At times we use rules of thumb as a general good-practice approach to money advice. Such rules help provide a general foundation of fiscal responsibility that if followed consistently will help you build a lifelong habit of fiscal character. I have previously posted about emergency reserves, but today’s discussion will center on the types of accounts you should be using for saving and investing.
A good savings habit starts with how much to save, but begs the question of what kind of account(s) should be used to accumulate this flow of cash. There are three main types of accounts, much like a three legged stool, that everyone should utilize to provide the most flexibility and tax-smart wealth accumulation.
- Tax deferred savings with distributions 100% taxable at ordinary income tax rates. (401k, 403b, SEP, IRA)
- Tax deferred savings with tax free distributions. (Roth IRA, Municipal bonds, Life Insurance)
- Tax deferred savings with distributions taxed at capital gain rates. (Individual or joint investment account)
The most widely used investment vehicle is a qualified retirement plan offered by most employers for tax-deferred retirement savings. You should contribute at least enough to get the full employer match on your contributions …. This is free money, so don’t leave it on the table! Although qualified accounts provide tax-deferred retirement savings, this account should not be your only retirement savings vehicle as there are age, access, and tax implications.
After making qualified plan contributions to pick up the employer matching, additional contributions should go to a tax-deferred but tax-free account such as a Roth IRA or a Roth option in your qualified plan if available. If you make too much money to qualify for Roth IRA contributions, any form of permanent life insurance can work too, as it has the same properties but without the age and contribution limits. Since this accumulation bucket grows tax-deferred and distributions are tax-free, it allows tax diversification in retirement when used in conjunction with a fully taxable retirement portfolio. I’m not a fan of taxes, even in the working years, but income taxes in retirement just seems so wrong.
The third type of account everyone should have is a regular individual or joint, if you’re married, investment account. The growth is only taxable at capital gains rates, and depending on the account holdings, tax can be deferred for as long as you hold the securities. Capital gains rates are then dependent on your qualified income and can range from a high of 20%, to 15% for married couples making between $78,751 and $488,850, or even zero if you are married and earning less than $78,750. However, the best characteristics are no age or accumulation restrictions, which means you can save as much as you want, and can take out what you want, when you want it. This vehicle creates an enormous level of flexibility to take advantage of opportunities not available because of the tight government restrictions on other types of accounts.
Each investment account type provides unique saving, investment and tax characteristics. But by having all three account types as part of an overall retirement investment strategy, you will provide for the most flexibility of use, better tax control and generally give yourself a greater sense of confidence in over your retirement income plan.