Account types
This post is part of the Financial Freedom Guide series
OK, at this point you may be asking:
I'm on my broker's website and they're asking me what kind of account I'd like to open. Help!?
What the heck is an IRA, employer 401(k), 403(b), 457(b), individual 401(k), or any of the other members of the zoo of US retirement accounts? And which one should I put my money into?
Should I contribute "Traditional", "Roth", or "After-Tax" funds?
What the heck is a "Backdoor Roth contribution”?
Don't despair - you've come to the right place!
Apologies in advance, this is going to be US-specific. If you'd like to write a guest post on how to optimize tax advantaged retirement saving in your country, please hit me up in the comments or drop me a message!
If US investment account options aren’t relevant to you, feel free to skip ahead to the next article on How do I optimize taxes? - or go back to the previous article on Brokers and fund managers. Let’s jump in!
Regular brokerage accounts
Regular brokerage accounts are great! You can put your money in or take it out at any time and for any reason. You can buy and sell whatever securities you please in them. They're also where you'll do all your tax loss and tax gain-harvesting.
Which points us to their only downside: Interest, dividends, and capital gains realized in regular brokerage accounts are taxable as and when received. That said, if you hold your investments for long enough (as you should) - i.e., 1 year for long-term capital gains, 60 or 90 days for qualified dividends from US and certain other corporations - you can qualify for lower capital gains tax rates. Other ways to reduce your taxes in regular brokerage accounts are tax-free municipal bonds and the 20% pass-through business income deduction on US REIT dividends passed as part of the 2017 TCJA.
Regular brokerage accounts have a "bad rep" for retirement savings but if you are pursuing Financial Freedom, not only will you likely need to expand your savings beyond what you can contribute to various retirement accounts, there are also some distinct advantages to doing so as part of a diversified investment account strategy.
Individual Retirement Accounts (IRAs)
As the name says, these accounts can be opened by individuals and function much the same as regular brokerage accounts. The difference here is that they can have certain tax advantages if you play the game right and understand how to use the litany of complicated IRS rules to your advantage. Here's a high-level overview:
Traditional IRAs
Add funds: Up to an annual limit ($6,000 for most people in 2021), tax deductible if you qualify. This means, to the extend your contributions are tax deductible, you can add pre-tax funds.
Earnings: Not taxable while in the account
Withdrawing funds: Taxed at ordinary rates - plus 10% early withdrawal penalty if you withdraw before age 59 1/2 and don't meet certain exceptions
Roth IRA
Add funds: Up to an annual limit ($6,000 for most people in 2021), if you qualify. No tax deduction, you always add after-tax funds (same as with regular brokerage accounts).
Earnings: Not taxable while in the account
Withdrawing funds: Contributions are never taxable. Conversions are not taxable and 10% penalty tax-free after 5 years. Earnings are not taxable after age 59 1/2 but otherwise taxed at ordinary rates - plus 10% withdrawal penalty if you withdraw before age 59 1/2 and don't meet certain exceptions
The IRA annual contribution limit counts across all your Traditional and Roth IRAs put together, not per account. You can "convert" Traditional funds from an IRA or other retirement account into Roth funds. To the extent conversion amounts derive from previously tax-deducted (i.e., pre-tax) funds, they become taxable income in the year of conversion. Watch out for the pro-rata rule!
IRAs are a fantastic tool in your tax optimization toolkit. You can open them with most providers which also offer regular brokerage accounts. As with regular brokerage accounts, I personally prefer Vanguard.
BONUS: Backdoor Roth IRA
If your income exceeds both the Roth IRA contribution limit and makes some or all of your Traditional IRA contributions nondeductible, consider a "Backdoor Roth IRA" contribution. Here is how it works:
You contribute the maximum you are allowed to a Traditional IRA. Some or all of these funds won't be tax deductible as you are exceeding the income limits but you can still make “nondeductible” (after-tax) contributions.
Turn around and "convert" these nondeductible funds to Roth. This moves them from your Traditional IRA to your Roth IRA account and turns them into Roth funds. As your contributions were already after-tax to begin with, no income tax is due on them. Watch out for the pro-rata rule when doing this! Earnings on your after-tax contributions are taxed at ordinary rates.
This tax code loophole used to be kind of hush hush but was officially sanctioned by Congress as part of the 2017 TCJA.
Pro-rata rule
This rule stipulates that when you convert Traditional IRA amounts to Roth, you must first add together all your Traditional IRA, SEP, and SIMPLE funds (it's a zoo!) and determine which percentage of your funds is derived from pre-tax vs after-tax/ nondeductible contributions as of December 31 of the year of conversion. You then pay income tax on the "pro rata" share of the conversion that is pre-tax.
One way to avoid this is to first roll all pre-tax balances in your Traditional IRA, SEP, and SIMPLE accounts into your employer 401(k), 403(b), 457(b), individual 401(k), or other retirement account not already listed here (I'm literally not sure what other animals might live somewhere in this zoo). This cleans your slate so to speak and allows the full amount of your contributions to be converted tax-free. - Just watch out not to do the conversion earlier in the year thinking you have a clean slate, only to then forget about it and roll some pre-tax funds from your former employer's 401(k) into any of your Traditional IRA, SEP, or SIMPLE accounts later in the year. Remember, what counts is your account situation on December 31 of that tax year, not when you do the conversion. It's easy to get wrong and it hurts! Of course the reverse is also true, meaning you can fix an error as long as you do it before December 31 the same year.
Employer-sponsored retirement accounts
401(k)s
Named after their eponymous subsection of the IRS code, 401(k)s are offered by employers and managed by a range of administrators (Fidelity being the largest by AUM). In conjunction with the administrator, your employer sets the plan rules, fees, available investment options, and offers matching funds, if any.
