The Taxman Cometh.

Module 2: Conquer ROTHs + IRAs

mod2-featured

Two things in life you can’t avoid – death and taxes.

 

When it comes to investing, this second one is a major consideration.  We want to minimize taxes at every opportunity. 

 

What we’ll learn about:

  • Which retirement account is best for you
  • Tax-advantaged accounts and their differences

  • Understanding capital gains and dividends

 

*This module isn’t fully exhaustive of all types of accounts or tax considerations, but covers the bulk of what most mortals will encounter and care about. For example, we won’t discuss SEPs or 403(b)s but the concepts still apply. It should also be noted that this module is intended for investors based in the US. Remember: work with a tax professional as needed.

What are tax-advantaged accounts?

These accounts fall into 2 camps: tax-deferred (pay taxes later), and tax-exempt (pay no tax). You can see immediately that we like both of these options.

Tax-advantaged accounts are retirement accounts – 401(k), IRA, Roths – so you may already be familiar with them.   

 

High-Level:

  • Employer sponsored accounts (401s, 403s, etc) are subject to the $19,500 contribution cap each year across accounts. These accounts will also carry required distributions when you turn 72, but can be accessed at age 59 ½ without penalties. To contribute to these accounts you need to be employed. 
  • Individual accounts (IRAs and Roths) are subject to the $6,000 annual contribution cap across accounts. 
  • In general, 401(k) > IRA, but a Roth IRA > Roth 401(k) in terms of benefits. 

 

401(k)  / Tax-Deferred: These are employer sponsored retirement accounts. Contributions are taken out of paychecks before any income taxes so you get more mileage out of your money. Taxes are felt on distributions when you take those down the road. Some employers will match your contributions up to a certain percentage, which is free money. Make sure to take it when available. 

Roth 401(k) / Tax-Exempt: Also employer sponsored accounts but contributions are taken out after taxes. Unlike the Roth IRA below, Roth 401(k)s require distributions at age 72. 

IRA / Tax-Deferred: Individual account, contributions are made after taxes but could qualify as tax deductions when you file each year (subject to income restrictions).  If either you or your spouse however has a 401(k) or similar, it’s unlikely you can get these deductions. The tax deductions are a synthetic way to make your contributions to these accounts look like they are pre-tax like a 401(k). 

Roth IRA / Tax-Exempt: Individual account, contributions made after taxes. No required distributions and no taxes after 5 years. 

See below for all the details and comparisons between these account types. 

(For a full list of different retirement plans, the IRS has you covered.)

Why are they powerful?

By far the main advantage is growth, gains, and income in these accounts have no tax implications until you start to withdraw money decades down the road (if ever). 

Since these accounts aren’t incurring taxes on a yearly basis, more of your money is reinvested, making ‘compound interest’ stronger and faster, accelerating growth. 

 

Let’s look at a simple example. Assume you’ve invested $10k and let it sit in a tax-advantaged account for 15 years. 

 

At a modest 7% annualized growth rate, you would have ~$28k by year 15 without any further contribution. 

 

However, if you invested the $10k in let’s say a regular brokerage account, you would be incurring some capital gains and dividends each year (most likely), that would reduce your return by 10%-15% comparatively. At the end of year 15, you could expect to have around $25k. 9% less than if this money was kept in a tax-advantaged account. 

 

Now if we’ve learned anything in finance, ‘rewards’ never come completely free….

Downsides

Due to the huge advantages, the government limits how much you can invest into these accounts each year. Otherwise, that’s all anyone would probably do and it would drastically cut down the government’s tax revenue. 

 

Liquidity.  You can’t take money out of these accounts before retirement (earliest at age 55), so there’s no way to sell $500 of stock to furnish your pandemic-induced home office. There are some exceptions to this (non-qualified distributions) to help with say a health emergency, but these accounts should be tapped as a last resort.  For now, just assume this money is locked up until retirement. 

 

Qualifying. Not everyone can open a Roth account, and not everyone qualifies for the tax-deductions normally associated with IRAs (see contribution limits and rules).  

