Tax Advantaged Retirement Investing
Wondering about the details of the various types of tax advantaged retirement accounts? Between 401K, 403B, Traditional IRA, Roth IRA and HSA, things can get a little confusing. Hopefully I can help clear things up a bit below.
The goal of these accounts is to allow your contributions to grow tax-deferred or tax free in investment accounts. Meaning you’ll only be taxed on gains as income once gains are realized (withdrawn from the account). I personally only invest in broad-based low cost index funds & ETFs. A favorite among financial independent enthusiasts are Vanguard funds.
An excellent resource for more detailed information on index funds is The Money Guy and J L Collins.
Employer Sponsored Retirement Accounts (401K 403B or SEP IRA). These accounts are offered by an employer and have certain limitations. Contributions to these accounts are pre-tax, reducing your taxable income. Distributions from these accounts in retirement are subject to income tax laws at the time of withdrawal. Account participants can contribute up to the annual max of $19,500 in 2020 plus an additional $6,500 for participants 50 and older. This does not include the matching from employers that are typically associated with these accounts. In depth details for each account type can be found on the irs.gov site here.
Roth IRA. This account type is separate from your employer, uses after-tax dollars and is not tax deductible. Instead, gains can be withdrawn tax-free as long as certain qualifications are met: account must be at least 5 years old and participants must be 59 1/2 or older. Otherwise, there are tax penalties for withdrawals outside of these parameters.
This tax-free growth allows you to take full advantage of pulling funds out in retirement, a time when you’ll most likely be in a lower tax bracket, thereby reducing your tax liability.
Account participants are able to contribute up to the annual max of $6,000 in 2020 plus an additional $1,000 for participants 50 and older, based on your income and tax filing status. This is the total contribution limit across all IRA types. Check out the irs.gov site here to find out if you qualify for the annual max contribution.
There are no required withdrawals (or required minimum distributions — RMDs) for the Roth IRA.
Traditional IRA. This account type is still separate from your employer, but unlike the Roth IRA, the Traditional IRA offers a tax deduction in the same year it is contributed, which reduces your taxable income. These dollars grow tax-deferred, meaning you’ll pay income taxes (not capital gains or dividend taxes) once the funds are withdrawn in retirement, when you’ll more likely be in a lower tax bracket. Contributions to a Traditional IRA account may be tax deductible, dependent on whether or not you are covered by a retirement account through your employer. See more information on the irs.gov site here.
Contribution limits are the same for Roth IRA ($6,000 for both 2020 for those under age 50 1/2; $7,000 for those 50 1/2 and older). This is the total contribution limit across all IRA types. Also, at age 72, participants are required to start making minimum withdrawals, also known as required minimum distributions (RMDs).
HSA. A Health Savings Account is a plan that is available for participants enrolled in a qualifying High Deductible Health Plan through their employer. The beauty behind HSA is the triple tax advantage: the funds are contributed pre-tax, the contributions grow tax deferred, and the withdrawals are tax free if used for qualifying medical expenses. Another benefit is the funds can be used for things other than medical expenses after age 59 1/2 and taxed only as income tax, not as capital gains or dividends.
Maximum annual contribution limits for 2020 are $3,550 for self-only and $7,100 for families with an annual “catch-up” contribution amount for participants 55 or older of $1,000.
Non-retirement Tax Advantaged Accounts. This includes Health Flexible Spending Account (FSA) & Dependent Care Flexible Spending Account (FSA). These accounts work through payroll deduction that are placed into savings accounts with your health insurance provider for health and dependent care expense reimbursements. These deductions reduce your taxable income, thereby reducing your tax liability. The 2020 annual contribution max is $2,750 for health and $5,000 for dependent care expenses, depending on your tax filing status.
Know of any other useful tax advantaged retirement accounts? Please feel free to share below!