So let’s get into some nuts and bolts. You want to invest, you want to start saving. Where should you put your hard earned cash? It’s all so damn confusing. First, it doesn’t have to be and it’s not that complicated. Folks like to make this complicated, so they can try to sell advice, but I’m going to tell you right now that anyone can invest, and anyone can do it well. At least as well as pretty much any major wall street investment firm out there. It’s simple.
But before we get into what stocks or funds or bonds to buy (you can see what we own if you’re curious) we need to cover something even more basic – where to put the money, i.e. the type of account you should use. There is a confusing mix of acronyms out there, so we first need to cut through some bullshit to see clearly.
Account types will ultimately determine how you’re taxed on your investments and how accessible they are, which can often be more important than the stocks, bonds, and funds you actually invest in. You can find an endless discussion on the pros and cons of each type of account. I’ll go into those details as well in later posts to give you my take on how to take advantage of each type, but the bottom line is that they all can play a role in a good retirement strategy.
WARNING! Venture further at your own risk! This post is going to be DRY! I’m going to get into some gritty details. Proceed with caution! You have been warned!!
So here’s the full list that the VAST majority of people will be interacting with. It’s actually not that long!
This is your bread and butter basic account. You put money in. You take money out. If you do well and it goes up, you can be taxed on the gains you’ve made when you sell (these are called capital gains). If you get any dividends or interest you’re also taxed on those. Those taxes on dividends and capital gains can be high if you have a very high income or zero if you’re in low tax brackets. Anyone can put any amount of money into a taxable account with no restrictions or penalties. You can also take money out without restrictions or penalties (except for the tax on capital gains).
Your most vanilla retirement account. You have complete control over it and can invest in pretty much whatever you want. If you put money in you get to deduct that amount from your taxable income in the current year. This is why it’s often called a “Pre-Tax” IRA. Basically, you’re putting in money you have not paid taxes on. Glorious!
The government takes its cut at the backend. When you withdrawal from a deductible IRA you pay income taxes on the full amount. This can either be very good if you’re in a much lower income tax bracket when you start withdrawing money or very bad if you’re in a very high tax bracket. There are a few other restrictions to keep in mind:
- You’re limited to contributing $5500 ($6500 if you’re over 50) across ALL IRAs (ROTH, non-deductible) per year in 2016
- If you withdraw anything (barring a few more advanced uses) before 59 1/2 you pay a 10% penalty
- You have to start withdrawing at 70 1/2 at amounts prescribed by a formula – these are called “required minimum distributions”
- IRA contributions are not deductible at very high-income levels or if you’re covered by a 401k plan at work and make more reasonable incomes – this limit applies to the Grizzlies.
Similar to an IRA with you in complete control. The primary difference comes in how the two are taxed. In a Roth IRA you don’t deduct the contributions from your income – hence they are “after-tax” contributions. But after that initial tax bill, everything in a Roth IRA is generally free and clear of a tax bill forever. However, there are some caveats for the Roth IRA as well:
- You actually can withdraw from a Roth IRA at any time without any penalties, but only the amount you originally contributed.
- If you withdraw any gains prior to age 59 1/2 those gains can be taxed at your ordinary income tax rates PLUS you have to pay an additional 10% penalty. There are a few caveats to this but it’s usually best to assume that gains in a Roth are simply locked up till age 60.
- There are no required minimum distributions from a Roth IRA. The government already got its cut so they don’t care how long you leave it there!
- Similarly to the IRA, the Roth IRA is not available for those with high incomes.
This is a bit more of a special case. High-income people like the Grizzlies, unfortunately, can’t deduct IRA contributions from our taxes. However, we still make annual IRA contributions. They’re just using “after-tax” dollars. The IRS considers all they IRA’s you have one big pot, so the effects of this on future tax bills and transfers can get complicated. But the basics are that if you decide to do something like move money to a Roth IRA the amount you move out of your IRA is taxed at a prorated amount determined by how much pre-tax and how much post-tax dollars you have in there. Like I said – complicated. I’ll save the details for a later post.
Most folks with a corporate job are at least somewhat familiar with these. You sat down for some dry HR presentation several years ago, they told you the importance of contributing, you checked some boxes on a form and washed your hands of it. A few % of your income started getting diverted to a plan that you check in on every year or so. For a lot of people, that’s all they ever interact with their 401k. They pick a few funds that their employer directs them to and that’s it. Time to dig that information out of the closet and start paying attention.
The rules around 401(k)s are very similar to those of the IRA’s explained above but with two huge differences.
One, your employer and whomever they have selected as the company to manage their 401(k) have complete control over what investments you have access to. This can become a serious problem if the funds available are crap. Crap can usually be identified simply sorting using fees charged. Higher fees = larger piles of crap.
Two, 401(k) contribution limits are MUCH higher. $18k ($24k after 50) can be deducted from taxes plus whatever your employer decides to kick in. In addition, you can contribute large amounts of “after-tax” money as well if your employer has set it up. The total annual maximum for 401(k)s from all these sources is currently $53k, almost 10x what you can put in an IRA.
Health Savings Accounts
These are a bit of a weird beast when it comes to retirement savings. For all the details look here and here. There are some awesome benefits to these plans but they can get complicated. Be careful and check back in here when I dive in a bit more. Essentially these are savings accounts that were originally designed to be for medical expenses, however, tax wizards have now gotten their hands on them and realized that they can make AWESOME retirement plans. The primary restriction for on accessing these plans is that you have to have a high-deductible health insurance plan. But if you clear that hurdle you should consider them. Basically, they work like this
- You contribute “pre-tax” dollars to the plan
- You can withdraw any amount at any time tax-free as long as it’s for qualified medical expenses
- Once you reach 65 you can treat anything you have in an HSA the same way you treat a normal IRA
This essentially allows you to combine the pre-tax benefits of an IRA with the tax-free withdrawals of a Roth IRA. Like I said – pretty cool! And we’ll dive into just how to use these to great advantage later.
Those are the accounts that the majority of people will interact with, all in about 1000 words. There are some special circumstances we’ll cover later. But if you know those six different account types and the basics of what they do you’re 50% of the way to figuring this investing and retiring thing out. Like I said – not that complicated.
Other Special Accounts
There are a few other accounts that are worth mentioning in passing as there will be some folks taking advantage of these. But generally, they’re for special circumstances like government or small business employees.
403b – nearly identical to a 401 k plan but offered to employees of government or tax-exempt groups like schools or churches.
TSP – Basically a 401k plan for employees of the federal government. These are AWESOME if you have access to them – mainly because the funds they have in them are insanely simple and offer the lowest fees around.
457 – 401(k) plans for state and local public employees
SEP IRA – An IRA for very small businesses, usually only one or two people. If you’re self-employed you’ll generally be using this.
SIMPLE IRA – Similar to a SEP but with a few minor differences when it comes to administration and who can contribute.
Keogh Plans – A more complicated version of the SEP and SIMPLE plans for small businesses. The big differentiating factor is the higher contribution limits.