All fields have their own industry jargon and alphabet soup of abbreviations, but the investment world just might have the most. In the U.S. alone, there are 4,000 publicly traded companies, over 1,400 exchange traded funds (ETFs) and over 9,000 mutual funds, each with its own ticker. Tickers range from the cutesy (like WOOF, the ticker of a chain of veterinary hospitals) to the cryptic (the ticker JASBX doesn’t tell you much about the bond fund it represents). On top of that, the accounts used to hold your investments are often named according to the subsection of the tax code that created them, like the 401(k), or by initials, like the IRA or TSP. It is easy to get all of this alphabet soup mixed up!
(photo used under public domain)
In this blog, we wanted to provide an easy guide to some common types of investment accounts, as well as a few general tips on how to use them.
Individual Retirement Account (IRA)
These are investment accounts you can open with major custodians like Fidelity or Schwab. As it says in the name, these are individual accounts—you cannot open a joint IRA with two people as owners. You can hold any security in an IRA, and the maximum annual contribution you can make per year per person (even if you contribute to more than one IRA account) is $5,500 ($6,500 if you are over age 50).
- Roth IRA: Roth IRAs are tax-advantaged—meaning that you contribute earned income that you have already paid income taxes on, but any future earnings and withdrawals are completely tax free. This makes IRAs a very powerful tool for compound interest! Unfortunately, not everyone is eligible for a Roth IRA because there are income limits. Once you have an individual adjusted gross income over $133,000, or a joint adjusted gross income level over $196,000, you are ineligible to make Roth IRA contributions. (There is a strategy to convert a Traditional IRA into a Roth IRA, but whether it is appropriate for your income and tax situation may vary.)
- Traditional IRA: Investors of all income levels can make contributions to a Traditional IRA, as long as they are under age 70.5 (there is no age restriction for a Roth). This type of account is tax-deductible in the year of the contribution (up to a certain income level), but any withdrawals are taxed at ordinary income tax rates. The tax deduction is a nice perk, but it is especially sweet if you take advantage of a Traditional IRA during higher-earning years, but you withdraw when you are in a lower tax bracket.
- Spousal IRA: Normally any money put into an IRA must be earned income—but for married single-earner households, the spouse who does not earn an income can use a Spousal IRA to save for retirement. Spousal IRAs can be Roth or Traditional, depending on the joint income level.
Workplace retirement plans
Workplace retirement plans come in many different flavors based on factors such as the size of the company and whether you work in the public or private sector. Typically these accounts are tax-deferred, meaning you can contribute money from your paycheck before taxes are ever taken out. The full amount you contribute from your salary grows in investments over time, but when you take money out, you owe taxes on the original contribution and its growth. It is a good idea to contribute at least 10% of your salary, or enough to get the company match, if available. Aim to increase contributions up to the maximum allowable amount per year, perhaps by increasing your contribution whenever you get a raise at work.
- 401(k) Plan: The maximum contribution for a 401(k) is $18,000 per year, plus an additional $6000 catch-up contribution when you are over age 50.
- 403(b) Plan: A 403(b) Plan is similar to a 401(k), but is only for workers in public education and certain other tax-exempt organizations, as well as certain religious ministers. 457 Plans are for state or local government employees and tax-exempt non-government entities. The maximum annual contribution is the same as for 401(k) plans.
- 457 Plan: 457 Plans are for state or local government employees and tax-exempt non-government entities. They are similar to a 401(k) or 403(b), and the maximum annual contribution is the same, but there are a few key differences: government contractors can participate, and the employer does have the ability to make contributions for the employees. Unlike 401(k) and 403(b) accounts there is no 10% penalty for withdrawals prior to age 55 (though ordinary taxes do apply), and if the account is for a government employer, the account can be rolled into an IRA at retirement.
- Profit sharing plan (PSP): A profit sharing plan allows business owners to make a discretionary contribution for their employees, though they are not required to do so every year. Employees do not contribute to this plan, but some employers offer it as a benefit.
- Thrift Savings Plan: For federal employees. The TSP is similar to a 401(k) structure, but has a simplified basket of investment options. The maximum contribution is the same as 401(k) plans.
- Pension: Today pensions are rare, but if you are lucky enough to have one, be aware that you will be taxed on distributions. Early withdrawals are also penalized at 10%.
- Individual 401(k) or Simplified Employee Pension (SEP) IRA: If you are self-employed, you have several options to maximize your retirement savings and tax deductions for your business. The individual 401k could be a great option for a self-employed spouse depending on his or her income. At the same income level, the individual 401k can potential allow for a greater contribution amount than a SEP IRA. However, it has more administrative responsibilities and possible costs than a SEP IRA.
Taxable account (also called an after-tax or brokerage account)
Any earnings or interest in a taxable account is taxed in the year they occur (with the exception of tax-advantaged investments like certain municipal bonds), and there is no tax deduction for contributing. This makes taxable accounts sound less attractive, but they actually have a very important role in a retirement income strategy.
Remember that tax-deferred accounts like 401(k)s have not had taxes taken out yet (unless it is a Roth IRA, which has completely tax-free distributions). If you are in the 25% tax bracket, for example, you own 75% of your 401(k) balance while Uncle Sam owns 25%. The taxes are deferred to a later date—but they must be paid eventually when you make a withdrawal. Tax-deferred plans are drawn down much faster in retirement than after-tax plans for this reason. In a taxable account, the balance of the account is really all yours (less capital gains taxes). When you retire, using funds from a taxable account first and allowing tax-deferred money to continue to grow for a few more years (when you could potentially be in a lower tax bracket anyway) can be very impactful.
Because you have already paid the taxes on after-tax investment funds, this type of account gives you extra diversification and retirement security. Investors should contribute to both types of accounts to benefit from each of the two approaches.
How to decide how much to put toward which accounts?
This would require a closer look at your overall financial picture. You should ensure that you have sufficient liquid assets, that you don’t have high-interest debt to pay off, and that your monthly cash flow is healthy. Then, it depends on your long-term financial goals and needs—for example, how much would you need to save per month now to provide for a certain level of retirement income in 15 years?
The team at Halpern Financial is happy to perform this analysis for our clients. We welcome your questions and hope this explanation has made the alphabet soup of retirement savings a little more palatable!
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Halpern Financial, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Halpern Financial, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Halpern Financial, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Halpern Financial, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.