Do You Have The Ultimate Retirement Account? Part 1
What is the ultimate retirement account? Well, before I tell you, let’s see if we can come up with specific criteria that would make a retirement account the ultimate retirement account.
The major benefits of contributing money to any type of retirement account, as opposed to a taxable brokerage or savings account, are the tax advantages. Due to their tax advantages, retirement accounts and plans let you keep more of your money and pay less in taxes. However, they each have their own rules and restrictions for both contributions to and distributions from those accounts. If you would like to learn more about the specifics of different types of retirement plans and accounts available, check out my 3 part series of posts on The Top Ten Terms You Should Know About Retirement Plans & Accounts.
But back to the original question. What would be the criteria a retirement account would have to meet to be considered the ultimate retirement account? I would argue that it would have to have more tax advantages than any of the other accounts.
So let’s start by analyzing the tax advantages of retirement accounts. I believe the best way to understand these tax advantages is to think of them in 3 separate phases.
Phase 1
The first phase is on the front end when you contribute money to a retirement account. If the amount of money you contribute to a given retirement account can be deducted from your income tax bill that year, it is considered a pre-tax account. This means contributions are made with pre-tax dollars.
For example, to make the math easy, let’s say your paycheck was $10,000. Let’s also assume that you pay an effective income tax rate of 30%. In this example you would then owe $3,000 in income tax. Now let’s say you contributed $1,000 to a pre-tax retirement account. This results in a $1,000 tax deduction. So now your taxable income is $9,000 and you would owe $2,700 in income tax, saving you $300 in taxes. Pretty nice, right? But remember, there is a catch here. When you withdraw the money, which is usually after age 59 1/2 to avoid penalties, you will owe income taxes on the money that is distributed to you.
The most common examples of pre-tax retirement accounts are the 401(k), 403(b), and traditional IRA.
Roth IRAs do not have this up front tax advantage.
Phase 2
The second phase is when the money is growing within the retirement account.
Let’s compare and contrast money invested in a taxable brokerage account vs. a retirement account to better understand this tax advantage. Let’s also assume the money in each account is invested in mutual funds that contain both stocks and bonds, as is the case for most people. This invested money grows in a couple of ways.
First, the shares of these funds you own hopefully appreciate (go up) in value over time. For example, let’s say the $1,000 invested from our example above grows in value by 10% (again for easy math) over the next year. This means that at the end of the year your shares would be worth $1,100, which is awesome! Do you owe taxes on this? If you do not sell the shares, you would not owe any taxes on the appreciation in value, regardless of whether it is in a taxable account or a retirement account. You only owe taxes on this gain if you sell your shares AND if it is in a taxable account (non-retirement account). This $100 you make in profit is what is called a capital gain, so you would owe capital gains tax on the $100 profit. If this were in a retirement account, you could sell the shares and reinvest the money in a different investment, but still in that same account, and you would NOT have to pay any taxes.
The second way this money grows is by earning dividends and interest. The stocks in your fund will pay dividends and the bonds will earn interest. This is usually paid to your account quarterly or semiannually, but varies based on the fund. If the investment were in a taxable account, you would owe taxes on these dividends and interest each year. If, however, the investment were in a retirement account, you would not owe taxes on these dividends and interest each year.
Not having to pay taxes while the money is growing in the account is one of the major tax advantages of retirement accounts.
For extra credit, here is a subtlety of this phase. This money is said to grow tax-deferred for pre-tax accounts like the 401(k), 403(b), and traditional IRA. This is because when you begin taking distributions from the account at retirement age, both the original money you contributed AND the gains are taxed as ordinary income, thus the taxes were deferred. On the other hand, after-tax accounts like a Roth IRA are said to grow tax-free. The beauty of a Roth IRA is that because the money contributed was taxed on the front end (no tax deduction), you do not have to pay any further taxes on either the original contribution OR any of the gains when they are distributed, thus they are tax free.
Phase 3
The last phase is when money is taken out of the retirement account, aka distributed. As I alluded to above, when money is distributed from a 401(k), 403(b), or traditional IRA, it is taxed as ordinary income. So there is no tax advantage in phase 3 for these accounts.
However, money distributed from a Roth IRA is not taxed, so it has a huge tax advantage at this stage.
Putting It All Together
In summary, accounts like a 401(k), 403(b), and traditional IRA have significant tax advantages in phase 1 and phase 2, but not in phase 3. These are double tax advantaged accounts with taxes due on the back end.
Conversely, Roth IRAs do not have a tax advantage in phase 1, but do in phase 2 and phase 3. This is a double tax advantaged account with taxes dues on the front end.
So, I’ll ask you again, what would be the criteria for the ultimate retirement account?
The ultimate retirement account would have to be an account with tax free contributions, tax free growth, AND tax free distributions. In other words it would be a triple tax advantaged account.
Does such an account exist? If you know the rules and play the game right, then yes, there is such an account.
Check out part 2 of this post next week when I discuss what this ultimate retirement account is and how you can take advantage of it.
Thanks for reading. I hope you are doing well in your progress towards reaching FI. If you have any questions or comments that might help other readers, please list them below. In the meantime, keep working towards Freedom Through FI!
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