Which Account Do I Use?
Which account(s) do I use for retirement or other investments?
This is an extremely important question to ask, and is often the most vague when you have so many years ahead of you and you aren't sure of the different implications for each potential scenario.
The biggest questions to ask are the tax implications for each account as well as the other rules for income limits, annual contributions, when the money is taxed, what are the fees, and what investment options do I have.
Here are some scenarios to consider. *You need to make your own analysis of your own personal situation, and you may need to consult a fee-only financial advisor for a one-time overview of your own unique circumstances before making ANY investment decisions.* To not pass this off to a commission-based advisor... you will blow almost half of your savings in fees and commissions.
Am I younger than age 35? If yes - you should definitely consider a Roth IRA first if your annual combined income is under $183,000. With a lower teacher income early on (lower taxes) and much more time to let your investments compound, you will save the most in taxes by having your Roth IRA income tax-free in retirement. Under current tax law, if your MAIG is below $61,000, you can take a small tax credit for retirement savings (pension, IRA, 403(b) or 401(k)).
If you are not younger than 35 - there is a fine line between after-tax and pre-tax investing and you'll need to make some calculations of taxes saved now versus in retirement. If you feel the government "match" of tax savings now is worth it, or if you don't have 15-20 years of compounding, or if your teacher salary is high and would like some tax savings now (and if your tax bracket will likely be lower in retirement), you may want to do a pre-tax account like the Traditional IRA, 403(b), HSA or 401(k).
I'm going to max out both my Roth IRA and my spousal IRA and I want to do more investing, what do I do next? Since the Roth IRA is the only after-tax option, your other choices are all pre-tax. Currently, the contribution limit to a Roth IRA is $5,500 per person per year ($11,000 combined if married) and there is a $1,000 catch-up provision after age 50, so a combined $13,000 for a couple over 50 years old. If you wish to invest beyond your annual IRA limit, you must decide between a 403(b)/401(k) or using your HSA as a retirement account.
Traditional IRA - I would only use this is if your combined income is below $98,000 to allow it to be fully deductible. If it is over $98,000, you have other options that do make tax deductible contributions. The good thing about an IRA is you have virtual freedom to invest anywhere with any funds you wish. A Vanguard IRA account in good index funds is the least expensive investment route you can do. Traditional IRA contributions (if partially or fully deductible) lower your MAIG and thereby reduce your Federal, State and Local taxable income.
403(b)/401(k) - I would probably only use this if my Trad. IRA isn't fully deductible (if you make over $98K/year combined) AND/OR if I want to invest beyond the IRA limits (if married - $11,000 or $13,000 depending on age). With contribution limits of $18,000 or $24,000 if over 50, the 403(b)/401(k) is the largest tax-deferred retirement account. These accounts give you much less control than an IRA, are more expensive, and are often laced with hidden fees and costs. Many 403(b)s and 401(k)s do not offer enough diversified index funds. If you are investing heavily and can do a Roth or Trad IRA, you could consider splitting your portfolio amongst the different accounts to meet your asset allocation and give you the lowest possible fund expenses. For example, if you have a good (cheap) stock index fund in your 401(k), you could fund that (especially if you get a match from your district), and purchase a bond index fund in an IRA account. Bond funds are usually more expensive than stock funds, so you probably want control over what bond index fund you pick (use an IRA if you can). It's not uncommon to have multiple accounts in your portfolio - the question is what makes most sense from the perspective of taxes, costs, fund choices and annual contribution limits.
403(b) and 401(k) contributions lower your MAIG and thereby reduce your Federal, State and Local taxable income; virtually identical tax advantages to the Traditional IRA. If your school matches your 403(b) or 401(k) contributions always take this first before doing anything else. Free money is hard to pass up.
HSA - This is a very unique account with a lot more items to consider. This is the only account where contributions reduce not only taxable income, but also your FICA taxes if done on payroll deduction through your school's business office. From a pre-tax perspective, this is the biggest tax advantage. Under current law, this account also has just about as much freedom as a Traditional IRA since you can move your available checking money to any HSA company (be careful to check the rules for your particular account to avoid transfer fees). Of course, any medical expenses paid with this account during your lifetime are tax-free. You can use your HSA for any reason after age 65 and it will be taxed at your ordinary income rate just like your pension, 403(b)/401(k) or Traditional IRA.
