What are Your Options for Tax-Advantaged Retirement Savings and Investments?

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retirement, retirement withdrawals, self-employed retirement accounts, tax changes, tax deductions, tax efficient locations, tax-sheltered accounts, saving for college

One of my favorite overused sayings is the one that states, “There are only two things certain in life – death and taxes.” However, I suppose this statement is used so frequently for the reason that it really does hold true. You are going to die, and you are going to in some way or another pay tax on your income now or in the future.

I personally have not heard of anyone that has ever been bankrupted or kept from reaching millionaire/billionaire wealth status because of taxes alone. Even so, that doesn’t mean that the effect of taxes should be ignored. Quite the opposite in fact – the effect of taxes is significant. As savers and investors responsible for self-directing our own money, I believe we have a fiduciary responsibility to ourselves to optimize our finances in such a way that we pay the fewest taxes required by current laws. 

One very potent strategy that we, as normal individuals, have at our disposal in performing the aforementioned optimization is to utilize various tax-advantaged savings/investing vehicles. As I mentioned several days ago in my post about blindly saving for retirement without considering the withdrawal process, there are two big problems I have encountered over the past few years (and ones that I am guilty of as well) circling in the air around how people utilize tax-advantaged money vehicles:

  • Problem 1 with the Way People Use Tax-Advantaged Vehicles People focus far too much on the advantages, while forgetting to really have the disadvantages sink in.
  • Problem 2 with the Way People Use Tax-Advantaged Vehicles – People don’t fully understand all of the various tax-advantaged vehicle options at their disposal (i.e. getting focused solely on one with the exclusion of the others).   

In order to address these two problems I have experienced, the purpose of this post will be to review the tax-advantaged savings options on the market today. While doing this, we’ll cover both the advantages and disadvantages of each, but I’ll try to more blatantly call out some of the disadvantages of each vehicle in order to help people know what they are getting in to with the use of red text. I’ll also include my take on how I will or will not incorporate each in to my personal investing/saving strategy at the end of the post.

Let’s get started!

Tax-Advantaged Vehicles – Retirement Accounts

The first group of tax-advantaged savings/investing options that are available can be grouped in to the broad category of “retirement accounts.” Essentially, these carry this label, as you probably know, because they are designed to be vehicles that are only tapped/accessed/have money withdrawn from DURING RETIREMENT (hence the name!). With the possible exception of annuities, all of these retirement accounts are self-directed in the regard that you more-or-less have discretion in investing the funds as you want.

In general, it can be said that these have significant tax advantages, but you have the distinct disadvantage that your money is not quite as accessible as if it were in a taxable account. Having said that, let’s now work through each of these one by one:

Traditional and Self-Employed 401k

This is the tax-advantaged savings/investing retirement account that is most often used (in my experience) by workers at mid to large-sized companies.

  • It has the significant advantages of contributions being on a pre-tax basis and your earnings accumulating on a tax-deferred basis. 
    • This is nice because you don’t have to worry about the possibility of triggering a taxable event when you go to re-balance your asset allocation each year. 
  • Another big advantage (one that you definitely want to capitalize on) is that employers often match contributions up to a certain % of your income. Don’t ever let free money pass you by! 
  • They also do not have a low-income requirement like Roth IRA’s. 

Yes, putting money in to your 401k is super easy (done by your employer before it ever hits your bank account), and since it is pre-tax, it allows you to save 30% more money minimum! However, these benefits come with a price, i.e. disadvantages that I feel need to be highlighted more than they often are:

