In an earlier blog, we took a look, in a general way, at some key investment concepts. Now, let’s explore the tax implications of some investment options. We want you to choose the right tax advantaged investment vehicle. Your choice can have a huge impact in the long term.
“In this world nothing can be said to be certain, except death and taxes.” We have Benjamin Franklin to thank for that little idiom, and it can seem like that is very true. However, when making investment choices we aim to minimize the amount of money the government will collect in taxes. While we aren’t tax advisors and everyone’s situation is different, we can give you a little background on what we’re talking about.
Employer-Sponsored Benefit Plans
Employers offer many different kinds of benefit plans that can range from health benefits to disability and life insurance to retirement plans. (Some even offer pet insurance!) Employers can attract and maintain good, long-lasting employee relationships by offering good benefits. Employees who take advantage of the offered retirement plans can reap tax savings. The most common employer-sponsored retirement plans include 401(k) and Roth 401(k) plans, as well as 403(b) and Roth 403(b). The primary difference between the two is the type of employer sponsoring the plans—401(k) plans are offered by private, for-profit companies, whereas 403(b) plans are only available to nonprofit organizations and government employers. Although there are other subtle differences in the plans, the tax advantages covered in this blog are the same for both the 401(k) and 403(b).
Make Saving Automatic
When handling your money, the more you can automate the better–like setting up automatic bill payments. Another wise move is taking advantage of payroll deductions when investing. Many employers encourage saving for retirement through plans paid for through payroll deductions so be sure to take advantage of those options when available.
Types of Tax Advantaged Investment Plans
Let’s break down the key differences between some of your options:
401(k) Plans
- Offered by employers.
- Some employers match your contribution with their own money up to a certain amount.
- “Pre-tax” money – Money invested in a 401(k) is removed from your gross income before being taxed.
- Your taxable income is reduce by the amount you paid into the 401(k). It might put you in a lower tax bracket.
- Tax deferred – Withdrawals, known as distributions, are subject to income tax.
- Minimum age you can withdraw money without 10% penalty is 59 1/2.
- Your annual contribution to a 401(k) plan is capped at $19,500 in 2020. Employer matches are not included in that $19,500; however, the combined employee/employer contribution limit is $57,000.
Roth 401(k) Plans
- Offered by employers.
- Some employers match your contribution with their own money up to a certain amount.
- “Post-tax” money – Money invested in a Roth 401(k) is taxed BEFORE being deposited into your account.
- Does not reduce your taxable income amount.
- Withdrawals, known as distributions, are NOT subject to income tax. However, employer match amounts ARE subject to tax when withdrawn.
- Minimum age you can withdraw money without 10% penalty is 59 1/2, BUT you must have held the account for at least five years.
- The annual contribution limits are the same as the traditional 401(k). If you participate in BOTH a traditional 401(k) and a Roth 401(k) plan, the contribution limits must be split across the two.
Choosing Between the Two
First things first…always take advantage of free money. If your employer is offering to match contributions up to a certain amount, that is free money to you. At a minimum, be sure to invest up to the amount of the match in whatever plan is included.
When you are just getting started in your career, you may find that your budget is stretched too thin to solely invest in a Roth 401(k). Using after-tax money takes out a bigger chunk from your cash flow than using pre-tax dollars.
However after you retire, the Roth 401(k) plan will allow you to withdraw your money tax free (except for the employer match amounts). Tax free withdrawals are pretty sweet.
The best choice, if available, is to invest a bit in both. Take advantage of any employer match, and then spread your contribution across the two different plans.
What about IRAs?
IRA plans are either traditional or Roth. Here are some of their key features:
- Not offered by employers. The individual must open an account with an outside investment institution.
- The annual contribution limit is $6,000 in 2020. This amount is in addition to the maximum limit under a 401(k) plan.
- Roth IRA plans are not available to those whose modified adjusted gross income is over a certain amount. Click here for the chart for 2020.
- Traditional IRA deposits are tax deductible. You won’t owe tax on that money until you withdraw it. (The amount of your tax deduction will vary depending on whether or not your employer offers a retirement plan at work and your modified adjust gross income.)
- Roth IRA deposits are not tax deducible. Those distributions will be tax-free in retirement.
- Early withdrawals from a Roth IRA (before 59 1/2) have no penalty when used for things such as a first-time home purchase, unreimbursed medical expenses, or qualified education expenses. The withdrawals must be from your contributions. Early withdrawals from earnings will be subject to a penalty.
- IRA plans offer a wide selection of investment options.
If your employer does not offer a company match on a 401(k), consider going with an IRA instead. After you max out the contribution limits available with an IRA, begin making contributions to a 401(k)–even though there is no match from the employer.
Crock Pot Investing
Often a really good option for investing long term is with age-based portfolios. When you are young and have a longer period of time between now and your retirement, investments can be more aggressive. As you approach retirement, the investments are shifted into more conservative choices which won’t carry as much risk.
The benefit of choosing an age-based option is that you put the money in and don’t have to think about it afterwards. That is why we compare it to a crock pot–put the ingredients in the pot, cover it with the lid, and then don’t touch it. Age-based portfolios don’t need much stirring. They make automatic shifts for you over time and are a prudent choice when investing long term. To learn more about selecting the right portfolio, check out our blog Investing 101: A Beginner’s Guide for Recent College Graduates
Keeping Your Tax Advantaged Choices in Mind
When making investment choices, keep in mind your goals and timeline. You want to limit the amount of money subject to taxes. Will your tax bracket be lower now or in retirement? (We can’t really be sure what the tax brackets will look like in the distant future!) Do you want to pay taxes on your investment now or when you withdraw it? Your investment choices can have a huge impact in the amount the government will keep from your income and investments.
