OK fine! I am convinced! The only way for me to retire with any financial security is to have my money work for me. But there are so many different ways to invest, and none of that stuff makes any sense to me! I’ll just hire a financial adviser and let them figure out what to do with my money.
This is how a lot of us feel once we hear that investing is the only way to get to financial freedom or get to retirement faster. However, only few of us take the initiative to move beyond taking a hands-off approach to our financial health. Being that you are reading this and are taking a vested interest in your financial future, you are in the minority. Congratulations!
So where do we start? Let’s talk options:
- Traditional IRA vs Roth IRA
- Traditional IRA– an account that can be used to save money and invest for retirement. Depending on your filing status and income level, you may be able to fully or partially deduct your contributions, however you will pay taxes on any distributions when you take them out in retirement. Contribution limit as of 2023: $6,500 ($7,500 if your 50 or older).
- Roth IRA– an account that can be used to save money and invest for retirement. This account uses after tax money (money you have already paid income taxes on) when you fund the account. However, since you have already paid the taxes on the initial investment, your gains are not taxed and neither are your withdrawals from the account. Contribution limit as of 2023: $6,500 ($7,500 if your 50 or older).
Note: you cannot directly contribute to a Roth IRA account if your income exceeds $144,000 ($153,000 in 2023) for single filers and $214,000 ($228,000 in 2023) for married couples filing jointly. However, you can still get a Roth IRA account if you do something called a backdoor Roth IRA.
- Traditional IRA– an account that can be used to save money and invest for retirement. Depending on your filing status and income level, you may be able to fully or partially deduct your contributions, however you will pay taxes on any distributions when you take them out in retirement. Contribution limit as of 2023: $6,500 ($7,500 if your 50 or older).
- Traditional 401k/403b vs Roth 401k/403b
- 401k and 403b are essentially the same type of retirement account. The designation is dependent on the type of company that you are working for (for profit or non-profit). For example, 401k accounts are usually offered by private, for-profit companies. 403b accounts are usually offered by tax-exempt, non-profit organizations. Contribution limit as of 2023: $22,500.
Watch out for an employer’s match!!! This requires that you contribute a minimum amount to your account and your employer will match your contribution. That’s free money! Don’t miss out on this!!!
Traditional 401k/403b– Retirement account where contributions can be deducted from your income tax free. However, you will be required to pay taxes on any withdrawals you make in retirement
- Roth 401k/403b– Retirement account that you fund with after tax dollars. However, your future withdrawals and gains will be tax free.
- 401k and 403b are essentially the same type of retirement account. The designation is dependent on the type of company that you are working for (for profit or non-profit). For example, 401k accounts are usually offered by private, for-profit companies. 403b accounts are usually offered by tax-exempt, non-profit organizations. Contribution limit as of 2023: $22,500.
- Health Savings Account (HSA)
- This is a savings account that allows you to set aside pre-tax dollars that are earmarked for medical expenses. In this account you contribute pre-tax dollars, invest them into the market, and do not pay any taxes on any gains that you realize (after you sell the securities). The money in this account should be used exclusively for medical expenses and requires you to have a high-deductible health plan in order to open and contribute to an HSA. Any money withdrawn from this account will require medical receipts to prove they are medically related, otherwise the withdrawal will be taxed.
- You are allowed to contribute up to $3,650 for the year as an individual and up to $7,300 for family coverage. The funds in this account do roll over year to year, so if you don’t spend the money, it is still invested and growing tax free.
- Taxable Brokerage Accounts
- This is a regular investment account that uses after tax money. Here any gains you make on a sale of a security (stocks, bonds, index fund, etc.) will be subject to taxes. If you sell a security in less than a year after you bought it, the gains will be subject to your income tax rate. If you sell it over a year after you bought it, the gains will be subject to capital gains tax (15-20% depending on your income).
- This is a regular investment account that uses after tax money. Here any gains you make on a sale of a security (stocks, bonds, index fund, etc.) will be subject to taxes. If you sell a security in less than a year after you bought it, the gains will be subject to your income tax rate. If you sell it over a year after you bought it, the gains will be subject to capital gains tax (15-20% depending on your income).
- Real Estate
- Known as the biggest wealth generator in the world, real estate allows you to create wealth using real assets (ones that you can touch and feel) as opposed to paper assets.Real estate allows you to participate in, depreciation write-offs, property appreciation, loan paydown, and cashflow when done correctly
- You can own real estate outright yourself or with partners, invest in real estate investment trusts (REITs), or syndications
- 529 Account
- This account is geared towards education. The 529 account functions similar to a Roth IRA or Roth 401k as you are investing after-tax dollars into mutual funds, ETFs, and other investments. The money grows tax-free and is withdrawn tax-free, as long as it is used for education expenses.
- Contributions are not deductible from federal income tax, however it does qualify for state income tax deductions (in over 30 states).
- 457b- the additional 401k/403b for government employees
- This is basically an additional 401k or 403b for government employees. Typically, there is no Roth option for these accounts, but you do get to have the traditional pre-tax deduction.
- Make sure you know who owns or is providing this account to you. If it is the State or a huge public university that is highly unlikely to go bankrupt, then this is a great option. If it is just your hospital that is providing this account, they have a higher chance of going bankrupt and can seize the assets in this account to pay back their creditors if they do file bankruptcy.
These are the main investment accounts that are available to most people. The descriptions above are a very base overview of what the designation for each of these accounts are. However, which account should you fund first? Next? So on and so forth?