Before contributing to your employer's 401(k), you should review the plan's fee schedule and determine if the tax advantages of investing in the plan outweigh the plan's fees and potentially limited investment options. You may have to adjust your asset allocation in your other investment accounts and/or pick different investments in your 401(k) than you would ideally like (such as a Target Date Fund) to make it work. Many reputable employers have fantastic offerings, others not so much. Even in the latter case it typically makes sense to contribute at least up to the amount your employer will "match" (i.e., give you extra free money).
Once you separate from your employer you can "roll over" your 401(k) funds to an IRA or your new employer's retirement account(s), so it can make sense to contribute even to terrible plans if you know you will move on from your (probably equally terrible) employer before long.
Just as with IRAs, the IRS adjusts 401(k) contribution limits for inflation over time. In 2021, the contribution limits are:
Employee contributions: $19,500 (or $26,000 if you are turning 50 or older)
Total contributions from all sources: $58,000
Again as with IRAs, you can - if your employer allows this - add either Traditional or Roth funds to your 401(k), up to the combined Traditional and Roth employee contribution limit. This limit is separate from and in addition to the IRA contribution limit. Which gets us to the part not many people realize:
If the employee contributions are capped at $19,500 (or $26,000), what's up with the difference between that and the $58,000 overall limit? Well, this is space your employer can fill with pre-tax funds (they get a tax deduction for this). This may be as part of a matching scheme - e.g., your employer might match your employee contributions dollar for dollar up to a certain percentage of your income - or straight up employer contributions as part of your compensation package.
Any headroom your employer doesn't fill, you may be able to take advantage of with so-called "Voluntary After-Tax" contributions if your employer's plan allows for it. This works much like nondeductible contributions to your Traditional IRA (see Backdoor Roth IRA) and is particularly attractive if your employer allows "in-plan Roth conversions", or if you know you will separate from this employer before long and can then roll these after-tax funds into your Roth IRA. Either way, you would have achieved a so-called Mega Backdoor Roth contribution for as much as $38,500 in just one year (the $58,000 overall limit minus your $19,500 employee contributions) - sweet! Also, there's no need to worry about the pro-rata rule as that rule only applies to IRAs, not 401(k) accounts.
Roth funds are very attractive as you can withdraw your contributions tax and penalty free at any time. Withdrawing conversions (like your backdoor Roth funds) is also tax free - and 10% penalty tax-free 5 years after the conversion. Even earnings on your contributions/ conversions become tax free once you reach age 59 1/2. So you definitely want to have a significant portion of your nest egg in Roth over time. We will do a more thorough review of the ins and out of this on the next page on How do I optimize taxes?.
Rounding this out, investment earnings in your 401(k) aren't taxable while in the account, just as with IRAs. The distribution rules vary a bit by employer but are broadly in-line with IRAs. Basically, if you are over 55 years old, take a look if your 401(k) gives you options or advantages your IRA does not. If not, you can just as well roll your 401(k) into your IRA once you separate from your employer.
403(b) and 457(b)
Simply put:
401(k)s are primarily set up by for-profit employers and need to comply with the regulations in the Employee Retirement Income Security Act (ERISA). This includes provisions to prevent management-level and other highly compensated employees from receiving a disproportionate share of the plan's benefits.
403(b)s are exempt from these regulations and can only be set up by non-profit employers such as schools, universities, or other tax-exempt organizations
457(b)s are also exempt from these regulations and can only be set up by state and local government employers as well as some non-profit employers
All three of these accounts work mostly the same, and some employers even offer two or even all three of them. There are some differences in contribution and withdrawal rules across these accounts, two of which stand out:
While contributions to 401(k)s and 403(b)s count against the same annual contribution limit - even if you switch employers - the 457(b) has a completely separate contribution limit. This means you may be able to contribute substantially more to your employer retirement accounts than the rest of us plebs if you have access to one.
Uniquely among retirement accounts, 457(b)s withdrawals are never subject to the 10% early withdrawal penalty. This means you can use 457(b)s to smooth out your income and stay in lower tax brackets over time. Of course that would also mean having to give up the tax advantages of having your money in a retirement account. It may thus make more sense to convert/ roll over your 457(b) funds to your Roth IRA once appropriate. That also gives you tax and penalty-free access to your conversion amount after 5 years - and allows your earnings to become tax free once you meet the Roth IRA withdrawal stipulations.
Individual or solo 401(k)
Wait, what? Didn't we cover 401(k)s already? Yeah, but in order to get access to one, you need an employer to offer one to you. If you are self-employed and don't have employees (else you set up a 401(k) like any other employer), you can create a solo 401(k) just for yourself. This then allows you to contribute to your solo 401(k) both as "employee" and "employer". Like with other retirement accounts, this is limited by both the annual 401(k) contribution limits and your income. You can find more details here.
Summary
OK, we introduced many of the most important US retirement accounts and contrasted them with regular brokerage accounts. Along the way we learned about Backdoor Roth IRAs, Mega Backdoor Roth contributions, and some of the other retirement savings tools available to you.
If you have any questions, please don't hesitate to post them in the comments below. I will do my best to answer them and may add/ modify points above and create further deep-dive posts. Similarly, if you spotted something above that is incorrect or missing a critical piece of information, please hit me up in the comments or drop me a message direct. Thanks guys - I look forward to learning together with you!
PLEASE NOTE: US retirement accounts are complex and this post cannot hope to comprehensively discuss all of their rules and T&Cs. As always, the content of this blog is for entertainment purposes only. I am not a qualified financial advisor, tax accountant, or lawyer. Please consult authoritative sources, apply your own judgement, and/or seek advice from qualified professionals before making any investment or tax decisions.
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