  •  All amounts withdrawn (contributions + earnings) from a 401k are taxed as ordinary income at the state and federal level. 
    • At first glance, this may not seem like that big of a deal because, hey, after all, you got a tax break on the funds that you put in to the 401k in the first place.
    • However, if we dig a little deeper in to an example, it becomes obvious that pre-tax 401k contributions are not perfect since at the withdrawal point, you’re paying taxes on a large amount of earnings that have accumulated after 40+ years (we’ll take a look at an example in the Roth IRA section below).
    • Just consider that you’ve got $1 million accumulated in your 401k for retirement. You’re feeling pretty good about your future. However, don’t be surprised when you find out that you really only have $600,000 because you need to pay 30% in federal income tax and 10% in state taxes prior to the money hitting your bank account in retirement.
  • Your savings/investments are NOT accessible prior to the age of 59.5 without a 10% penalty.
    • Unless you meet one of the specific IRS exceptions such as disability, death, or unemployment (a good article explaining the different exceptions can be found here), you will not only pay the ordinary income tax on 401k withdrawals, but you will also pay a 10% penalty for early access. This could amount to 40-50% of your withdrawals! Quite steep if you are needing the cash to capitalize on other needs or opportunities. 
    • This penalty alone would personally keep me from tapping my 401k with the exception of if it were an extreme emergency. This would be somewhat inconvenient in the event that something comes up where I need a good chunk of my savings – a child getting married/going to college, buying a rental property, etc.
  • You are required to make RMD’s, or Required Minimum Distributions, after the age of 70.5. 
    • If you don’t make these distributions, you’ll be hit with a 50% penalty (essentially, a penalty + income tax at a high bracket) on the money that you should have been distributing. 



SEP, Traditional, and Rollover IRA

The next tax-advantaged retirement vehicle that we come to is the group that go by the name, Individual Retirement Accounts (IRA’s). From a taxation and savings withdrawal perspective, SEP, Traditional, and Rollover IRA’s are treated very similar to the Traditional 401k described above (although the contribution limit for a SEP IRA is generally higher):

  • They have the advantage of contributions being on a pre-tax basis, and your earnings accumulate on a tax-deferred basis.
  • They do not have a low-income requirement like Roth IRA’s.

Also like with Traditional 401k’s, the benefits of these three types of IRA’s come with a price, i.e. the same  disadvantages discussed previously:

  • All amounts withdrawn (contributions + earnings) from a 401k are taxed as ordinary income at the state and federal level. 
  • Your savings/investments are NOT accessible (excludes exemptions) prior to the age of 59.5 without a 10% penalty.
    • Unless you meet one of the specific IRS exceptions such as disability, death, first-time home-buying, higher education, or unemployment (a good article explaining the different exceptions can be found here), you will not only pay the ordinary income tax on IRA withdrawals, but you will also pay a 10% penalty for early access.
    • However, the good news is that compared to the penalties for 401k withdrawals, the rules regarding what situations avoid the penalty for IRA’s are much more lenient (encompass more situations). See the link mentioned above for more details.
  • You are required to make RMD’s, or Required Minimum Distributions, after the age of 70.5. 

Roth IRA

Having covered the more traditional pre-tax retirement vehicles, we can now move on to some well-established, but perhaps less widely-employed/known retirement accounts that approach taxes from a different angle.

First, let’s discuss the Roth IRA – my favorite and perhaps the most powerful tax-advantaged savings vehicle currently available. 

  • A really cool thing about Roth IRA’s is that they are tax-advantaged in a way that they are in fact tax free! 
  • Although the contributions are made after-tax, your money accumulates tax-free, and withdrawals of contributions + earnings are tax free after the age of 59.5, provided that you opened and funded your first Roth IRA more than 5 years ago. What this means is that if your current Roth IRA balance is $1 million, all 1 million of those Dollars can actually hit your bank account and are not subject to taxes skimming 40% right off the top.
    • Aside from the withdrawals in retirement not being taxed, the distributions also DO NOT increase your Adjusted Gross Income, meaning that distributions don’t cause your general tax bracket to increase.
    • Due to the power of compound interest, I’ve read that at retirement age, retirement accounts consist of 90% earnings and 10% contributions. Because of this, it makes sense to at least consider the desire to only pay taxes on the 10% contribution part in exchange for skipping the taxes on the 90% earnings side.
    • An example is useful to illustrate this difference. Let’s say that a 22 year old lands her first job after college and saves $1000 in a Roth IRA. Assuming a level 30% tax bracket during her lifetime, this would equate to contributing $1300 on a pre-tax basis to a 401k. 
    • After 40 years of 10% annual compounded growth on the contributions, the $1000 Roth IRA contribution would have grown to ~$45,000, while the $1300 invested in the 401k would have grown to ~$59,000. (Note: $1000 is approximately 2% of the total account value of $45,000)
    • The Roth IRA amount could be withdrawn free of taxes, so the $45,000 balance is still intact. However, since the 401k amount is exposed to taxes, that balance gets reduced to ~$42,000.
    • So, this means that if you assume a constant tax bracket (which is not realistic because being 22 years old, you are likely in a lower tax bracket than at retirement), you still end up with a higher balance in retirement with a Roth IRA. 
    • Of course, this example also operates under the assumption that the 22 year old does indeed invest the larger amount in the pre-tax 401k account since that is before taxes. In my experience, I have found that people do NOT indeed take this tax difference in to account when they invest. They simply want to invest $XXX.XX and don’t think about it’s current worth on a pre or post tax basis.
  • A very powerful, yet little-known aspect of Roth IRA’s is that you can actually take out your CONTRIBUTIONS at ANY TIME without tax and without penalty
    • If you think about it, this can be huge! If you have a contributed to your Roth IRA for 20 years at $5,000 per year, you could have $100,000 to remove and use as you want without tax and without penalty. And even better, whatever earnings this money has accumulated in the Roth IRA at the time will continue growing in the account tax-free. Pretty cool if you ask me! 
    • This is a stark difference from the IRA’s and 401k’s discussed already where earnings and contributions withdrawn prior to 59.5 years of age are not only taxed but also subject to a 10% penalty! 
    • Rollover Roth IRA contributions can be withdrawn after a 5 year seasoning period without taxes or penalties.
  • Unlike the other vehicles discussed above, you are NOT required to make RMD’s, or Required Minimum Distributions, after the age of 70.5.