Since you need money to cover your yearly health care deductible, I suggest waiting until the end of the year and moving any unused portion of contributions to an HSA investment account. The contribution limit for 2015 is $6,650 (additional $1,000 if over 55). My plan has a $2,600 deductible paid by our district, so I could put in an additional $4,050 if I wish that would not be used for medical and would build towards savings.
With excellent fund choices, low fees, and the greatest pre-tax savings, I might consider using the HSA before a Traditional IRA or 403(b)/401(k) (after receiving any match that the district offers). There is no income limit to using an HSA, and the money is taxed exactly the same. The disadvantage of using the HSA as a retirement account that you eat off of is you can't access the money for non-medical purposes until age 65. This forces the investor to wait 5.5 years longer than the IRA or 403(b)/401(k) person, thereby letting the account grow even LARGER before making withdrawals. Let's consider this example:
Say you had $300,000 by age 59 1/2 (the minimum age to begin IRA and 403(b)/401(k) withdrawals). If this money is in an IRA, 403(b) or 401(k), you could begin withdrawals. At a 4% withdrawal rate, you would take out $12,000 per year. If it was in an HSA, to avoid tax penalties, you must wait until age 65 to withdraw your money. During that time, the $300,000 continues to compound for 5.5 more years. At a 7% compounding rate, the account will now be over $435,000 and your 4% withdrawal is $17,400 per year. By forcing yourself to wait 5 years, you end up with $135,000 more in retirement and you saved more in taxes along the way. To have $300,000 accumulated in 25 years, you need to save $3,800 per year into the HSA above what you use for your deductible. Since I can put an additional $4,050 in my HSA above my deductible, this is doable for me. The HSA also has no Required Minimum Distributions like a Trad. IRA, so you can control how much you take out each year after age 65.
Taxable Accounts
If you have 5 years or longer to save for a major purchase or need additional room for retirement savings, you can use a taxable investment account. This can be done through any discount brokerage firm online. Do not invest for less than 5 years because the stock market swings are too violent year to year.... you need a longer time window to ensure growth. 95% of the rolling 5-year periods and 99% of the rolling 10-year periods have made money in the history of the stock market. If you remember 1929, 1987 or 2008, the market dropped by over 50%... you don't want to take that chance - make sure you can invest for more than 5 years.
Taxable accounts also allow great flexibility; however, they are fully exposed to capital gains, dividends and interest income and are therefore taxable by law. You want to make sure to invest in funds that have the least amount of realized capital gains, have qualified dividend distributions and have little or no payable interest income. This means to purchase something like a Vanguard Total Stock Market index fund or S&P 500 index fund. These two have little stock turnover per year (they sell less than 5% of the stocks held in the fund each year to keep expenses and taxes low), and have qualified dividends (no taxes paid on dividend distributions). The only bonds I would purchase in a taxable account are tax-exempt municipal bonds or tax-exempt treasury bonds. All other bonds pay interest income that is fully taxable and also will encounter capital gains when the bond reaches maturity.
If you wish to invest for a purchase for 5 years or longer outside of retirement savings, the "safest" and greatest tax savings is an S&P 500 index fund. These stocks have lower volatility, low turn-over, and have qualified dividends paid out (be sure dividends are automatically reinvested). Remember - any time you sell at a profit creates a taxable gain (and anytime you sell at a loss creates an opportunity to do what is called "tax loss harvesting"). Also, if you hold shares for longer than 1 year, you will pay the Long-Term Capital Gains rates which is much lower than Short-Term Capital Gains.
If you do not qualify for an IRA due to a large income or wish to invest beyond the 403(b) or 401(k) contribution limits, a taxable account is your only option. In this case, purchase BOND FUNDS, REITs and INTERNATIONAL STOCK FUNDS in your 403(b)/401(k) and purchase US TOTAL STOCK or S&P 500 FUNDS and TAX-EXEMPT BONDS in your taxable account. Never buy balanced funds or Target Retirement/LifeStrategy funds in a taxable account since these hold international and bond funds. This will save you the most in taxes. Reversing this would create anywhere from a 25% to a 50% reduction in your nest egg. Remember, taxes are the single greatest cost to an investor, so be wise with whatever you choose to put in a taxable account.
