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We in the financial planning world love our acronyms: 401k, IRA, TSP, RMD, S&P500 and many more. You likely have an alphabet soup in your investment portfolio.
Let’s do some de-coding. Essentially, your investment accounts fall into two categories: retirement accounts and non-retirement accounts. Retirement accounts have special tax treatment. These are also known as qualified accounts.
Retirement accounts (pre-tax)
This means you have not yet paid taxes on the money. It was withheld from your paychecks during your working years. Or, you contributed the money to an IRA, then deducted it from your income when you filed your taxes that year. You will pay income tax on withdrawals you make from these accounts.
Example: you and your spouse have household income of $70,000 in 2021 from Social Security and pensions. You withdraw $20,000 from your pre-tax account this year. You now have household income of $90,000. How much tax do you pay on the $20,000? Your regular income tax rate.
If you are under age 59.5, you will pay an additional 10% income tax in most cases, often referred to as a penalty.
Under federal law, you have to start withdrawing small amounts from these accounts annually when you’re 73. This is called a Required Minimum Distribution (RMD).
Pre-tax accounts are taxable to your heirs.
Retirement accounts (Roth)
You fund Roth accounts with after-tax money. In return, everything you put in and all the growth is tax free (as long as you’re 59.5 and had the account five years). This is one of the rare times in life Congress lets us take profits tax free. Roth accounts are excellent for people who have a long time to invest. All that time will most likely result in a lot of growth, which is all tax free.
You can always withdraw your Roth principal tax free. If you make a withdrawal under 59.5, you’ll pay tax and a penalty, but only on the growth.
Roths do not have RMDs. They are tax-free to your heirs.
In summary, retirement accounts can be pre-tax or Roth. Examples of retirement accounts are IRA, 401k, 403b, 457, Missouri deferred compensation and Federal TSP. All of these are connected to an employer, except for IRA, which stands for Individual Retirement Account. You own your IRA, and no employer is involved.
Retirement accounts are always individual - not owned jointly with a spouse and not owned by a trust.
Non-retirement accounts
These are known as “nonqualified accounts.” You fund them with after-tax money.
You pay taxes only on the growth. Unlike retirement accounts, there is no limit on how much you can contribute. And there are never penalties for withdrawals, regardless of age.
Because you most likely own pre-tax and after-tax accounts, it gives you opportunities to plan your withdrawals. Which do we pull money from? Think about the taxes, and we’ll find the answer.
Now let’s clear up a common point of confusion: the type of account does not affect investment performance. We often get questions like “Does a Roth IRA grow better than a regular IRA?” The answer is no. All that matters is the investment inside the account. You can buy Walmart stock inside a Roth, pre-tax or nonqualified account.
If Walmart grows by 4%, the performance is the exact same in all three accounts!
You can put just about anything you want inside any of these accounts. They can be checking accounts, savings, CDs, stocks, bonds, mutual funds, annuities, etc.
If you need a maitre d’ to help with your alphabet soup, let us know. For the tax aspects, talk to your accountant.
Travis Ford, CFP®, is a partner and financial planner at Wallstreet Group Advisors in Jefferson City. 573-297-2049 or travis@wallstreetgroupadvisors.com. Securities and advisory services offered through CreativeOne Securities, LLC member FINRA / SIPC and an investment advisor. Wallstreet Group Advisors and CreativeOne Securities, LLC are not affiliated.
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