The following is an excerpt from Personal Investing: The Missing Manual.
Tax-advantaged accounts come with a variety of features, but the most common characteristic is delaying the time when you have to pay taxes. Tax-deferred means your money can grow unfettered by taxes, which come due only when you withdraw from the account. You can reinvest the full amount of interest, dividends, and capital gains you earn to compound for years without a dollar going to taxes. Only when you withdraw money during retirement do you pay taxes; at that time, your tax rate might be lower.
Chapters Chapter 10, Chapter 11, and Chapter 12 give you the full rundown on different types of tax-advantaged accounts, but here's a quick introduction:
- 401(k) and 403(b). These tax-deferred accounts (Section 10.2.1) have become the mainstay for employer-sponsored retirement savings, with the majority of employers choosing to offer them over traditional pension plans. You contribute a percentage of your paycheck before paying taxes on it, so your tax savings reduce how much you pay out of pocket for your contribution. For example, if you're in the 25% tax bracket and contribute $10,000 to your 401(k) or 403(b), you save $2,500 in taxes, so your net out of pocket is only $7,500.
In 2010, the maximum annual contribution is $16,500. (If you're over 50, you can add a catch-up contribution of up to $5,500.) You must start withdrawing from your account when you're 70 ½.
Tip: If your company matches a portion of what you contribute, that match is like an immediate 100% return on the portion the company matches. It's unlikely you'll find a return that good elsewhere, so if you can't afford to contribute the maximum amount to your 401(k), at the least, contribute enough to get the full company match.
- Traditional IRA. Anyone with earned income (salary, wages, tips, bonuses, and so on) can contribute to a traditional IRA, another tax-deferred account option. If you've contributed the maximum to your 401(k) or 403(b), a traditional IRA is one way to get more money into retirement savings. In 2010, you can contribute up to $5,000 (plus an additional $1,000 catch-up contribution if you're over 50). Your contributions might be tax-deductible depending on your income. For example, if you're single and your adjusted gross income is less than $56,000, your entire contribution is tax deductible.
You must be younger than 70 ½ and have earned income to contribute to a traditional IRA. As with 401(k) plans, you must start withdrawing when you reach age 70 ½.
Note: If you switch jobs and don't want to keep your retirement funds in your employer-sponsored retirement plan, you can move your money into a rollover IRA to continue the tax deferral.
- Roth IRA. Similar to traditional IRAs, 401(k)s, and 403(b)s, you don't pay taxes on interest, dividends, and capital gains in a Roth IRA (Section 10.2.2.2). What gets everyone's attention is that you withdraw from these accounts tax-free after the age of 59 ½. The catch is that contributions to a Roth IRA aren't tax deductible. That is, you pay taxes on the money before you contribute to the account. With some income limitations, Roths have the same contribution and catch-up limits as traditional IRAs.
Roth IRAs have other features that make them attractive for saving for your later retirement years. You can continue to contribute after you reach 70 ½, and there's no mandatory annual distribution at any time. Because you contribute after-tax money, you can withdraw your contributions at any time without paying taxes or penalties.
Note: Because you contribute after-tax, you can withdraw your contributions without paying taxes or penalties. Before you can withdraw earnings tax-free, you must be 59 ½ and have converted or contributed to the Roth at least 5 years earlier.
- Roth conversion. If you convert a traditional or rollover IRA to a Roth IRA, you have to pay taxes on the tax-deferred contributions you made to the original account. Section 10.2.3 helps you decide whether a conversion makes sense for you.
- Inherited IRA. A beneficiary of an IRA can transfer the money into an inherited IRA to keep the tax-deferral going until the IRS requires distribution. The tax rules for inherited IRAs make Einstein's theory of relativity look like a piece of cake, so consulting a tax advisor is a good idea if you inherit an IRA.
- SEP-IRA. For small businesses or self-employed individuals, the simplified employee pension IRA (SEP-IRA) is the easiest pension plan option. You can contribute up to 25% of your income each year (to a maximum $49,000 in 2010). You can set up a SEP-IRA for a side business even if you already have a 401(k) at your day job.
Note: See Retirement Plans for Small Businesses to learn about other retirement account options for small businesses, such as Keogh and SIMPLE plans.
- Section 529 college savings plan. Investments grow tax-deferred in these popular college savings plans. Withdrawals are tax-free as long as you use them for qualified educational expenses (Section 11.2.1). The contribution limits are high, sometimes as much as $300,000. Whoever contributes to the account is the owner, who can then name a family member as the beneficiary. That's good news for two reasons. First, colleges don't take the 529 investment into account when they calculate a student's financial aid, because the account isn't in the student's name. Second, if the current 529 beneficiary ends up getting a big scholarship, you can change the beneficiary.
- Section 529 college prepaid plan. Prepaid plans lock in future tuition costs at today's rates (Section 11.2.2). They aren't as popular as 529 savings plans, because they make it harder to roll over into another plan or switch to another beneficiary.
- Coverdell education savings account. Investments in these accounts grow tax-deferred, and withdrawals are tax-free if you use them for qualified educational expenses. The big drawback to these accounts is the $2,000 annual contribution limit, a drop in the bucket for college costs.
