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Taxman Graph-iti: Do you know when your accounts are taxed?

Another Second Opinion

August 23, 2023

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Pop-quiz hotshot, fill out this chart:

If this was too easy for you, move along, this isn’t the post you’re looking for.  If you’re slightly unsure, either follow along or skip to the end.  *Spoiler alert, I’m going in order.

Retirement Accounts

There are so many to “choose” from it seems slightly overwhelming at first.  You really don’t get that many choices, if you’re self-employed you can’t invest into a 403(b), if you’re in private practice, you can’t contribute to a 457(b).

So what do these numbers(and letters) mean and which ones can I contribute too?  The former comes from IRS tax code, the latter is determined by said tax code.  Without getting too complicated as there are tons of nuances, here’s the gist of these numbers(and letters):

• 401(a)-only offered to certain government employees
• 401(k)- one of the most common plans offered by corporations.
• 403(b)- for public education, churches and non-profit hospital employees
• 457(b)- for government agencies and some non-profits
• Simple IRA- available to businesses with <100 employees
• SEP-IRA- for small businesses and the self-employed
• DBP- self-employed owners of a business
• Solo 401(k)- for a business owner and spouse

So again, no one fits into all of these categories, so don’t feel like you’re missing out because you don’t have a 403(b), 457(b), etc. They are all essentially the same-they allow a certain amount of pre-tax income to be contributed, often times with an employer match.  Moral of the story-take full advantage of any of these accounts you’re eligible for.

Roth IRA

First off, it’s named after the late Senator William Roth of Delaware, so now you know.  This type of retirement account is different from the traditional account in that you do not get a tax deduction when you contribute.

Sounds like a bad deal at first, but it turns out when it comes time to withdraw funds during retirement, you don’t have to pay any taxes at all!  It’s like extra money that Uncle Sam doesn’t need to know about, all because he got his piece a when you first put it in.

Unfortunately if your income is too high, you’re not allowed to start a Roth IRA.  But do not fret, the government has opened up another door to get your money into a Roth IRA…the…wait for it…Backdoor Roth IRA!

Basically you can take another retirement account, pay some taxes and convert it into a Roth.  Is this the right move for everyone? No, if you’re in the top tax bracket and have some more room to invest pretax money, then you should probably do that.  Once you’ve maxed that out, then consider this for sure.

Health Savings Account (HSA)

When it’s time to choose which health insurance plan you sign up for, amongst the HMO and PPO options is sometimes an HSA.  You still pay a premium for your insurance and get the benefits the table says you get, but it also gives you the option of putting more pretax money aside for future medical expenses.

Say what?!? Yeah, pretax money, which grows tax-free and can be withdrawn tax-free for qualified medical expenses. This is one of the few “triple tax breaks” out there, assuming you use it correctly.

You are limited on how much you can contribute each year, but are not forced to use it if you have medical expenses. Any money sitting in the HSA when you hit 65 yrs is treated the same as a traditional retirement account.

College Savings Plan (529)

If you have kids and want to get a jump start on saving for college, this is something you should consider.  My state does not allow me to deduct any of my contributions (sad face emoji), but most states allow you to deduct a certain amount.  Regardless, the investment will grow tax-free and can be withdrawn tax-free assuming it’s for a qualified higher education expense.

But what if my first child decides to pursue a career in Hollywood rather than going to college?  Do not worry, you can transfer the amount invested into your second child’s account tax-free.  Maybe this will cover medical school also, so they can eventually support their older sibling’s restaurant (…er Hollywood) career.

Taxable Investment Account

On the surface, the tax implications of having this account seem very unfavorable.  Under the surface, it’s kind of true still, but maybe not as bad as it seems.

These accounts are funded with post-tax contributions.  The advantage? You can take the money back out whenever you want.  The disadvantage?  You have to pay taxes on anything you gained.

• Short-term capital gains: for any investment owned <1 yr, any gain in value is taxed at your current tax rate.  If you’re in the top tax bracket, this obviously isn’t good.
• Long-term capital gains: for any investment owned >1 yr, any gain in value is taxed  at a lower rate, still based on your tax bracket, but only up to 20%.

So money went in after taxes and was taxed when it came out, will it grow tax free then?  Unfortunately it will not.  Any dividends received each year will be taxed, but similar to capital gains, there are two rates at which they’re taxed.

• Non-qualified dividends: taxed as ordinary income at your current tax rate
• Qualified dividends: taxed at the same rate as long-term capital gains, more favorable to those in the top tax bracket

There are plenty of ways to take advantage of these taxable accounts: tax-loss harvesting, donor-advised funds, withdrawing during early retirement to preserve your retirement nest egg(s).  These are topics for another day.

And without further ado, the complete chart:

When your investing accounts are taxed           www.anothersecondopinion.com

What are you WORTH?