Tax, IRA, Investments… it’s Complicated

Welcome to a novice’s mind after spending an inordinate amount of time researching on IRAs and investment options. Be warned about the occasional assumptions and generalizations.

So what are some of the investment options available to younger demographic having a steady stream of income, an employer-sponsored retirement plan and some cash to spare each pay cycle?

Investment Options

Broadly, they can be classified as either pre-tax (tax-deferred) options or after-tax options. Some of the popular options available under each class are

Pre-tax (tax-deferred)

  • Traditional (Pre-tax) 401k
  • Traditional IRA

After-tax

  • Traditional (After-tax) 401k
  • Roth 401k
  • Roth IRA
  • Brokerage account-based individual investment options such as stocks, bonds, funds etc.

Traditional (Regular) 401k – Pre-tax and After-tax

These are available through an employer sponsored plan. The plans typically offer a pre-tax 401k but they may also offer an after-tax version as well. The employee usually signs up (or automatically signed up at a certain level of contribution by some employers) when hired. Usually the employer matches the amount contributed by the employee at a certain rate (dollar-to-dollar, 50 cents on the dollar etc.). As the name suggests, contributions to pre-tax account are made from pre-tax dollars and after-tax from after-tax dollars. There are limits on the amount that can be contributed to these accounts. Together (pre and after-tax), the contribution could not exceed $17,500 in 2014. The limits are set by IRS and could change every year. Key point to note here is that the limit – $17,500 – does not include the amount contributed (matched) by the employer. But, there is a limit to the total amount contributed by both employer and employee – $52,000 – for 2014. I would like to know a company that contributed that generous $34,500 for the employee!

When time comes for withdrawals (distribution) from these accounts, taxes are to be paid on the the money withdrawn from the pre-tax account at the prevailing income tax rate at the time of withdrawal. In contrast, only the earnings (capital gains) are taxed at the applicable capital gains tax rate at the time of withdrawal from an after-tax account. However, both these accounts are subjected to mandatory withdrawals (probably at a certain percentage) beginning at the age of 70.5. Optionally, withdrawals may start at age of 59.5. If the withdrawals happen earlier than age 59.5, then they have to be one of the ‘qualified’ events – such as first time home purchase, etc. – if not, then the withdrawal will be hit with a 10% penalty on top of any applicable taxes. In contrast, if the withdrawals do not start at age 70.5, then there may be a late withdrawal penalty of up to 50%.

It is also important to note that the traditional 401k plans are subject to the Highly Compensated Employee (HCE) rules set by the IRS to ensure equitable retirement account contribution opportunities to all employees in a company. In 2014, an employee that earned $115,000 per annum was considered a “highly compensated employee” and may not be eligible for full contributions to their 401k account under certain conditions. But it should be noted that making a $115,000 per year itself doesn’t necessarily disqualify an individual from contributing to their 401k. In combination with several other rules, the IRS determines whether the employer satisfies (or passes) the HCE test and hence making the contributions of the employees eligible.

Roth 401k

Roth 401k is a similar (employer-sponsored) plan as the 401k plans discussed above. The contributions are made using after-tax dollars. The contributions count towards the annual limit applicable to the pre-tax and after-tax 401k accounts. So in all, employee and employer contributions to pre-tax, after-tax and Roth 401k accounts, cannot exceed $51,000 in 2013.

An important difference here is that, there are no income limits applicable to the contributions. Any employee can contribute to this plan as long as it is offered by the employer. Another key difference is that the ‘qualified’ (if the Roth 401k account is at least 5 years old) withdrawals from this account are completely tax-free – for both contributions and earnings.

Traditional IRA

Traditional IRAs are opened and maintained by individual investors, outside of an employer sponsored program. Traditional IRAs have a contribution limit of $5,500 for the year 2013. As with 401k plans, the contribution limit may change every year. The contributions made to traditional IRAs are fully tax-deductible, if the income stays within $95,000 for joint filers and $59,000 for single filers. If the income is within $115,000 for joint filers, then a portion of the contributions are tax-deductible ($69,000 for single filers). Beyond $115,000 ($69,000 for single filers), contributions are not tax-deductible. The limits are much higher for joint filers where only one spouse is offered an employee-sponsored retirement plan.