 

Penalties. If you take money out before retirement age, there is usually a 10% penalty which crushes any upside. 

 

Required Distributions. For 401(k) and IRAs, you will need to take distributions whether you need them or not at age 72 and beyond. Not a huge downside, but it can erode inheritance of next generations. 

 

Earned Income. You need to be working to contribute, and passive income from things like rental properties doesn’t qualify. 

 

Limits. Contributions are capped. 

 

All reasons to still utilize a regular brokerage account as well, particularly for anyone planning to retire before age 60 pretty much.

Comparison. Putting it all together.

Apples to Apples?
401(k) Roth 401(k) IRA Roth IRA
Tax Advantage Deferred Exempt Deferred Exempt
Eligibility Up to employer. Usually need to be 21 and have 1 yr of service. Up to employer. Usually need to be 21 and have 1 yr of service. You or spouse has taxable compensation You or spouse has taxable compensation
Contributions Max $19,500 across 401(k) and Roth 401(k) in 2020. Max $19,500 across 401(k) and Roth 401(k) in 2020. Max $6k if under age 50 or $7k if over across IRA and Roth Max $6k if under age 50 or $7k if over across IRA and Roth. Consult income limit table as there is a ‘phasing out’ of how much can be contributed for incomes within a certain range
Deductible Contributions None None Yes, if under income thresholds None
Income Limits None None None If single: less than ~$125k If married: less than ~$200k (refer to limit table for more details)
Tax on Withdrawls Taxed at your income tax rate None if account open for 5+ years Taxed at your income tax rate None if account open for 5+ years
Required Distributions At age 72 At age 72 (can be avoided by rolling into a Roth IRA) At age 72 Never
Rollovers Can roll into other 401s or IRAs Can roll into a Roth IRA To other IRAs or Roth conversions (w/ taxes). Sometimes can go back to a 401(k) To other Roth IRAs
Early Withdrawl Penalty 10% on unqualified distributions before age 59 1/2 No penalty on distributions from contributed amounts. 10% penalty on unqualified distributions on growth/earnings before age 59 1/2 OR if less than 5 years from funding the account. 10% on unqualified distributions before age 59 1/2 No penalty on distributions from contributed amounts. 10% penalty on unqualified distributions on growth/earnings before age 59 1/2 OR if less than 5 years from funding the account.

Which Account To Open?

It should be simple, but it’s not. Here’s a decision tree to help you make a plan.

 

Please make sure to consult the latest IRS rules on contribution limits, and eligibility for tax deductions, and Roth contributions as this is a slight simplification. The exercise below assumes a ‘married filing jointly’ status for any questions related to a spouse. Just an FYI.

decision-tree

One thing to note, if you are working but your spouse is not, you can open an IRA or Roth in their name and make contributions on their behalf. You would need to be bringing in an income greater than what you contribute to both your and your spouse’s accounts and file taxes married filing jointly.  For example, instead of $6k / yr into your Roth IRA, you can contribute $6k to yours and $6k to your spouse’s. It’s a good way to double up on your nest egg if you have the ability to do so. 

 

If your spouse is working, send them this link to go through the same exercise to make sure your household is taking full advantage of tax-advantage investing!

Other things that are taxed…

Since we’re talking about tax-advantaged accounts, it’s a good time to speak to other types of investment taxation. 

 

Capital Gains: When you sell a security or asset and realize a gain vs. how much you invested to begin with. There are two types, long-term and short-term capital gains. 

  • Short-Term: Assets held less than 1 year. Taxed at your income tax rate. 

  • Long-Term: Asset held more than 1 year. Tax rates based on yearly income:

    • 0% rate for incomes less than $40,000

    • 15% rate for incomes less than $441,500

    • 20% rate for everyone else 

Capital Losses: The opposite of gains. Capital losses occur when you sell assets for less than what you paid. These offset capital gains, so your’ net capital gain’ each year is the tax basis. The other thing to note, is if your losses exceed your gains, you can claim up to a $3k deduction on ordinary income in a tax year. If your net loss was greater than this, you can carry forward the loss to future tax years until it’s all eaten up. 

