There are many options now to invest in accounts intended for use for retirement. It can be a little overwhelming! Let us break down the different options available to you so you can choose the one that is most suitable for you.
Retirement accounts
The idea is that you can put your money into an account, choose which investments you want to buy, and then don’t have to worry about paying taxes year after year while contributing to the account. This is contrary to A Taxable account Or a non-retirement account in which you may owe taxes in the tax year in which you sell an asset for a gain or income.
The difficulty comes when many options and flavors are offered for these accounts with their different rules.
Traditional Individual Retirement Account (IRA)
This account is considered a pre-tax account. The logic here is to put money from your salary here (2024 maximum annual contribution of $7,000 or $8,000 if you’re 50 or older), let your investments grow without being taxed, and then when you retire you’ll be taxed as ordinary income when you withdraw from this the account.
One interesting rule that works with all retirement accounts is that you can withdraw money for 60 days tax-free, provided it is placed in another retirement account by the end of the 60 days. This is called an indirect rollover and is allowed once a year per retirement account. Some IRA providers do not have the ability to transfer funds directly to another provider, so they will send you a personal check and you are responsible for placing it in another IRA within the time frame.
For those of us who are ambitious, this is basically a 0% interest loan for two months that you can take out on yourself, as long as it is paid off in full by day 60. The opportunities and risks/missed gains are endless with what you can do with the money during those 60 days!
Pros
- Delaying payment of taxes. You may think you’ll be in a lower tax bracket in retirement compared to your working years
- If you leave a job, you can roll over (roll over or transfer) your employer’s pre-tax plan to this account
- You get a tax deduction for contributing pre-tax dollars to this account
- Typically more investment options than your employer’s plan (stocks, bonds, CDs, mutual funds, ETFs)
- You can contribute 100% of your income or the maximum contribution, whichever is less
cons
- Withdrawals are considered income and will add to your taxable income, which may push you into another tax bracket if you have other sources of income, thus increasing your tax liability.
- Starting in 2024, once you reach age 73, you must begin taking required minimum distributions (RMDs), which have the same effect as the previous point.
- Low maximum contribution limit compared to most employer plans
Employer plans
Each employer may have their own set of rules, so we’ll go over the general rules and components here. In order to retain employees, employers offer accounts (401k, 403b, SIMPLE/SEP IRA, Pension, etc.) in which the employer invests and/or the employee invests for his or her future retirement.
You can choose between pre-tax contributions or after-tax contributions, but regardless the gain is considered pre-tax. Once you leave a job, some plans allow you to roll previous plans into your new jobs plan or you can roll them over to a traditional IRA (sometimes referred to as a Rollover IRA but essentially nothing different).
Pros
- Higher contribution limits than a traditional or Roth IRA
- You can invest in both an employer plan and a traditional IRA or Roth IRA (not all 3).
- Sometimes the employer makes contributions and/or matches employee contributions
- If you need money from your plan, to avoid taxes, you can impact Plan your employer by taking out a loan against the value of the plan (it can be a scam if you can’t pay it back)
- If you own your own business, you can set up your own employer plan and contribute as both an employer and an employee. This can save you $50,000+ per year depending on your income and how your plan is structured.
cons
- Limited investment options
- Vesting schedules, or the time until you have full access to the funds in your account, can vary depending on your employer
- Plan-specific rules and fees
- If you withdraw the money too early (before you turn 59½), not only will the distribution be taxed, but you may also face a penalty, causing you to lose more of your money.
Roth IRA
This account is similar to a traditional IRA, but only after-tax dollars are contributed to this account. Once contributed, contributions can be withdrawn tax-free. After certain timing and age rules are met, gains can also be withdrawn tax-free.
There are income limits, so if during the year you contribute to a Roth IRA and your income comes above the limit, you will have to either take the contributions at your bank or open a traditional IRA and convert (commonly referred to as recharacterizing) the Roth IRA contribution to a traditional IRA .
Pros
- Accounts can be opened for minors with an adult acting as guardian (Earned income Still required in order to contribute)
- Contributions can be withdrawn tax-free at any time
- Qualified withdrawals (medical emergencies, first-time home purchase, etc.) can also be tax-deductible, work with a tax accountant to make sure they qualify.
- Even if your income is too high to contribute directly to a Roth, you can contribute to a Traditional IRA and convert (convert) the contribution to a Roth IRA. This is commonly called a “back door” Roth contribution/conversion.
- Similar investment options like a traditional IRA (Stocks, Bonds, CDs, Mutual fundsETFs)
cons
- As of 2022, the maximum contribution per year is $6,000 ($7,000 if you’re 50 or older), not per account if you have multiple accounts.
- Income limits make it difficult for high-income earners to contribute
- As with other retirement accounts, there are withdrawal rules you must follow so make sure you have some cash elsewhere to avoid withdrawing from this account too frequently.
Self-Directed IRA (SDIRA)
This type of account is not talked about frequently in financial courses or at large brokerage firms where many people have retirement accounts. SDIRAs simply allow you to invest in whatever you want. As long as it’s not your home or personal property, you can buy it. This option gives you the ability to reap all the benefits of a retirement account, while providing the option to invest in investments that are important to you.
There are specific companies you will have to look for that offer these types of accounts. SDIRA accounts are usually more expensive than the accounts we’ve already mentioned with monthly or annual fees depending on the type or number of investments you have. However, this may be a small price to pay if the investment opportunity were greater.
Pros
- Investing in non-traditional assets (cryptocurrency, art, commodities, Real estate, Private investments, Loansetc.) that do not track major stock/bond market cycles
- You can transfer or transfer funds from previous retirement accounts to this account
- If you have specialized knowledge in a particular field, you can use that money to invest in those lesser-known opportunities
- You can choose to make it a pre-tax or after-tax account
cons
- Contribution limits follow the previously mentioned options depending on how they are structured (traditional, Roth, employer plan, etc.)
- Paperwork and fees required to open the account, as well as for each investment and transaction
- Higher risk with assets that are not publicly traded
- Illiquidity risk with assets that you may not be able to control or cannot withdraw your funds from if you need funds in an emergency
- Ownership in companies, real estate, private investments, etc. can expose you to the possibility of lawsuits that may affect the assets you have purchased.
How does this help me grow my passive income?
Asset location is just as important as asset allocation. After making your investment decision, you should then decide which account is the best place to hold your investment to maximize your return.
If you’re just starting out, you may decide that you can only buy a few dividend stocks. So you can look forward to opening a Roth IRA and start building tax-free passive income streams. This also gives you the option to call back contributions if you get into trouble without any tax or penalty consequences.
What if you’re a high-income earner who’s been saving money in a 401k fund for years and decide you want to diversify into private investments or real estate?
You may decide to roll some of your 401k funds into a SDIRA and start diversifying your investments. You may also consider converting your pre-tax 401k contributions to after-tax if you think your income will continue to grow and are willing to pay at the current tax rate.
Maybe you have Online business And you’ve finally built enough income streams to step away from your day job to work on your channel/website/business full time. If you have money left over from investing in your business and paying yourself, you might consider opening your own employer plan so you can save more than you could before. Employer contributions are expenses that can reduce your company’s taxable income.
All of these accounts have the potential to benefit you on your passive income journey. By understanding what your investments will be like Taxableyou can find out where the maximum benefit lies for you depending on your personal circumstances. Tax and legal advisors can also help you determine the appropriate account structure for a particular investment, but they can’t tell you whether an investment is a good idea or not, that’s your job!