This is an extremely important question to ask, and is often the most vague when you have so many years ahead of you and you aren't sure of the different implications for each potential scenario.
The biggest questions to ask are the tax implications for each account as well as the other rules for income limits, annual contributions, when the money is taxed, what are the fees, and what investment options do I have.
Here are some scenarios to consider. *You need to make your own analysis of your own personal situation, and you may need to consult a fee-only financial advisor for a one-time overview of your own unique circumstances before making ANY investment decisions.* To not pass this off to a commission-based advisor... you will blow almost half of your savings in fees and commissions.
Am I younger than age 35? If yes - you should definitely consider a Roth IRA first if your annual combined income is under $183,000. With a lower teacher income early on (lower taxes) and much more time to let your investments compound, you will save the most in taxes by having your Roth IRA income tax-free in retirement. Under current tax law, if your MAIG is below $61,000, you can take a small tax credit for retirement savings (pension, IRA, 403(b) or 401(k)).
If you are not younger than 35 - there is a fine line between after-tax and pre-tax investing and you'll need to make some calculations of taxes saved now versus in retirement. If you feel the government "match" of tax savings now is worth it, or if you don't have 15-20 years of compounding, or if your teacher salary is high and would like some tax savings now (and if your tax bracket will likely be lower in retirement), you may want to do a pre-tax account like the Traditional IRA, 403(b), HSA or 401(k).
I'm going to max out both my Roth IRA and my spousal IRA and I want to do more investing, what do I do next? Since the Roth IRA is the only after-tax option, your other choices are all pre-tax. Currently, the contribution limit to a Roth IRA is $5,500 per person per year ($11,000 combined if married) and there is a $1,000 catch-up provision after age 50, so a combined $13,000 for a couple over 50 years old. If you wish to invest beyond your annual IRA limit, you must decide between a 403(b)/401(k) or using your HSA as a retirement account.
Traditional IRA - I would only use this is if your combined income is below $98,000 to allow it to be fully deductible. If it is over $98,000, you have other options that do make tax deductible contributions. The good thing about an IRA is you have virtual freedom to invest anywhere with any funds you wish. A Vanguard IRA account in good index funds is the least expensive investment route you can do. Traditional IRA contributions (if partially or fully deductible) lower your MAIG and thereby reduce your Federal, State and Local taxable income.
403(b)/401(k) - I would probably only use this if my Trad. IRA isn't fully deductible (if you make over $98K/year combined) AND/OR if I want to invest beyond the IRA limits (if married - $11,000 or $13,000 depending on age). With contribution limits of $18,000 or $24,000 if over 50, the 403(b)/401(k) is the largest tax-deferred retirement account. These accounts give you much less control than an IRA, are more expensive, and are often laced with hidden fees and costs. Many 403(b)s and 401(k)s do not offer enough diversified index funds. If you are investing heavily and can do a Roth or Trad IRA, you could consider splitting your portfolio amongst the different accounts to meet your asset allocation and give you the lowest possible fund expenses. For example, if you have a good (cheap) stock index fund in your 401(k), you could fund that (especially if you get a match from your district), and purchase a bond index fund in an IRA account. Bond funds are usually more expensive than stock funds, so you probably want control over what bond index fund you pick (use an IRA if you can). It's not uncommon to have multiple accounts in your portfolio - the question is what makes most sense from the perspective of taxes, costs, fund choices and annual contribution limits.
403(b) and 401(k) contributions lower your MAIG and thereby reduce your Federal, State and Local taxable income; virtually identical tax advantages to the Traditional IRA. If your school matches your 403(b) or 401(k) contributions always take this first before doing anything else. Free money is hard to pass up.
HSA - This is a very unique account with a lot more items to consider. This is the only account where contributions reduce not only taxable income, but also your FICA taxes if done on payroll deduction through your school's business office. From a pre-tax perspective, this is the biggest tax advantage. Under current law, this account also has just about as much freedom as a Traditional IRA since you can move your available checking money to any HSA company (be careful to check the rules for your particular account to avoid transfer fees). Of course, any medical expenses paid with this account during your lifetime are tax-free. You can use your HSA for any reason after age 65 and it will be taxed at your ordinary income rate just like your pension, 403(b)/401(k) or Traditional IRA.