As I mentioned above, no retirement vehicle is totally perfect, and the Roth IRA is not exception in that it does have certain distinct disadvantages.

  • You have to pay taxes in the current year on the contributions you make to a Roth IRA (since they are made with post tax Dollars). 
    • This could be a BIG disadvantage if you make a lot of money now and will not have much income in retirement when you take the withdrawals.
  • Unlike the 401k’s/IRA’s discussed above, you must have a sufficiently low income to qualify to make Roth IRA contributions. 
    • Full Roth IRA contributions can only be made if you are single and make $110,000 per year or married filing jointly making $173,000 per year.
    • However, if you do make over these income levels, you can still have a Roth IRA by performing a backdoor Roth IRA conversion by converting Rollover/Traditional IRA’s (which do not have income requirements) to a Roth IRA. 
  • The earnings on your savings/investments are NOT accessible (excludes exceptions) prior to the age of 59.5 without a 10% penalty on top of ordinary income tax.
    • Mike from Oblivious Investor explained this better than I ever could, so I will refer you all to his post here for more detail
    • Briefly, if you do not die, become disabled, or purchase a home for the first time, withdrawal of your earnings in your Roth IRA prior to the age of 59.5 will be subject to normal income taxes. This is not a good thing since you already paid the taxes on that money, right?!!?
    • Further, if you don’t fall in to the exception category, on top of income taxes, you will also owe a 10% penalty for withdrawal of earnings. 
    • Essentially, what this means is that unless you have a “qualifying” reason for withdrawing earnings from a Roth IRA, you pretty much won’t be able/won’t want to take out your earnings.

Roth 401k

Another tax-advantaged retirement account that utilizes Roth-style tax treatment is the Roth 401k. What I’ve read is that these accounts were pretty slow to catch on after their introduction in 2006, but due to a 2010 extension that kept these plans in place, they are becoming more and more popular. Indeed, I think they are a very promising option for long term investing/savings.

Let’s take a look at some of their characteristics:

  • As with a Roth IRA, contributions are made after-tax. 
  • Your money accumulates tax-free, and withdrawals of contributions + earnings are tax free after the age of 59.5, provided that you opened and funded this specific Roth 401k more than 5 years ago (Note: this is different than with Roth IRA’s where the 5 year rule counts from the time that you funded your first ever Roth IRA).
  • You can contribute much more money each year than with a Roth IRA. For 2013, employee’s can contribute up to $17,500 to their Roth 401k. Nice! You can also have/contribute to both Traditional and Roth 401k’s, provided that the combined yearly contribution is less than $17,500.
  • Along these same lines, there are no low-income limitations that prevent higher income earners from contributing to a Roth 401k, like there are with a Roth IRA.
  • Roth 401k contributions are still eligible for employer matches. However, the employer match money will sit in a pre-tax traditional 401k account. Even with this, it’s hard to turn down free money! 
  • After you terminate your employment with your employer, you can roll over Roth 401k balances to a  Roth IRA. This is very useful to avoid the Required Minimum Distributions after age 70.5 (more on this in disadvantage section below).

