 

Traditional IRA

 

When you contribute to a Traditional IRA, you receive a tax deduction equal to the contribution. This reduces the amount you’ll owe in taxes. If your marginal tax rate (federal, state, and local combined) is 20%, a $6,000 contribution will save you $1,200.

As is true of all of the accounts we’ll discuss today, you can invest in publicly traded assets like stocks, bonds, mutual funds, and exchange traded funds (ETFs) in an IRA. If you’re interested in alternative investments like precious metals, crowdfunded or syndicated real estate, or investment properties, you can hold them in what’s called a self-directed IRA. There are also self-directed 401(k) options and both can hold investments as varied as Farmland via FarmTogether or wine with Vinovest.

Your investments will grow tax-free in a traditional, tax-deferred IRA. However, when you withdraw money from an IRA, you will pay income tax on the withdrawals at ordinary income tax rates.

Not everyone can contribute to a traditional IRA. If you have the option of an employer-based retirement plan like a 401(k), you cannot contribute if you, as a single tax filer, earn more than $75,000 in 2020. The amount you can contribute is decreased over a modified adjusted gross income (MAGI) of $65,000 to $74,999.

If you are married and file taxes jointly, the phaseout range is $104,000 to $123,999 of MAGI. At $124,000, you cannot contribute to a traditional tax-deferred IRA.

I will briefly mention that if your income doesn’t allow you to make a tax-deferred traditional IRA contribution, you can still make a non-deductible contribution to a traditional IRA. The tax treatment of these is not great, so this is usually done as the first step of a backdoor Roth contribution. More on that later.

 

 

Roth IRA

 

A Roth IRA is another option for your annual IRA investment. You are limited to $6,000 in total IRA contributions per year; most people will choose one or the other (traditional or Roth) for their entire annual contribution.

Money invested in a Roth IRA does not benefit from a tax deduction. It does grow tax-free like the traditional IRA.

The best feature of a Roth IRA is that withdrawals are never taxed. The money can be withdrawn tax-free.

Like the traditional IRA, withdrawals after age 59.5 will be penalty-free. A unique feature of Roth contributions is that the amount contributed can be withdrawn at any age without tax or penalty five or more years later. The earnings, however, must remain in the Roth IRA.

There are income limits for Roth IRA contributions, as well, but if you’re over the limit (or there’s even a small chance you think you might be), there is an indirect way to contribute called the backdoor Roth.

Single filers earning more than $124,000 will see the amount they can contribute to a Roth IRA decrease until it reaches zero at a MAGI of $139,000. Married couples filing taxes jointly have a phaseout range of $196,000 to $206,000. Again, these are 2020 numbers and they’ll be adjusted upward with inflation.

 

Backdoor Roth IRA

 

The fact is that no one actually earns too much to contribute to a Roth IRA. If you’re in or above the phaseout income range, you just have to add an extra step.

The “backdoor Roth” is a two-step process, involving a non-deductible IRA contribution followed shortly thereafter by a Roth conversion. The end result is the same as if you had contributed directly, but it takes a bit longer.

For complete instructions, including screenshots along the way, please see the Backdoor Roth IRA 2020: Step by Step Guide with Vanguard.

One advantage that a Roth IRA has over a traditional IRA is the lack of required minimum distributions. At age 72, the government requires you to withdraw a percentage of your traditional IRA at a rate that increases as you age. Roth IRAs are not subject to RMDs.

 

Should You Contribute to a Traditional or Roth IRA?

 

I feel most investors should take advantage of an annual Roth IRA contribution. If your income is such that you qualify for a traditional contribution, you have a fairly low marginal tax bracket and the upfront deduction isn’t all that beneficial. If you plan on retiring early, however, you may eventually be in a position to make tax-free or low-tax Roth conversions when retired. In that case, traditional IRA contributions might make sense, even in a relatively low tax bracket.

On the other hand, Investing in a Roth IRA means you are done paying tax on that money forever. If tax rates are higher in the future when you’re ready to access your IRA money, you will be happy to have a tax-free “bucket” housing a portion of your retirement.

An exception can be made for the rare high-income individual who has no employer-based retirement plan available. If you can defer $6,000 or $7,000 (age 50 and up) in the 32% federal tax bracket or higher, I would recommend making a traditional IRA contribution.

There are other factors that go into the Roth versus traditional decision, and I’ll go into more detail as we discuss the Roth versus traditional 401(k), as there are no income limitations on what you’re allowed to do there.

 

401(k)

 

A 401(k) is an employer-based retirement plan that allows investors to shelter quite a bit more money annually. Government employees may have a 403(b) instead. The two are very similar and can be considered interchangeable for the purposes of today’s discussion.

In 2020, an employee can contribute up to $19,500 in a 401(k) and the employer can kick in as much as $37,500 in matching and profit sharing for a total of $57,000. If you’re at least 50 years old,  add $5,000 to your potential employee contribution and total annual contribution.

It’s common, although not mandated, for an employer to match some of your contributions. For example, for every dollar you contribute, they might give you a one-dollar employer contribution up to a certain threshold. This is free money, and in this example, an immediate 100% return on the money you contribute to the 401(k).

Even if money is tight, contributing enough money to your 401(k) to get the full match needs to be a top priority.

Contributions from an employer will be tax-deferred, but you may have a choice on your employee contribution of traditional, tax-deferred or Roth contributions to your 401(k). You may also be able to do some of both. If you’re unsure, check with your human resources department or refer to the plan documents.

 

Traditional 401(k)

 

When you make traditional contributions to your 401(k), you lower your taxable income by the amount contributed. Employer contributions will not lower your taxable income.

