This past month the financial advisors at Ruedi Wealth Management covered three different types of tax-advantaged accounts in their "Investing 101" columns.
Make sure to look for them every Sunday in News-Gazette’s Business Extra section, but in case you missed them this past month, below are the Investing 101 columns from July.
401(k) Plans Part 1
by Paul R. Ruedi, CFP®
The majority of people who save for retirement do so in an employer-sponsored retirement plan; 401(k)’s are by far the most common. Named for the section in the tax code that created them, the 401(k) plan is a specific type of account that allows employees to save for retirement and lower their taxes in the process.
There are several key features of 401(k) plans that investors should understand, so I will have to break this topic into multiple columns. In this column, we will start with employee contributions, employer contributions, matching, and vesting.
Employees are able to choose to set aside a portion of their own money from each paycheck and have it automatically contributed to their 401(k) plan, this is called an employee contribution. Employees are able to designate a certain percent they would like to contribute, and this is an important number to be aware of because it may determine how much your employer adds to the plan on your behalf.
In addition to the contributions you make yourself, your employer may also contribute to your 401(k) fund on your behalf, which is called an employer contribution. Some employers automatically put a few percent of their employees’ salary into a 401(k) even if they do not contribute themselves. Companies may choose to match a percentage of the amount the employee contributes, and matching provisions vary from company to company.
It is important to note that employer contributions may come with some strings attached and employees may not actually own them until a certain vesting period has passed. Some employers designate their contributions as 100% vested immediately, so the employee owns them and if for some reason they leave the company or need to withdraw the money, it is 100% theirs. Others may have their contributions vest over a longer period of time in order to incentivize employees to stay at the company. They may have a graded vesting schedule where a certain percentage of their contributions vest each year. Others may have more of a cliff, where contributions become 100% vested all at once after a certain number of years.
Employee matching contributions are free money, and even if they come with a vesting schedule, they should be taken advantage of to the fullest extent possible.
401(k) Plans Part 2
by Paul R. Ruedi, CFP®
In my last column I covered how money is contributed to a 401(k) plan. But employees must then choose to designate their contributions as Roth or Traditional for tax purposes and decide how to invest those contributions.
Traditional 401(k) contributions can be deducted from your income and lower your tax bill now. They then grow tax-deferred but when it comes time to withdraw the funds you will be taxed at your ordinary income tax rate. Roth contributions are the opposite, you cannot deduct them now, but they grow tax-free and can ultimately be withdrawn tax-free given all the rules are followed.
Whether you will be better off designating contributions as Roth or Traditional depends on what your tax rate is now compared to the future. If you are in a higher tax bracket now than you will be in retirement, it makes sense to fund a Traditional 401(k) to avoid paying taxes now, in order to pay them at lower rates in the future. If you are in a lower tax bracket now than you will be in retirement, it makes sense to make Roth contributions to pay the taxes now at lower rates and save on taxes during retirement.
Many people think a 401(k) is an investment type itself, but it is actually just a type of account that holds investments. Employees are generally given a menu of different investments to choose from, and there are several things they should consider when choosing their investments options. 401(k) documents often don’t provide all the most important information, and you may have to do some research yourself by searching the ticker symbols or names of the investment options on Google or Yahoo finance.
The first is the asset class, or type of investments a particular fund or investment choice invests in. The three broadest types are stocks, bonds, and cash. 401(k) plans may have options to invest in sub-groups like specific types of stocks (US or international, small company stocks or large company stocks) or certain types of bonds as well. Investors should choose a mix of stocks and bonds that is appropriate for their age and financial goals.
Employees should make sure their 401(k) investment options are diversified, holding thousands of companies not just dozens or hundreds. They should be aware of the expenses of each of the investment options. The higher the expenses, the lower the investment returns – that is just simple arithmetic. Though employees may also be shown the performance of the investment options, they shouldn’t read too much into this as past investment performance is not necessarily an indicator of future results.
What is an IRA?
by Daniel Ruedi, CFP®
An IRA – short for Individual Retirement Account, is an investment account that allows people to set aside money for retirement with the added benefit of tax savings.