Withdrawals from this account must start beginning at the age of 70.5 (optionally may start at age 59.5, without penalties). Withdrawals will be taxed as regular income at the applicable tax rates at the time of withdrawal.

Roth IRA

Roth IRA is much like traditional IRA but with some important differences such as the following.

Contributions to Roth IRA are made with after-tax dollars only. They are not tax-deductible. Withdrawals are completely tax-free, including any earnings accrued on the contributions as long as the withdrawals happen after a certain period of the contributions being held in the account (5 years in 2013) and that the withdrawals happen after the usual penalty-free timeline of age 59.5.

However, the contributions are subject to the limits – both income limits and the amount that can be contributed. Together with contributions to Traditional IRAs, the amount contributed cannot exceed $5,500 in 2013. Joint filers are not eligible to contribute if the earned income exceeds $188,000 in 2013. However they are eligible for partial contributions if the income is in between $178,000 and $188,000. Full contributions can be made if income is less than $178,000. The corresponding limits are $112,000 and $127,000 for single filers.

Individual investment options outside of IRAs

Information about these are available aplenty. An individual investor may choose to invest in a lot of different vehicles depending on their interest and level of risk-tolerance. In the interest of keeping this discussion focused on IRAs and their role in making up an individual investor’s options of investment, let us skip getting into the details of this section.

Investment Precedence

Deciding on where to put the money depends on a few factors, starting with the percentage of income one is comfortable setting aside for investment. Probably the next biggest factor is whether the investor anticipates falling in to a higher or a lower tax bracket come retirement season of life. Finally, assuming an interest in after-tax investment, a key factor of whether the investor sees it prudent to stay out of IRAs (freedom of withdrawals without penalties), with the knowledge that investments outside of IRAs do not typically come with FDIC protection.

With a strategy to take full advantage of the employer’s match on 401k and based on interest, either maximize on pre-tax or after-tax investments, following order of investment seems to make the most sense to me.

Pre-tax investment (anticipation of being in a lower tax bracket at retirement)

This means that the investor should focus more on getting the most deductions from all the contributions to IRAs during the years in employment. Keeping that in mind, investing in the following order of precedence may make more sense.

  1. Take full advantage of the employer-match to 401k and max-out on the pre-tax contributions to 401k.
  2. Open a Traditional IRA and max-out on the contributions
  3. At this point, any investment would have to be after-tax. Since we maxed-out on both 401k and IRA options, any investment from this point on would most likely have to be from an individual brokerage-based account, outside of the IRAs.

After-tax investment (anticipation of being in a higher tax bracket at retirement)

Here, the focus should probably be more on the after-tax options but at the same taking advantage of any freebies such as an employer-match to the 401k plan.

  1. Take full advantage of the employer-match to 401k. Does the employer offer a Roth 401k? Max-out contributions all into the Roth 401k. But note that the employer’s match will have to go into the regular 401k (pre-tax) account. If no Roth 401k is offered, max-out on the after-tax contributions to 401k. If no after-tax option is available on the plan, contribute to regular 401k (pre-tax), just enough to get the full match offered by the employer.
  2. Open a Roth IRA account and max-out on the contributions there.
  3. If there is still money left to contribute (assuming employer’s plan only has the pre-tax option), either max-out on 401k or operate on the outside independently with a brokerage account.

Conversion to Roth IRA

Whether due to a change in expectation of an investor falling into lower tax-brackets in future or exercising an option of transferring an IRA when switching employers, a potential smart move at any point is to convert traditional 401ks and traditional IRAs to Roth IRAs. This kind of conversion can be done once a year. However, when doing that, there may be a potentially huge tax bill due, depending on how deep into the investment timeline the conversion is made. The tax bill could be split between the year making the conversion and the next. But, if the tax is paid for by the monies involved in the conversion, that will be counted as ‘distribution’ and hence, depending on whether the conversion is made after age 59.5 or before, a penalty may be applied. A preferable option would be to foot the tax bill from external funds, in which case, there would be no penalties and the investor could reap all the benefits from moving the monies into a Roth IRA.

Disclaimer: I’m not responsible for any consequences resulting from taking any of the suggestions in this blog.

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