There are three main types of accounts to consider when investing for your retirement. Each type has its own advantages and disadvantages, so choosing the right mix is essential for creating a successful retirement plan or potentially retiring sooner. Let’s dive into the pros and cons of each account type and discuss when they should be used in your financial strategy.
Traditional (Pre-tax Money)
Pre-tax money has traditionally been a popular way to save for retirement. By contributing pre-tax funds, you can reduce your taxable income for the year, with both the contributions and the growth being taxed in the future. Account types associated with this tax treatment include traditional IRAs, the traditional component of a 401k/403b (which can encompass both your contributions and the employer contributions), and most pensions, which are treated as pre-tax assets. The main advantage of this type of account is the immediate tax benefit and the deferral of taxes until a future date. For instance, if you earn $100,000 per year and contribute $20,000 to a traditional 401k, you can deduct this amount from your taxable income, reducing your total taxable income to $80,000 for the year.
The drawback to pre-tax money is that future withdrawals are fully taxable at your ordinary income bracket, along with the possibility of required minimum distributions (RMDs) in your late 70s. For example, if the $20,000 contribution from the earlier scenario grew to $100,000 and you withdrew the entire amount, you would have an additional $100,000 of reportable income for that year.
Another drawback is the limited flexibility in withdrawals from pre-tax accounts. Generally, pre-tax money offers very little room for penalty-free withdrawals until you reach the appropriate retirement age (59.5 years of age at the time of writing this article). There are hardship withdrawals or loans from a 401k, and other exceptions to avoid the penalty, but typically, this can be the least flexible account type.
Pretax Money
| Pros | Cons |
|---|---|
| Immediate tax benefit | Fully taxable upon withdrawal at ordinary income rates |
| Lowers taxable income | Required minimum distributions (RMDs) in late 70s |
| Limited flexibility for penalty-free withdrawals until retirement age |
Roth (Post-Tax)
Roth accounts were created in the US in 1998, so they are relatively young compared to their traditional counterparts. Roth money is the opposite of traditional assets as there is no immediate tax benefit; however, the contributions and the growth can be returned to you tax-free, provided you follow all of the rules. Generally, what you contribute to the account (also known as basis) can be withdrawn penalty- and tax-free at any time, even if you are below the designated retirement age.
Traditional and Roth accounts are subject to the same contribution limits for both IRAs and employer-sponsored plans. This means the maximum amount you can contribute to the account is the same, regardless of how much goes into each type of tax-advantaged account
However, the growth in the account is treated separately. Once you open a Roth account, there is a 5-year clock on the earnings in the account before you can pull the funds penalty- or tax-free. Once the five years have passed, you can potentially pull your earnings out penalty-free, but they may be subject to tax if you are below the designated retirement age. If you are older than 59½ and the account is older than five years, then the growth is typically treated as tax-free. There are no required minimum distributions from the Roth accounts either.
It is important to note that the Roth has three ‘buckets’ from which your distributions will be pulled. The order of the ‘buckets’ is basis, conversion contributions, and finally earnings. Every time you withdraw funds from your Roth, the tax treatment of the distribution is dependent on which ‘bucket’ the funds are pulled from. Funds will be pulled from the first bucket, and once that is depleted, it moves to the second, and so on. This means you can pull the money from the basis bucket penalty- and tax-free until your basis is depleted. (It becomes a little more complex if we try to pull the basis from a Roth account that is linked with an employer plan than it is from a Roth IRA due to the potential to have a mix of Roth and traditional assets in the employer plan. For simplicity sake this will be reviewed in another article.)
Let’s stick with the $20,000 example from before but contribute it to a Roth 401k this time. In this case, you tell the IRS you made the full $100,000 of income (rather than $80,000 in our last example), but when we go to pull the $80,000 of growth out in retirement, it is completely tax-free (if we followed all of the rules).
Post-Tax Money
| Pros | Cons |
|---|---|
| Tax-free growth and withdrawals (if rules followed) | No immediate tax benefit |
| Contributions can be withdrawn penalty- and tax-free at any time | Must follow specific rules for tax-free growth withdrawal (5-year rule and age 59½) |
| Flexibility in accessing contributions | Conversions can have their own five-year holding periods |
| No Required Minimum Distributions (RMDs) |
Non-Qualified Money
The final account type is the money you can save or invest outside of tax-advantaged accounts, typically referred to as a brokerage account. These accounts offer no tax deferral, meaning all realized income or gains are immediately taxable in the year they occur. For example, if you owned a CD that paid you $1,000 in interest, you would report the income immediately. In contrast, with a retirement account, you would only have income when a distribution occurs.
Think of it like this: in your retirement accounts, there is a curtain drawn, and anything that happens behind the curtain (buys and sells or income produced from the assets) is disregarded by the IRS. The IRS is only concerned when something crawls out from underneath the curtain (when money leaves the account). With a brokerage account, the curtains are always pulled back, and the IRS cares about everything that happens within the account. The immediate taxability of the account can be a con compared to the tax advantages of true retirement accounts, but this account offers the most flexibility and access, as you are not locked up until retirement age. Another advantage is the treatment of long-term assets in the form of long-term capital gains taxes over ordinary income.
If the asset is held for longer than 12 months before it is sold, you could potentially pay lower taxes on the growth. We refer you to the IRS.gov to search your own long-term bracket, but to help better your understanding, here is how long-term gains can be beneficial:
Let’s say you are in the 24% tax bracket and the 15% long-term capital gains bracket. You own a stock ‘ABC’ which you bought for $10 and it is now worth $30.
If you sell it before 12 months, then you will generally treat the gain as a short-term gain, which is taxed at your ordinary income tax bracket. So, $20 in ordinary income for that year in which you sold, or about $4.80 worth of tax, bringing your total gain to $15.20 ($20 – $4.80).
If you sell it after 12 months and are subject to long-term capital gains, the $20 is treated as a long-term gain and is taxed at 15%, or $3 worth of tax, rather than the 24% ordinary income bracket, for a total gain of $17 ($20 – $3).
To get the most out of this account you really need to focus on Tax-Efficient Investing or else you can create tax drag which can pull down on your returns but that is another article in itself.
Non-Qualified Money
| Pros | Cons |
|---|---|
| Most flexible account type | No tax deferral benefits |
| No restrictions on withdrawals | Immediate taxability of realized gains and income |
| Long-term capital gains taxed at lower rates | Subject to short-term capital gains taxes if sold within 12 months |
| Potentially lower taxes on long-term gains |
When to Use Each Account Type
This is the hardest question of the day and there truly is no one-size fits all approach and it depends on your own financial situation as there are several pros and cons to each account. The best way is to analyze your own tax situation or seek the advice of a professional financial advisor like a Certified Financial Planner® on letsmakeaplan.org, who should have an in-depth knowledge around these concepts.
Once you have selected which account to utilize you will now need to focus on how you are invested to maximize efficiency which you can read about here: Maximizing Wealth with Strategic Asset Location