There are two different types of IRAs: Traditional IRAs and Roth IRAs. Though similar, they are in some ways opposites for tax purposes.
When you contribute to a traditional IRA, you can deduct the payment from your income now, lowering your current tax bill. Any money invested in an IRA grows tax-deferred, so you do not have to pay taxes on any investment gains until you withdraw them in retirement. When the funds are withdrawn, you then owe taxes on the entire amount of the withdrawal (your contributions and any earnings) at your ordinary income tax rate.
Traditional IRA investors must wait until age 59½ to withdraw their money, or they will be hit with an extra 10% penalty on the entire amount withdrawn. They must also start taking out required minimum distributions once they turn 72. Anyone with earned income can contribute to a traditional IRA and can receive a deduction for up to $6,000 worth of contributions ($7,000 if over age 50), though this amount may be reduced based on their income and whether their workplace has a retirement plan. There is no limit to non-deductible contributions to traditional IRAs.
Roth IRAs are in many ways the opposite. Contributions to Roth IRAs are made with “after-tax” dollars – you do not get to deduct them and lower your taxes now. Contributions then grow tax-free and when it is time to withdraw from the account during retirement, the entire withdrawal (contributions and earnings) is tax free.
In order to receive special tax treatment, Roth IRA investors must wait until age 59 ½ and the account must be open for 5 tax-years before withdrawing any funds from a Roth IRA, or they will owe taxes and a 10% penalty on the earnings portion of the withdrawal. Since contributions to Roth IRAs are made with after-tax dollars, they can always be withdrawn tax-free, penalty free. People under certain income thresholds can contribute up to $6,000 per year to a Roth IRA, or $7,000 if they are over 50.
IRAs are easy to open up with major brokers like Charles Schwab, Vanguard, and Fidelity. IRAs are attractive to investors because of their tax benefits, but also because they provide more flexibility and investment options than a 401(k). In addition to the mutual funds found in 401(k)’s, IRAs can also hold ETFs, individual stocks, CDs, and even real estate.
529 College Savings Plans
by Ryan Repko, CFP®
A 529 College Savings Plan is a special type of savings account that allows investments to grow tax-free if the proceeds are used for qualified education expenses. These plans are provided by individual states and nearly every state has at least one; Illinois, for example, has two. The plan is sponsored by each state, but it does not have to be the state where the beneficiary attends school.
The plans are funded with after-tax dollars and contributions are not deductible on federal tax returns, though they may be on some state tax returns, like they are in Illinois. In a 529 savings plan, you can invest your contributions in a portfolio of mutual funds or similar investments offered by the plan provider. The account balance goes up and down based on the performance of the investments in the account.
The big sticking point is that in order to avoid taxes on the gains in the account, the proceeds must be used for what are deemed qualified education expenses. Qualified education expenses include tuition and fees, books, computer technology and equipment (including internet access), special needs equipment, and some room and board expenses. If the proceeds are not used for qualified education expenses, earnings on those proceeds will be subject to tax at your ordinary income tax rate plus a 10% penalty. There are some exceptions, for example if the beneficiary dies, becomes disabled, or receives a scholarship, in which case the earnings will avoid the 10% penalty but will be subject to tax at your ordinary income tax rate.
529 plans are commonly used to fund education expenses for a beneficiary who is not the owner (often a child or grandchild), and the owner of a 529 plan maintains ownership until funds are withdrawn. There is no limitation on who can be a beneficiary; anyone with a Social Security Number or Tax ID can be one. An owner cannot designate multiple beneficiaries for the same account, so if there is a need to fund college expenses for multiple people, one would usually fund unique 529 accounts for each beneficiary. That being said, the beneficiary of a 529 can be changed, so it may be possible to use the same 529 plan and switch beneficiaries over time.
529 plans provide some extra help when it comes to funding higher education, but the majority of the progress towards this goal will be based on advance planning and diligent saving. Savers should start early to give themselves extra years to save, and their investments extra time to compound and grow.