- Health savings account. If you have a high-deductible health insurance plan, you can set up a health savings account (HSA), described in detail on Section 12.4. In 2010, an individual can contribute up to $3,050 pre-tax with a $1,000 catch-up if you're 55 or older. Unlike with flexible spending accounts, you don't have to use the money you contribute during a specific year. You can invest the money in the same kinds of options you have with an IRA. Withdrawals for health care are tax-free.
Note: Medical savings accounts (MSA) work like health savings accounts, except that only self-employed people or employers with 50 or fewer employees qualify for them.
I love my 529 plan also because I can deduct what I contribute from my Michigan taxes. You can choose a plan from any state, regardless of where you live, so do a lot of research and pick the best plan for your circumstances.
Posted by: Everyday Tips | August 19, 2010 at 09:43 AM
One possible rub I see with a tax-deferred account:. YES, dividends grow tax free until withdrawal, BUT dividends are taxed at a lower rate maxing out at 15%, while withdrawals from a tax-deferred account will be taxed at whatever your rate is at that time.
Hence one forgoes a maximum tax rate of 15% on dividends in exchange for tax free growth with a possibly higher tax rate at withdrawal.
NOTE: my understanding is that these tax rates may be a moot point come 2011 (lots of tax law changes afoot),
Posted by: close to retirement | August 19, 2010 at 10:37 AM
Many companies also offer a Roth 401k, which is like an employer sponsored Roth IRA.
Posted by: Texas Wahoo | August 19, 2010 at 11:02 AM
The problem with 529 plans is that even though you can invest in any of the 50 states' plans, you are still limited, and frankly, most states' 529 plans were set up not based on any evaluation of how good certain funds are but rather, what fund is somehow politically connected. The majority of them are garbage. The pre-paid 529 plans are good in theory, but there are already several states who have defaulted on those plans. Check the status of your state's treasury fund and operating budget before going that route.
A Coverdell is much better, IMHO, because you can invest in anything you want. Yes, there is a $2k per year limit but honestly, if you invest $2k per year for 18 years and get a decent rate of return, you have covered a good chunk of college costs. Even at a 5% rate of return over 18 years, you are looking at $60k. That may not pay for 4 years at Harvard but it will pay for the majority of the costs of 4 years at State U. If my kid wants to go to Harvard, he/she can get a scholarship or take on some debt himself/herself.
Posted by: Bad_Brad | August 19, 2010 at 01:50 PM
An HSA is great because they are one of the few things that are tax free going in AND coming out, as long as they are used for qualified Medical expenses.
Posted by: EE2000 | August 19, 2010 at 02:13 PM
I love the HSA not just for financial reasons, but because I can use the money for my own orthodontic and elective procedures such as laser eye surgery. Most corporate health plans just cover your dependents up to age 25 for orthodontia, and do not cover elective procedures for the plan participant. You can also buy unlimited contact lenses, have teeth whitening that are also not covered under most corporate vision and dental plans. You can buy aspirin, stop-smoking drugs, orthopedics, and elective chiropractic care--pretty much anything for health and well being, except maybe for breast or penis enlargement.
Posted by: MSC | August 19, 2010 at 02:50 PM
There is no mention of Qualified or Non-Qualified Annuities. These are very useful planning tools for people with limited resources and periodic expenses.
Furthermore, Life Insurance is often overlooked in the discussion of tax-advantaged vehicles. All of the vehicles mentioned above have contribution limits... Life Insurance does not. Life Insurance has no early withdrawl penalties, no account maintenance fees, and competitive returns. The returns can and often do beat the performance of actively managed portfolios. There are ways to take money out of policies tax-free, maintaining tax-deffered cash value growth and the policy's tax-free death benefit. Life Insurance can be an ASSET CLASS.
I am not suggesting that everyone should buy Life Insurance for this purpose. Life Insurance is purchased first and foremost for the death benefit, and in many cases it is unsuitable for accumulation.
Posted by: Benjamin Bloom, LUTCF, CLTC | August 19, 2010 at 04:21 PM
I participate in my employers 401 k plan. I am over 50 years old. My contribution this year will be about 4k to the 401k. My gross earnings will be about 60k this year,and after deductions my AGI should be under the limits. If I understand your post I can still contribute $6000 to a tax deductable IRA for 2010 or do I have to limit out my 401k plan first. Thanks in advance----Paul
Posted by: Paul K | August 21, 2010 at 03:35 PM
Regarding the 529 savings plans, MasterPo read in the details for the NY plan that 529 plans MUST be included on the Federal Financial Aid form regardless of the owner.
And since colleges use the FFA to determine their own financial aid, ergo, colleges do take 529's into consideration.
Posted by: MasterPo | August 23, 2010 at 12:31 AM
First, colleges don't take the 529 investment into account when they calculate a student's financial aid, because the account isn't in the student's name. Second, if the current 529 beneficiary ends up getting a big scholarship, you can change the beneficiary.
Posted by: FT | December 28, 2010 at 01:30 PM