If you have access to a pension plan there is a good chance that you are either retired or work in the public sector. In the year 2023, most gainfully employed individuals do not have access to the once ubiquitous and lucrative pension plan. Instead, most of us have access to a litany of other plans, accounts, and savings programs often through our employer. Recently I met with a young couple who had the opportunity to contribute both to employer plans, individual accounts, college savings, and an HSA. There question to me was simply, “where should we be investing our money with all of these options?” The answer to that question will vary from person to person so it is important to understand your options and discuss with a professional. For now, here are the three broad categories to consider: Benefits now, benefits later, and a little bit of both.
Benefits Now
Most of the time when we talk about investing we discuss it in terms of our retirement. That is great and all but what about the here and now? If you work for a larger company then there is a good chance that you have access to an employer sponsored retirement plan such as a 401(k) or 403(b). We have talked about these plans frequently on this blog and the immediate tax benefits of participating in them. Specifically, you are allowed to contribute up to $22,500 (in 2023) of your pay, all of which is deducted from your income pre-tax. This has the effect of decreasing your taxable income for the year thus lowering your tax bill while also investing for your future.
Similarly, companies with less than 100 employees will often utilize what is called a SIMPLE IRA. There are some subtle differences between a 401(k) and a SIMPLE IRA but suffice it to say that the biggest difference from a tax standpoint is that your maximum annual contribution is lower in a SIMPLE IRA ($15,500 in 2023). It is also worth mentioning that if you are a business owner with no W2 employees then you also have the ability to open what is called a Solo 401(k). I won’t spend too much time on this except to say that your total contribution limit is significantly higher ($66,000 in some instances for 2023).
Lastly, any individual with earned income has the ability to contribute to an Individual Retirement Account (IRA). Contributions to an IRA are also made pre-tax like an employer plan and also have the effect of lowering your taxable income. The 2023 maximum contribution to these types of accounts is $6,500. However, if you also have access to a company retirement plan then your ability to deduct your IRA contributions will be limited depending on your income.
It should probably be obvious to you that those who benefit the most from the “benefits now” or tax-deductible options are those who have a current tax issue. If you are in a lower income tax bracket and/or have other deductions that usually result in you getting a tax refund, then this option probably doesn’t really resonate with you. Also, it should be noted that in all of these options any withdrawals from these accounts in retirement will be taxed at the investor’s ordinary income tax rate. The hope is that the retiree will be taking a lower income in retirement and thus will be in a lower income tax bracket. However, the trend in our government seems to be that taxes go up over time, not the other way around which is also something to consider!
Benefits Later
On the other side of the coin are accounts that, while they do not offer any current tax benefits, provide for substantial benefits in retirement! The account types in the “benefits later” bucket are often referred to as after-tax or Roth accounts. The name “Roth” is likely familiar to you as many people have what is called a Roth IRA. Accounts such as these are funded with dollars that have already been taxed. Usually, they are funded with direct deposits from an individual’s personal bank account. Since the contributions have already been taxed, they will not be taxed again upon withdrawal in retirement. What makes a Roth account especially appealing is that investment gains are also not subject to taxes when withdrawn in retirement. This is the exact opposite of the Traditional IRA or 401(k) in which every dollar withdrawn from the account is hit with ordinary income taxes. This can allow for substantial tax-free withdrawals in retirement.
On the flip side, since a Roth account is funded with after-tax dollars, this means that contributions to a Roth IRA are not tax deductible like those to the “benefits now” bucket. This makes the Roth a less interesting option to someone who is struggling with high tax bills. However, even if you do have a higher income and therefore higher taxes, it would still be worth talking with your advisor about allocating at least some of your contributions to a Roth account. Creating a potentially tax-free bucket of funds in retirement has proven to be very helpful to many people!
In addition to Roth IRAs, who’s contribution limits are the same as a traditional IRA, many 401(k)’s also now offer employees the option to make contributions on a Roth basis. The contribution limits for Roth 401(k) contributions are the same as pre-tax contributions. Recent legislation has also now made it possible for employer matching contributions to be made on a Roth basis as well. That same legislation has similarly opened the door for SIMPLE IRAs and SEP IRAs to also offer a Roth option.
A Little Bit of Both
There are a couple of account types that offer not only a tax benefit now but also a tax benefit in the future. Specifically, the accounts that come to mind are 529 College Savings Plans and Health Savings Accounts. If you have a high deductible health insurance plan (HDHP) then you also have the ability to contribute to an HSA. This type of account is meant to be a way for you to save money in order to cover your health insurance deductible and out of pocket costs. It accomplishes this by allowing you to make tax-deductible contributions that become tax-free if used for qualified medical expenses. For 2023, families are allowed to contribute up to $7,750 to an HSA. As a general rule of thumb, I usually suggest that clients maintain a balance in their HSA equal to their out-of-pocket max in their health insurance plan.
In much the same fashion, a 529 plan allows you to contribute funds with the intention of using them for educational expenses. One of the key differences is that you are only allowed to deduct contributions for state income tax purposes and those deductions are limited (in the state of MI they are limited to $10,000/year).
While both account types are intended for specific purposes, they have been used in the past as additional savings vehicles for high income earners. For example, some will fully fund their HSA for many years (and possibly even invest inside the HSA) with the intention of using those funds for long term care such as care in a nursing home. Recently, changes have also come to 529 plans which make them a more viable option for long term savings.
With the passing of the bundle of legislation known as SECURE Act 2.0, it will now be allowed for the remaining balance in a 529 plan to be transferred to a Roth IRA, however there are some ground rules. Beginning in 2024, 529 balances will be eligible for transfer into a Roth IRA as long as the owner of the Roth IRA is also the beneficiary of the 529. The 529 also needs to have been open for at least 15 years. Also, Roth transfers will be limited to the annual IRA contribution limits up to a lifetime max of $35,000 and the last 5 years of contributions and earnings are not eligible for transfer.
How you invest your money and into which of the three buckets will depend largely on your personal situation. It would be a good idea to consult a professional before moving forward with any of the 3 options. If you would like to chat about this in more detail, grab some time on our calendar here. Thanks for reading today’s post!
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.