Considerations for Savers: Which Account?
Saving money for retirement seems easy right? Systematically contribute as much as you can to an account. Invest it according to your risk tolerance. Let time and the power of compounding work its magic! Of course, in the world of changing tax laws and changing personal circumstances, it is not that simple.For savers, those in the asset “accumulation phase,” it is important to not only systematically save, but to also formulate a savings strategy. The strategy should simultaneously provide a balance between current and future tax benefits, while also keeping the door open to provide (penalty-free) liquidity should personal circumstances change.
Is it best to contribute to my company sponsored 401k plan, a Roth IRA, or a personal brokerage account?
On the surface this question seems pretty straight-forward, but to answer this question, it is important to understand the tax and accessibility implications of various types of investment accounts. The following are descriptions of the most common types of accounts utilized for retirement savings:
Traditional IRAs and 401(k) Plans (qualified accounts). Contributions to qualified retirement plans are generally tax deductible. That is, contributions reduce current taxable income. In addition, investment earnings of interest, dividends and capital gains are not taxed when earned. However, when distributions are taken from qualified accounts they are generally taxed to individuals at their tax rate on a dollar for dollar basis. Also, distributions taken prior to the age of 59 1/2 may be assessed a 10% early withdrawal penalty.
Roth IRAs. Contributions to Roth IRAs are not tax deductible. However, income, interest and capital gains in Roth IRAs are not taxable. In addition, distributions of the original contribution in Roth IRAs (the corpus) are not taxed or penalized. Investment earnings generated from Roth IRAs can be distributed tax and penalty free after the age of 59 1/2 (with some exceptions).
Personal accounts (non-qualified accounts). Personal accounts can be established at brokerage firms, mutual fund companies and banks. Contributions to personal accounts are not tax deductible. Income, interest and capital gains generated in these accounts are taxable in the year they are earned or realized. If a stock or mutual fund is sold, the gain on the sale is a capital gain and is generally taxed at capital gains rates. Investment losses realized in personal accounts can be used to offset gains and up to $3,000 of taxable income. Because taxes are paid in the year income is earned or realized, distributions from personal accounts are not taxable.
Tax Management As you can see, each type of account has varying tax attributes on both contributions and distributions. In addition, there are possible penalties to consider should you need the money prior to a certain age.Creating a savings strategy that can make maximum benefit of current tax savings, while also retaining flexibility to accommodate future disbursements is a key component of sound financial planning. We hope that you will give us a call should you have any questions.