 

Dividends: Distributions of profits to company shareholders (or from funds, investment companies, mutual funds). Dividends are a great form of recurring passive income and come in two main flavors. Here we go again:

  • Qualified: Taxed like long-term capital gains. 

  • Ordinary: Taxed at your income tax rate. 

 

So what are qualified dividends? Yea great question. The IRS states qualified dividends need to meet 3 criteria:

  • Paid by a US company or qualified foreign company

  • Not listed specifically by IRS as not qualifying (REITs, MLPs,…)

  • Meet holding period requirements. Generally you need to hold the security for at least 60 days (90 days for preferred stock). There are some more details here but nothing to really fret about. 

 

Trying to optimize around qualified vs. unqualified dividends is migraine-inducing so it’s usually good enough to pick a strong dividend equity fund and not worry about it, or for individual stocks, identify a handful of companies you like for the long-run, buy and hold. 

 

The main consideration here is the types of securities that automatically are excluded, namely REITs (real estate trusts) and MLPs (strange energy focused entities that usually pay massive dividends). 

 

Bond Interest: We’ve got US government bonds, municipal bonds, corporate bonds, and foreign bonds.  Pretty much all distributions from these is viewed as taxable income at your normal rate. However, for pure plays on US Treasury bonds, these are typically exempt from tax at the state level. For munis, distributions are exempt from federal taxes and in some cases state taxes if you live there. 

 

Since the government is going to take a cut from all of these, short-term gains being the worst offender, it makes even more sense to ‘incur’ these charges within tax-advantaged accounts to avoid the tax bill altogether. 

 

However, when it comes to a brokerage account without these protections, it’s all about mitigation. It’s not a great strategy to simply try and avoid any taxes, but to be ‘tax-aware’ in your investment selection within brokerage accounts, and adopt a less active approach to at least minimize the impact.

Considerations

Ok let’s land the plane. This is a ton of information to work with. 

 

It comes down to pairing the types of securities and investing style to the right account types. Active investing and securities that throw off capital gains are best done in protected accounts for example. 

 

For Taxable Accounts:

  • Adopt a more passive style -> less trading = less capital gains

  • Hold securities for a year or more = better tax rate on any gains 

  • Go for index ETFs, low-turnover funds = less capital gains

  • Go for Muni bonds => tax-exempt distributions (federal) 

  • Go for treasury bonds => tax-exempt distributions (state) 

  • Go for qualified dividends => lower tax rate 

  • Reinvest dividends as a way to rebalance => avoid selling high-performing assets to rebalance

  • Use options hedging (advanced) => protect gains, and unexercised generates capital loss to offset any capital gains. Don’t worry about this now, or maybe ever. 

  • Tax loss harvesting => sell to take a loss and put the proceeds back into a nearly identical investment. 

 

For Tax-Advantaged Accounts:

  • Adopt a more active style -> more trading = gains not taxed

  • Go for any type of bonds -> good place for TIPS

  • Go for any ETFs, sectors,  or active funds

  • Go for non-qualified dividends => high-yield MLPs or REITs are good here

 

General considerations:

 

  • Those in higher tax brackets need to be more aware of tax implications of investing, particularly incurring capital gains in non-retirement accounts.

  • It’s like peanut butter and jelly; having a brokerage AND some type of retirement account together is best. 

 

Everything we’ve learned thus far illustrates the level of complexity and nuance that comes with efficient investing and also why your unique financial situation is such a key variable. 

 

But have no fear. 

 

We’ve taken these factors into account when designing our model portfolios to get you started without the mass confusion. 

 

Onwards and upwards. Let’s open some accounts.

Dig Deeper:

IRA and Roth Contribution Limits

Spousal IRA

Withdrawals, Hardships, and Penalties from 401s and IRAs

Tax Treatment on Bonds

 

Disclaimer (sorry): Remember, supermoment does not provide tax, investment, or financial services and advice. Supermoment isn’t a registered investment advisor or CPA. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. In other words, it’s general info that is meant to educate. And you know the mantra, past performance is not indicative of future results. Investing involves risk including the possible loss of principal.