There are many options now for investing in accounts meant to be used for retirement. It can be a little overwhelming! Let’s break down the different options you have so that you can choose which one makes the most sense for you.
The idea is that you can put your money into an account, choose which investments to buy, and then not have to worry about paying taxes year by year while you are contributing to the account. This is in opposition to a taxable account or non-retirement account in which you will pay taxes in the year you sell an asset for a gain or collect income.
The difficulty comes in when you are presented many options and flavors of these accounts with their varying rules.
Traditional Individual Retirement Account (IRA)
This account is considered a pre-tax account. The logic here is to put money from your paycheck here (2022 max annual contribution of $6,000, or $7,000 if you’re 50 years old and older), let your investments grow without being taxed, and then when you retire you’ll be taxed at ordinary income when you withdraw from this account.
One interesting rule that works with all retirement accounts is that you can withdraw funds for 60 days tax-free, provided they are put into another retirement account by the end of the 60 days. This is called an indirect rollover and is allowed once per year per retirement account. Some IRA providers don’t have the ability to directly transfer funds to another provider so they will send you a personal check and you are responsible to put it in another IRA within the timeframe.
For those of us who are ambitious, this is basically a 2 month 0% interest loan you can take from yourself, as long as it is paid back in full by day 60. The possibilities, and risks, are endless with what you could do with the money within those 60 days!
- Delay paying taxes. Maybe you think you’ll be in a lower tax bracket in retirement than in your working years
- If you leave a job, you can rollover (rollover or transfer) your pre-tax employer plan into this account
- You get a tax deduction for contributing pre-tax dollars to this account
- Typically more investment options than an employer plan (stocks, bonds, CDs, mutual funds, ETFs)
- You can contribute 100% of your income or the max contribution, whichever is less
- Withdraws are considered income and will add to your taxable income, which could push you into another tax bracket if you have other income streams, thus increasing your tax liability
- In 2022, once you reach 72 years old, you must begin taking required minimum distributions (RMDs) which has the same affect as the previous point
- Low max contribution limit compared to most employer plans
Each employer may have it’s own set of rules so we’ll just go over the general rules and components here. In order to retain employees, employers offer accounts (401k, 403b, SIMPLE/SEP IRA, Pension, etc.) that either the employer invests in and/or the employee invests in for their future retirement.
You can choose between pre-tax contributions or after-tax contributions, but regardless the gains are 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 it into a traditional IRA (sometimes referred to as a rollover ira but nothing fundamentally different).
- 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 will make contributions and/or match employee contributions
- If you need money from your plan, to avoid taxes, you can leverage your employer plan by taking out a loan against the value of the plan (can be a con 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 the employer and employee. This can result in saving +$50,000 annually depending on your income and how you’ve structured your plan.
- Limited investment options
- Vesting schedules, or time until you have full access to the money in your account, can differ depending on the employer
- Various plan specific rules and fees
- If you withdraw funds too early (before you are 59 1/2 years old), you’ll not only get taxed on the distribution but could face a penalty as well, losing more of your funds
This account is similar to the traditional ira, but this ira is contributed to with only after-tax dollars. Once contributed, the contributions can be withdrawn tax-free. After meeting certain timing and age rules, the gains can also be withdrawn tax-free.
There are income limits, so during the year if you’ve been contributing to a Roth IRA and your income reaches above the limit, you’ll have to either take out the contributions to your bank or open a Traditional IRA and transfer (commonly referred to as recharacterize) the Roth IRA contribution to the Traditional IRA.
- Accounts can be opened for Minors with an adult as the custodian (earned income still required in order to contribute)
- Contributions can be withdrawn tax-free at any time
- Qualified withdrawals (medical emergency, first time home purchase, etc.) can also be tax-free, work with a tax accountant to ensure it qualifies.
- Even if your income is too high to directly contribute to a Roth, you can contribute to a Traditional IRA and convert (transfer) the contribution to a Roth IRA. This is commonly called a “back-door” Roth contribution/conversion
- Similar investment options as the Traditional IRA (stocks, bonds, CDs, mutual funds, ETFs)
- As of 2022, only $6,000 ($7,000 if 50 years old or older) maximum contribution per year, not per account if you have multiple accounts
- Income limits make it difficult for high earners to contribute
- As with the rest of the retirement accounts, there are withdraw rules you must follow so be sure you have some liquidity elsewhere to avoid drawing on this account frequently
Self-Directed IRA (SDIRA)
This type of account is not frequently talked about in finance courses or at the big brokerage houses where many people have retirement accounts. SDIRAs simply allow you to invest in whatever you want. As long as it is not your home or personal assets, you can buy it. This options gives you the ability to reap all the benefits of a retirement account, while having the option to invest in investments that interest you.
There are specific firms that you will have to seek out who offer these types of accounts. SDIRAs are typically more costly than the accounts we’ve already mentioned with monthly or annual fees based on the type or number of investments you hold. However, this can be a small price to pay if the investment opportunity is larger.
- Invest in non-traditional assets (cryptocurrency, art, commodities, real estate, private investments, loans, etc.) that don’t follow major stock/bond market cycles
- You can rollover or transfer funds from previous retirement accounts into this one
- If you have specialized knowledge in a particular field, you can use these funds to invest in those less known opportunities
- You can choose between making it a pre-tax or after-tax account
- Contribution limits follow previously mentioned options depending on how it is 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 you may not control or be able to get your money out of if you need funds in an emergency
- Ownership in businesses, real estate, private investments, etc. can open you up to the possibility of lawsuits that may affect the assets you bought
How does this help me grow my passive income?
Asset location is just as important as asset allocation. After you make your investment decision, you must then decide which account is the best place to hold your investment to maximize your return.
If you are just starting out, you may decide you can only afford to buy a few dividend stocks. Thus you could look to open a Roth IRA and start building up your tax-free passive income streams. This also gives you the option to recall the contributions should you get in a pinch with no tax or penalty ramifications.
What if you’re a high earner and have been putting money away in a 401k for years and you decide you want to diversify into private investments or real estate?
You may decide to transfer some of your 401k money to a SDIRA and begin diversifying your investments. You might also consider converting your 401k pre-tax contributions to after-tax if you believe your income will continue to grow and want to pay at your current tax rate.
Maybe you have an online business and have finally built up enough income streams to step away from your day job to work on your channel/website/business full-time. If you have money leftover from investing in your business and paying yourself, you may consider opening your own employer plan so you can save more than you ever could before. Employer contributions are an expense that could reduce your businesses taxable income.
All these accounts have the potential to benefit you in your passive income journey. By understanding how your investments will be taxed, you can know where the max benefit lies for you depending on your personal circumstances. Tax and legal advisors can also aid you in determining the right account structure for a given investment but they can’t tell you if the investment is a good idea, that is your job!