I offer you my experience and reasoning as to why I funded each account in the order that I did. This is one example of doing things, you may prefer a different order.
- Roth 403b
- My place of employment offers a 403b with a Roth option. Also, they offer an employer match. Therefore, I funded this account first because if I didn’t then I would miss out on a guaranteed return, which is the money that my employer would match to my account.
- I went with Roth instead of traditional and these are my reasons:
- The tax rate that I pay now will likely be the lowest tax rate for my income bracket that I will see. With the massive deficit that we have as a country and the inordinate amount of tax dollar spending we had during COVID, it is almost certain that taxes will increase in the future.
- When I do retire and need to draw from my Roth 403b, I do not need to worry about paying income taxes and therefore don’t need to over draw to cover those taxes. For example, let’s say I need $100,000 to live per year, all I need to do is withdraw that amount from my Roth 403b. If I am sourcing a traditional 403b for my income, I would withdraw the $100,000 for my living expenses and then need to withdraw an additional $15-20,000+ to pay the taxes, since this is viewed as income by the IRS. Doing this repeatedly every year will result in me consuming the funds in my traditional 403b much faster, compared to the Roth option.
- I still am planning on making some form of income when I retire, therefore having a tax-free option to draw from would be the most ideal solution for me.
- I am participating in pre-tax saving by also investing in a 457b account
- Backdoor Roth IRA
- Roth IRA serves as another source for tax-free withdrawals in retirement. The maximum contributions are much smaller compared to a 401k/403b/457 so it was an easy account to maximally fund. I wouldn’t receive any tax benefits by funding a traditional IRA, thus funding the Roth IRA would provide the tax-free withdrawals benefit, vs the taxable withdrawals in the traditional IRA.
- Roth IRA serves as another source for tax-free withdrawals in retirement. The maximum contributions are much smaller compared to a 401k/403b/457 so it was an easy account to maximally fund. I wouldn’t receive any tax benefits by funding a traditional IRA, thus funding the Roth IRA would provide the tax-free withdrawals benefit, vs the taxable withdrawals in the traditional IRA.
- Taxable brokerage account
- Allows for more selection in terms of available securities compared to the designated retirement accounts (403b/401k/457/IRA), as those are limited by what your employer and financial provider have agreed to make available to you. Selling of long-term holdings will allow for a capital gains tax (15-20%) vs an income tax on gains. You can tax-loss harvest in order to offset capital gains & income taxes.
- Allows for more selection in terms of available securities compared to the designated retirement accounts (403b/401k/457/IRA), as those are limited by what your employer and financial provider have agreed to make available to you. Selling of long-term holdings will allow for a capital gains tax (15-20%) vs an income tax on gains. You can tax-loss harvest in order to offset capital gains & income taxes.
- Real Estate
- This is an asset class that I really like, because I can touch, feel, and visit it. There many perks to owning real estate and it is how many wealthy people have generated and grown their wealth
- This is an asset class that I really like, because I can touch, feel, and visit it. There many perks to owning real estate and it is how many wealthy people have generated and grown their wealth
- 529 Plan
- Great way to fund college for your kids. Contributions are eligible for state income tax deductions. Thankfully, the state of Florida doesn’t have any state income tax, so my goal was to fund the Florida Prepaid plan (where you are able to pre-pay 4 years of college tuition and up to 4 years of housing).I also contribute a small recurring amount to the 529 plan as an added cushion for educational expenses.
- Great way to fund college for your kids. Contributions are eligible for state income tax deductions. Thankfully, the state of Florida doesn’t have any state income tax, so my goal was to fund the Florida Prepaid plan (where you are able to pre-pay 4 years of college tuition and up to 4 years of housing).I also contribute a small recurring amount to the 529 plan as an added cushion for educational expenses.
- 457b plan
- My place of employment allows for a 457b plan. This is a pre-tax account, so I am able to benefit from the income tax deductions. This account is tied with the financial solvency of my state funded institution, as such it is much lower on the totem pole to fund, as its value could be lost in case my institution went into bankruptcy. This account would be my first one to draw from in retirement, as I would need to pay income tax on any withdrawals. What that does allow for is continued growth in my Roth 403b and Roth IRA, as I can spare withdrawals from those accounts until the funds in the 457b are used up.
- My place of employment allows for a 457b plan. This is a pre-tax account, so I am able to benefit from the income tax deductions. This account is tied with the financial solvency of my state funded institution, as such it is much lower on the totem pole to fund, as its value could be lost in case my institution went into bankruptcy. This account would be my first one to draw from in retirement, as I would need to pay income tax on any withdrawals. What that does allow for is continued growth in my Roth 403b and Roth IRA, as I can spare withdrawals from those accounts until the funds in the 457b are used up.
- Health Savings Account
- This account is known as one of the best investment accounts you can have. You contribute pre-tax dollars, that is able to grow tax free, and you don’t pay any taxes on your withdrawals as long as they are medically related. It is a win-win-win account. So why am I not contributing to it? Short answer, we have kids and kids get sick a lot. Our kids have ENT issues, so we have had a few surgeries over the past few years. I enjoy the peace of mind of having a lower-deductible health insurance plan that allows for more conservative budgeting and minimizes significant financial impact. If you and your family don’t utilize your health insurance, then by all means switch to a high-deductible health plan, open an HSA and partake in one of the best investment accounts out there!
Hopefully this clarified the types of accounts that are typically available for most investors. Now that there is increased clarity there, what securities should you invest in? That is literally the million-dollar-question, let’s see what we uncover in the next post.