Since you need money to cover your yearly health care deductible, I suggest waiting until the end of the year and moving any unused portion of contributions to an HSA investment account. The contribution limit for 2015 is $6,650 (additional $1,000 if over 55). My plan has a $2,600 deductible paid by our district, so I could put in an additional $4,050 if I wish that would not be used for medical and would build towards savings.
With excellent fund choices, low fees, and the greatest pre-tax savings, I might consider using the HSA before a Traditional IRA or 403(b)/401(k) (after receiving any match that the district offers). There is no income limit to using an HSA, and the money is taxed exactly the same. The disadvantage of using the HSA as a retirement account that you eat off of is you can't access the money for non-medical purposes until age 65. This forces the investor to wait 5.5 years longer than the IRA or 403(b)/401(k) person, thereby letting the account grow even LARGER before making withdrawals. Let's consider this example:
Say you had $300,000 by age 59 1/2 (the minimum age to begin IRA and 403(b)/401(k) withdrawals). If this money is in an IRA, 403(b) or 401(k), you could begin withdrawals. At a 4% withdrawal rate, you would take out $12,000 per year. If it was in an HSA, to avoid tax penalties, you must wait until age 65 to withdraw your money. During that time, the $300,000 continues to compound for 5.5 more years. At a 7% compounding rate, the account will now be over $435,000 and your 4% withdrawal is $17,400 per year. By forcing yourself to wait 5 years, you end up with $135,000 more in retirement and you saved more in taxes along the way. To have $300,000 accumulated in 25 years, you need to save $3,800 per year into the HSA above what you use for your deductible. Since I can put an additional $4,050 in my HSA above my deductible, this is doable for me. The HSA also has no Required Minimum Distributions like a Trad. IRA, so you can control how much you take out each year after age 65.
Taxable Accounts
If you have 5 years or longer to save for a major purchase or need additional room for retirement savings, you can use a taxable investment account. This can be done through any discount brokerage firm online. Do not invest for less than 5 years because the stock market swings are too violent year to year.... you need a longer time window to ensure growth. 95% of the rolling 5-year periods and 99% of the rolling 10-year periods have made money in the history of the stock market. If you remember 1929, 1987 or 2008, the market dropped by over 50%... you don't want to take that chance - make sure you can invest for more than 5 years.
Taxable accounts also allow great flexibility; however, they are fully exposed to capital gains, dividends and interest income and are therefore taxable by law. You want to make sure to invest in funds that have the least amount of realized capital gains, have qualified dividend distributions and have little or no payable interest income. This means to purchase something like a Vanguard Total Stock Market index fund or S&P 500 index fund. These two have little stock turnover per year (they sell less than 5% of the stocks held in the fund each year to keep expenses and taxes low), and have qualified dividends (no taxes paid on dividend distributions). The only bonds I would purchase in a taxable account are tax-exempt municipal bonds or tax-exempt treasury bonds. All other bonds pay interest income that is fully taxable and also will encounter capital gains when the bond reaches maturity.
If you wish to invest for a purchase for 5 years or longer outside of retirement savings, the "safest" and greatest tax savings is an S&P 500 index fund. These stocks have lower volatility, low turn-over, and have qualified dividends paid out (be sure dividends are automatically reinvested). Remember - any time you sell at a profit creates a taxable gain (and anytime you sell at a loss creates an opportunity to do what is called "tax loss harvesting"). Also, if you hold shares for longer than 1 year, you will pay the Long-Term Capital Gains rates which is much lower than Short-Term Capital Gains.
If you do not qualify for an IRA due to a large income or wish to invest beyond the 403(b) or 401(k) contribution limits, a taxable account is your only option. In this case, purchase BOND FUNDS, REITs and INTERNATIONAL STOCK FUNDS in your 403(b)/401(k) and purchase US TOTAL STOCK or S&P 500 FUNDS and TAX-EXEMPT BONDS in your taxable account. Never buy balanced funds or Target Retirement/LifeStrategy funds in a taxable account since these hold international and bond funds. This will save you the most in taxes. Reversing this would create anywhere from a 25% to a 50% reduction in your nest egg. