Investment accounts are like shoes: you have your flats, wedges, and stilettos. They all have their place in your closet, each there for a certain purpose. Flats for your everyday life, they are reliable, easy to wear, and so they become our go to shoe in the present moment. Wedges are great to dress up an outfit or dress it down, they can be fun and stylish while still being somewhat comfortable. And then there are the stilettos that are sexy as hell, yet just as painful, OUCH! You pick the times to use them cautiously. Maybe there is little to no walking involved, a need to impress those around you, or they just complete the outfit. So how are investment accounts like shoes?
Well we have your non-retirement accounts that can be bank accounts, investment accounts, CDs, and such. Then we have after tax retirement accounts like Roth IRA and Roth 401(K)s and Roth 403(b)s. Lastly, we have pre-tax retirement accounts such as Traditional IRAs, 401(k)s, and 403(b)s. They all have their purpose just like the different shoes in our wardrobe, and they all work differently. Some of their pros, might be the other’s cons and vice versa. I get asked a lot about which one is the best to use so let’s take a deeper look at them.
First we have your basic non-retirement accounts where you invest or put after tax money, which is money you’ve already paid taxes on. Any money that is net from your paycheck is after tax money. Every year any capital gains on your non-retirement account may be taxable for that year, so if you earned $1,000, depending on the type of capital gains in the account, you may have to add $1,000 to your taxable income and thus pay taxes on it. Make sense? If you have the money invested, you may receive a 1099 tax statement each year showing your taxable gain. The good news is if you have a capital loss in the account, you can use the loss against your gains after meeting certain conditions and up to certain limits depending on the type of investment. The good news might not be that you have a loss, but at least you can offset some taxable gains with that loss. The retirement accounts don’t give you that option. Think of your flats when you hear non-retirement accounts because when you need money for your daily expenses or for emergencies it might be best to hit these accounts first. There usually are no penalties for withdrawing your money and you’ve already paid taxes on it, so you may not have a huge tax bill at the end of the year from the withdrawal. No penalties are like no blisters, better to have some flats to avoid killing your feet with blisters all day!
Next we have the after tax retirement accounts, or the Roth IRAs, Roth 401(k)s, and Roth 403(b)s. Your money goes into these accounts after tax, BUT the money grows tax free if certain conditions are met*. Remember, you may pay taxes on any capital gains each year for your non-retirement accounts. Well you don’t have to worry about that with these accounts. Plus when you withdrawal the money, it is non-taxable income. These accounts are your wedges, they are a great investing tool but there are still some pain if you withdrawal the money in certain ways. If you are not 59 ½ and have not held the account for 5 years, there is a 10% penalty on the withdrawals. There are some exceptions to the 10% penalty, but be careful! Any gains on the account will also be taxed if you withdrawal money before hitting that magic age of 59 ½ and the 5 year rule* May be subject to state, local, and alternative minimum tax. I never understood why it is such a random age, maybe you could tell me?
Lastly, are the Traditional IRAs, 401(k)s, and 403(b)s where you put money in pre-tax and get that nice tax deduction in the year you contribute. The money grows tax deferred, BUT once you take money out, it is all taxed. The money is added to your income and will be taxed at whatever tax bracket your income pushes you to. These are definitely your stilettos, they are very painful to take money out of. They are a great tool while you are saving money since they grow tax deferred, but you have to remember $100,000 in an IRA isn’t really worth $100,000. It’s worth a lot less depending on your tax bracket. So if you are in the 30% tax bracket, that $100,000 might be worth $70,000. So our pre-tax retirement accounts are tax inflated, and we need to be aware of that when we take money out. There is the same 10% early withdrawal penalty for any withdrawals prior to 59 ½ with some exceptions like the Roth IRAs.
The point is not one account is better than the other, but what is great and can create a well-rounded portfolio is utilizing all of them. If you have money invested in each one, you’ll have the advantages of each of them. It means you can be well-diversified for tax purposes. Just like we need stilettos for black tie events, weddings, and more formal gatherings, we need flats for our everyday lives. Having a well-diversified shoe collection is important, but having a well-diversified portfolio is a little more critical. At least in my book!
See how you can be better using the different types of investments accounts by scheduling a call with me. Click the button below to get started. It’s your life, it’s your choice, but I’d say your worth a little bit of planning with your money, don’t you?
Happy Polishing!
Jessica Weaver, CFP®, CDFA™, CFS®
Wealth Advisor