By Bryan Trugman, CFPⓇ
Once you’ve mastered savings habits and have a solid emergency fund (discussed in our Investing Basics Part 1), it’s time to start making your money work harder. After all, you work hard for your money, you want your money to work hard for you! With the help of compounding interest, the money you contribute to investment accounts could generate larger returns than a typical savings account.
Most investment accounts fall into one of two categories (in the context of taxation): qualified or non-qualified. These types of accounts refer to the tax treatment of contributions, growth, and withdrawals. Let’s discuss the different investment accounts and how to choose the right options for you.
Qualified Investment Accounts
Qualified accounts come with certain tax advantages, and are usually appropriate for money earmarked for retirement. Typically, there are two subcategories of qualified investment accounts: individual qualified accounts and employer-sponsored accounts.
Individual Qualified Accounts
These types of qualified accounts can be opened by individuals at a bank, financial institution, or brokerage firm. Keep in mind that individual retirement accounts have eligibility criteria, so not everyone can contribute each year, and even those that can may be limited. Some factors that impact eligibility and contribution amounts are age, amount of income, marital status, and whether or not you’re an active participant in an employer-sponsored plan.
In 2023, up to $6,500 ($7,500 if over age 50) can be contributed into an IRA or Roth IRA. Because everyone’s situation is different, it’s wise to consult with a financial advisor to determine how much you can contribute.
- IRA: Contributions into an IRA are usually made pre-tax, which lowers one’s taxable income in the year of contributions. While the money stays inside the account, the growth from gains, interest, and dividends are tax-deferred. However, when you withdraw from the IRA, the funds that are withdrawn will be taxed in the year of distribution. Conducting an early withdrawal (before age 59½) will also trigger taxes to be paid plus an early withdrawal penalty of 10%.
- Roth IRA: Contributions to a Roth IRA are after tax, so you won’t get the benefit of lowering your taxable income like with the IRA mentioned earlier. Similarly to the IRA, the growth of the money is also tax-deferred. The main benefit of the Roth IRA is that as long as you wait until after age 59½, all withdrawals (including gains) can be tax-free after a holding period of five years.
Employer-Sponsored Accounts
Employer-sponsored retirement accounts are offered by your employer, however not every company offers these. It’s important to consider taking advantage of these accounts if you’re lucky enough to work for a company that offers one. There are limits to how much you can contribute to these accounts each year, and the taxes are deferred until you withdraw the money in retirement. The most common employer-sponsored accounts include:
- 401(k)
- Roth 401(k)
- 403(b)
- 457
- Simple IRA
- SEP IRA
Your employer may enable you to contribute pre or post-tax dollars to these accounts in support of your retirement. As you add payroll contributions, you can decide on a mix of securities (such as stocks, bonds, and mutual funds) to invest your retirement savings in, which could help it grow further. Then once you’re ready to retire and withdraw the money, you’re taxed on the distribution of those funds in any pre-tax qualified accounts.
To further incentivize your participation, your employer may offer to match a percentage of your contributions to the account—effectively multiplying your retirement savings. If you decide to leave the company, be sure you’ve met the vesting requirements necessary to take the full value of both your contributions and your employer’s with you.
Employer-sponsored investment accounts are an option many people can participate in. Even if you’re uncertain how to adequately invest within your employer-sponsored plan, involving a trusted financial advisor can help you make the decision best suited for you.
Non-Qualified Investment Accounts
Non-qualified investments are treated differently than qualified plans from a tax perspective. These types of investment accounts don’t have the same tax deferrals or deductions as their qualified counterparts. The lack of tax benefits on non-qualified accounts might be a significant drawback for some. However, there are plenty of benefits to integrating non-qualified investment accounts into your portfolio:
- Unlimited and unrestricted contribution amounts
- There’s no limit on who can contribute as long as they’re 18 or older.
- Make withdrawals at any age without any penalties.
- Gains are subject to capital gains tax rates, which are usually smaller than ordinary income tax rates one would pay on disbursements from qualified accounts.
Non-qualified accounts include checking, savings, and brokerage accounts. Unlike most qualified accounts, which are owned individually, non-qualified accounts can be owned individually or jointly (with a spouse, for example), as well as Trust owned.
It’s crucial to have a non-qualified investment account to fund goals before 59½. For example, it’s common for our married clients to open a jointly owned brokerage account to save money for a home purchase.
With a non-qualified brokerage account, you can purchase multiple securities with after-tax funds:
- Real Estate Investment Trusts (REITs)
- Stocks
- Bonds
- Mutual funds
- ETFs
You still may be responsible for paying tax on the dividends, interest, and gains you’ve earned.
Find the Right Investment Options for You
Most people will need a portfolio of different types of qualified and non-qualified investment accounts to fund different financial goals and to take advantage of different tax situations as life unfolds. Choosing an investment account and strategy, identifying your risk tolerance, and determining which securities serve your goals is a complex undertaking. When you’re overwhelmed with the abundance of information and decisions involved in the investing process, it helps to partner with a financial professional.
The Attitude Financial Advisors team helps you invest strategically by developing a customized plan to help you pursue your goals with an attitude of confidence and clarity. When you’re ready to make sense of your investment options, reach out to me via email at btrugman@attitudefinancial.com or give me a call at (516) 762-7603 to set up a free consultation.
About Bryan
Bryan Trugman is managing partner, co-founder, and a CERTIFIED FINANCIAL PLANNER™ practitioner at Attitude Financial Advisors. With more than 15 years of experience, Bryan specializes in addressing the financial needs of new parents as they seek to realign their finances, assisting divorced individuals as they navigate an unforeseen fork in the road, and strategizing with those seeking to accrue a dependable retirement nest egg. Bryan is known for being a good listener and building strong relationships with his clients so he can help them develop a customized financial plan based on what’s important to them. He is passionate about helping his clients experience financial confidence so they can worry less and play more. Bryan has a bachelor’s degree in industrial and systems engineering with a minor in mathematics from State University of New York at Binghamton. He has served on the board of the Financial Planning Association and continues to be actively involved in the national organization. He is also a member of the Plainview-Old Bethpage Chamber of Commerce and has served as its vice president and as a board member. When he’s not working, you can find Bryan on the ballroom dance floor or engaged in a fast-paced game of doubles on the tennis court. To learn more about Bryan, connect with him on LinkedIn. Or, watch his latest webinar on: How Much Is Enough? A Surprisingly Simple Way to Calculate Your Retirement Savings Needs.
