There are a number of different types of accounts, and understanding them all, let alone choosing which one is right for you, can be tricky without the help of a financial advisor. Below, we have broken down different types of common accounts and the unique benefits they can bring to you.
The Most Common Types of Accounts and What They Mean
These accounts are created and contributed to with money that has already been realized as earned or received post-tax deductions. Meaning, you made the money and paid taxes already, so the IRS will not try to tax you on those dollars again. Your original contribution is called your tax basis, and it is used to determine your gains and losses. The amounts above or below your tax basis are your gain or loss for annual tax purposes. At the end of each year, you will receive a 1099-D which declares your gains and losses. Gains on investments that are held for less than one year are taxed at your ordinary income tax rate, also known as short-term capital gains. Investments sold after one year are taxed at a lower tax rate and are known as long-term capital gains. After you pay taxes on the gains, your cost basis will go up proportionately.
Types of taxable accounts:
- Individual – an account with one owner
- Joint with Rights of Survivorship – an account with two owners whereupon the surviving owner receives the entire account
- Joints Tenants in Common – an account with two owners whereupon the descendants designated beneficiary or their estate receives the proceeds of their portion
- Transfer on Death (TOD) – an account designation where a beneficiary can be added to the account, avoiding probate if the account owner dies and directing the account to the person intended to receive it
These are accounts where the contributions made are post-tax, but unlike a taxable account, you never pay taxes on any of the gains.
- Roth IRA – an individual retirement account that you can withdraw from after the age of 59 ½ or for qualified withdrawals, including buying your first home, the birth of a child, adoption expenses, or paying for college. While you can take out your contributions tax- and penalty-free before the age of 59½, any gains that you withdraw prematurely will be subject to taxes and penalties.
- 529 Account – must be used for qualified education expenses in order to enjoy tax-free benefits. These accounts can be transferred to blood relatives if the funds are not being used in the account holder’s name. If the funds are withdrawn for non-qualified expenses, there will be a penalty fee and taxes on any gains.
Tax-Deferred Retirement Accounts
These accounts are specifically designed for retirement, with limitations on when you can withdraw (59 ½ years old) from them and have mandates on when you have to withdraw (72 years old) from them. The contributions you make to tax-deferred retirement accounts go in before you are taxed. These accounts grow over time with no annual tax payments or benefits, however, any withdrawals that are made from the account are subject to taxes and are treated as income for the year. While these accounts are interesting vehicles in low tax environments and low-income tax rates, their benefit is limited if your tax rates are higher during retirement. This is where having tax knowledge or having a professional advisor with tax knowledge comes in handy. There is a difference between tax reporting (filing your annual taxes) and tax planning (planning to reduce tax payments over your lifetime) that needs to be considered. Taking a tax break now to pay taxes in the future isn’t a simple no-brainer like many people would like you to believe, because we don’t know what taxes will look like in the future.
- Individual Retirement Account (IRA) – As you may have gathered by its name, it is an account for one person and cannot be transferred into another person’s name. These accounts lose their tax contribution benefit as you exceed certain income thresholds, which are set annually. The tax benefit is recognized at the time of filing, not at the time of contribution, like the employer plans listed below.
- 401(k) – an employer plan that allows tax-deferred contributions as a payroll deduction, usually with higher limits than your IRA. Those limits are based on your plan type and are not always the maximum contributions dictated by ERISA rules. Some plans offer a Roth option, allowing the participant to contribute post-tax dollars with tax-free appreciation. Unlike a regular Roth, there are no income limitations to make contributions in an employer-sponsored Roth 401(k).
- 403(b)- a retirement plan established for the benefit of employees of public schools and certain tax-exempt organizations. These plans accept payroll-deducted contributions for participant-directed investing and are intended to help the employees meet long-term objectives, such as generating retirement income.
- 457 Plans – deferred compensation plans. There are "B" and "F" plans that have different contribution limits and rules, but are both subject to income tax at distribution. These are typically used in compensation packages to help defer out taxes to the recipient.
- Profit-Sharing – distributions of profit to employees by employers based upon the contributions the employer wants to make and calculated by ERISA rules around employer plans.
- Separate Employee Plan(SEP) IRA – created by business owners with contributions made solely by the employer, not the employee. Contributions are made as a percentage of income that is determined by the employer and maxes out at 25%, with a cap on the income that percent can be contributed toward.
How Do You Choose?
As you can see, there are a number of different accounts, each with its own tax treatment and limitations. The strategy is to accumulate funds and have an exit plan, both adding contributions, and withdrawing distributions, over time and in retirement, in the most tax-efficient way.
If you need help crafting your strategy, schedule an appointment by:
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