Just like the IRA, money invested in a 401(k) grows tax-free.  All money withdrawn (or converted to Roth) later on will be taxed at ordinary income rates when withdrawn or converted.

The money in your 401(k) can be accessed a bit earlier than the IRA money. There are no penalties or limitations on withdrawals if you retire (separate from your employer) in or after the year in which you turn 55.

 

Roth 401(k)

 

Some employers offer the option for employees to make Roth contributions to their 401(k).

This money gets the same treatment as the Roth IRA money. No up-front tax deduction, tax-free growth, and tax-free withdrawals.

 

 

Should You Invest in a Traditional or Roth 401(k)?

 

This could be an entire blog post. It is, in fact: Should You Invest in a Roth or Traditional 401(k)?

I generally prefer traditional contributions for high-income earners, particularly in the 32% federal tax bracket and higher. Roth contributions might make good sense at the 24% and lower tax brackets, but there a number of other factors to consider.

 

Factors that favor traditional (tax-deferred) contributions:

• High Income
• High Tax Bracket
• Single (higher tax brackets for single filers)
• High Income Tax State
• You Also Invest in a Taxable Account
• Close to Retirement
• Likely to Retire Early
• Anticipating Lower Taxable Income in Retirement
• You’re in a “phase out” income range for a tax deduction or credit
• You’re a natural-born saver

 

Factors that favor Roth contributions:

• Lower Tax Brackets
• Married Filing Jointly (related again to tax brackets)
• Low or No Income Tax State
• Few investments that are not tax-deferred
• Far from Retirement
• Planning on a traditional retirement age
• Anticipating Equal or Higher Taxable Income in Retirement
• You’re a natural born spender

 

 

Health Savings Account (HSA)

 

If your health insurance plan is considered an HDHP (high deductible health plan), you will be able to invest in an HSA. This allows you to defer another $7,100 of income per family or $3,550 in 2020 as you max out an HSA.

The beauty of these accounts is that they are tax-deductible in the year of contribution, but also grow tax-free and are treated like Roth money when withdrawn to be used to cover eligible health care expenses. Tax-deductible contributions, tax-free growth, and tax-free withdrawals make HSAs triple-tax free, and an outstanding place to invest. Unlike an FSA, the money in an HSA does not expire and can grow for decades.

The only way you pay tax on these HSA contributions is if you withdraw the money for non-healthcare purposes, which you’re allowed to do when you turn 65. In that case, the account behaves much like a traditional IRA or 401(k). Tax-deductible contributions, tax-free growth, and ordinary income tax on withdrawals. Most of us will have health care expenses that meet or exceed the balance of the HSA eventually, but it’s good to know there is that other option.

 

457(b)

 

Some highly-compensated employees may have access to a 457(b). There are two types: governmental and non-governmental, depending upon the type of employer you have.

They work a lot like 401(k) plans with a few notable differences. There’s typically no match or employer contribution of any kind. The contribution limits will be the same as a 401(k) and you are able to contribute to both.

One big difference is that you can draw from your 457(b) at any age without penalty as long as you have separated from your employer. That makes these accounts ideal for early retirees.

Some 457(b) plans have limited withdrawal options, including taking the entire lump sum as the only option. That can create a significant tax bomb if the balance is sufficiently high. Be sure to look into withdrawal options before deciding whether or not to contribute.

Finally, understand that the money in a 457(b) is considered deferred compensation and isn’t yours until you withdraw it. It could potentially be subject to creditor risk if your employer runs into financial trouble. This is more of a concern for non-governmental 457(b) accounts.

Governmental 457(b) money can be rolled over to an IRA, whereas the only rollover option for a non-governmental 457(b) would be a new employer’s non-governmental 457(b).

Some employers will offer a similar plan called a non-qualified deferred compensation plan, or NQDC. It works much like a 457(b) but is not subject to contribution limits. You simply choose what percentage of your compensation to defer, and in some cases, that could be 50% of your salary or more.

 

 

Cash Balance Plan

 

A cash balance plan is a defined benefit plan that allows you to make tax-deferred contributions. The amount you’re allowed to contribute is calculated by an actuary, and it increases with age, often climbing into the six figures.

The plans are required to be invested in a somewhat conservative manner. Most investors who use these plans will have a portion of their bond / fixed income allocation in their cash balance plan. For more on these accounts, see Cash Balance Plans: Another Retirement Plan for Professionals.

 

Taxable Account

 

When I say “taxable account,” what is that, exactly? It’s just the account in which you buy assets with your post-tax money. These are also referred to as “non-qualified accounts” or “brokerage accounts.”

Don’t be confused by the various terms; they all mean the same thing. It’s just an account that holds mutual funds, ETFs, stocks, or what have you. It doesn’t have the specific tax advantages of some of the retirement accounts, so extra attention needs to be paid to the tax implications of taxable account investing.

However, the taxation on these accounts isn’t nearly as bad as one might assume based on the name. In fact, there are ways in which it can be as good as a Roth IRA or awfully close to it.

How can a taxable account act like a Roth IRA? You could own assets that pay no dividend (Warren Buffett’s Berkshire Hathaway stock being a prime example), let it grow tax-free during your working years, and make your withdrawals tax-free in retirement as long as you have taxable income of $80,000 or less based on 2020 tax code if married filing jointly (half that for singles).

If you’re more comfortable with index funds rather than individual stocks, expect to see a tax drag due to dividends in the range of 0.3% to 0.6% per year depending on how much you earn and where you live.

 

 

There you have it! An introduction to retirement accounts. In the next lesson, you’ll learn abouIt the pros and cons of investing with Roboadvisors at Just Start Investing.