Along with some strong advantages, the Roth 401k is also not without its respective shortcomings/disadvantages.

  • You are required to make RMD’s, or Required Minimum Distributions, after the age of 70.5. 
    • However, as I mentioned above, you can get around this by rolling over your Roth 401k to a Roth IRA, a vehicle which does not have RMD’s. Nice! 
  • You have to pay taxes in the current year on the contributions you make to a Roth 401k (since they are made with post tax Dollars). 
  • Your savings/investments are NOT accessible prior to the age of 59.5 without a 10% penalty + ordinary income tax. In other words, you have the same access to a Roth 401k as you do with a Traditional 401k. No more, no less.
    • The rules regarding Roth 401k withdrawals are particularly dizzying, even for me as a PF blogger who enjoys learning about this stuff! 🙂 This is likely due to the fact that people have not fully adopted the use of this financial account yet enough to write much about it in plain English. I tried reading the IRS’s Q&A page, but found it of no use really. Surprise surprise, right?
    • A very important difference between the Roth IRA and the Roth 401k is that Roth 401k contributions CANNOT be withdrawn at any time tax and penalty free.  
    • Unless you died, became disabled, have huge amounts of medical bills, or are unemployed for a long time, ALL WITHDRAWALS prior to the age of 59.5 will be subject to a 10% penalty. A good article explaining the different exceptions to the 10% penalty can be found here.
  • The taxation on withdrawals made prior to the age of 59.5 are confusing as well.
    • The amount of taxable income on withdrawals of any size (even if they are less than the total amount you have contributed over the years) is calculated based on the % composition of the earnings in the Roth 401k account at the time of the withdrawal.
    • For example, say at age 69.5, you have a total balance of $100,000 in your Roth 401k, consisting of $90,000 of earnings and $10,000 in contributions.
    • If you were to take a $10,000 withdrawal before the age of 59.5, 90% or $9,000 of the withdrawal would be taxed as ordinary income, even though it is less than your total $10,000 contribution made over the years. A good description of this process can be found here

Stand-Alone Annuity

Our last stop on our tour of the various tax-advantaged retirement vehicles brings us to the somewhat-controversial annuity. As is the case with whole life insurance, the thing that makes these products so controversial is that the people offering them often do not have a fiduciary responsibility to get you hooked up with the most optimum product, since ones that are poorly designed will make the person selling them more money and you less money. There are, however, fairly good no-load annuities out there, such as the ones offered by Vanguard. At least that is my 2 cents…

  • As mentioned in my previous post about investing in annuities, annuities are essentially a mix between an investment instrument and an insurance policy. You (the investor) opens up an annuity account, funds it, and in return, the insurance companies gives you a guarantee that you will receive a regular stream of monthly payments/income and/or return for a set amount of time, depending on how the annuity is structured.
  • In the account, your contributions grow tax-deferred until withdrawal at the age of retirement (59.5 years of age). 
  • Annuities have no annual maximum contribution limit.
  • Contributions to an annuity are after-tax. However, once in the annuity account, your contributions can grow tax deferred until withdrawal.
  • Another good thing about annuities is that they are currently being offered in many different flavors. Some give you a fixed interest rate, some invest in equity mutual funds, some start paying out immediately, and some accumulate for years before paying out guaranteed income.

As usual, along with these beneficial characteristics, the annuity has some significant disadvantages as well.

  • Your savings/investments are NOT accessible prior to the age of 59.5 without a 10% penalty.
  • Ordinary income tax is owed on all withdrawals (early or after age 59.5) of annuity earnings but never for recovering your contributions/basis.
    • This is a definite disadvantage because even though you put post-tax money in to the annuity, you still will owe income tax on the earnings when you withdraw even during retirement (Note: this is different than the Roth IRA/Roth 401k above).
  • Annuities can be complicated and have decreased visibility of their inner-workings.
    • Often, you have to deal with sales-people that don’t necessarily have your best interest in mind. 
    • Because of this, you’ll likely need to really study up to make sure that the annuity product you are picking out is indeed right for you. 
    • Annuities are also complicated because it is difficult to understand how/if a guaranteed return is applied. This is especially true for variable annuities, and it makes all the more reason for the investor to know the right questions to ask before buying. 
    • Another thing I don’t like about annuities is that they are not as transparent as a mutual fund. In other words, you cannot simply go on Google Finance and look up the performance of an annuity, I don’t think at least…Because of this, you just have to trust that the information the agent or broker is provided you is correct. This is the same situation of trust/lack of trust with whole life insurance as well. 
  • Annuities can have higher fees. 
    • Because of the insurance wrapper around an annuity, there is going to be a cost involved. 
    • For Vanguard’s annuity products, the cost is between a 0.5-1% expense ratio. While that expense ratio isn’t bad, I wasn’t able to tell if that included the return guarantee. If it didn’t, I was reading something about it possibly costing an extra 2-3% of my holding values each year. Yikes! 

Conclusions and Path-Forward

If you’re fairly confused after reading this, you’re in good company! We’re all human. After writing about all of these products in one post, I became a bit dizzy as well and had to go drink some wine with dinner!

All of these products have so many things in common, yet have so many small things (that could potentially be significant on the money withdrawal side) as differences, that it is indeed hard for people to not be scratching their heads at this point.

In an effort to clear some of my personal confusion and indeed try to place some finality to this post, I’ve listed my brief personal opinions/verdicts/bottom lines/path-forwards for each of these tax-advantaged retirement vehicles below:

  1. We must never pass up free money, so the first place that I would commit my money is to fund my 401k to the maximum that is matched by your employer.
  2. In focusing on what I would do next, I cannot underestimate the power and flexibility that the Roth IRA allows in that I can access my contributions at any time tax and penalty free. Thus, my second move would be to fully fund my Roth IRA. Since I fully funded my Roth IRA, I cannot contribute to a Traditional IRA, so I don’t have to worry about that option. 
  3. If I had more money left to invest during the year, I would at this point need to ask myself the question – “Do I have enough money saved outside of retirement accounts that I can access without penalty for any needs before the age of 59.5?” (I need to work this out – keep an eye out for a post on the way soon!).
  4. If I determined that I had enough money accessible in non-retirement accounts, the third thing I would focus on would be fully funding my Self-Employed Roth 401k with Vanguard. I established a Self-Employed 401k back in 2011, but at the time, they didn’t offer a Roth 401k feature. However, I looked again recently, and low and behold, the option was there! Since I am a big fan of paying taxes in the current tax year in exchange for in the future, I would go with this option. If you currently have a Traditional 401k with your employer, I would highly recommend calling HR to see if a Roth 401k option is available.
  5. Due to the higher fees and increased complexity, investing in annuities would be something that I would only do if I was completely maxing out all of my other retirement account options (a nice situation to be in!). I do like the guaranteed return that annuities offers, so that might be more valuable as I age. However, if I wanted to stability right now, I could simply invest more in my short-term bond index mutual funds, which even in the turmoil faced in recent years only varies in price by 2% or so. 

Well – that about wraps things up for tax-advantaged retirement accounts!

In an upcoming post, I’ll detail the various non-retirement tax-advantaged vehicle options that investors have on the market these days. Keep an eye out for that – on the way soon!

How about you all? Which of these tax-advantaged retirement accounts is your favorite/do you use the most and why? 

Do you feel you’re possibly using one of them too heavily?

Share your experiences by commenting below!

    ***Photo courtesy of http://farm5.staticflickr.com/4047/5120304358_72af165e30.jpg

    Comments

    1. Keep in mind that there is a “separation of service” clause for 401(k) plans, so some people are able to get their money out at 55 without penalty.
      My recent post Year-End Note

      • Good point SB! I do remember reading about that while putting this post together. It's truly amazing how many little intricacies there are with these animals!

        Have you ever had to take a withdrawal from your 401k?
        My recent post How to Save Money in the Kitchen

    2. Neat article, thanks for sharing. You listed “SEP” and “Rollover” IRA’s, but I’m left wondering about what they are exactly, how they differ from a traditional IRA, and if they can be applied in my situation. Also, why did you exclude self-directed IRA’s? Thanks!

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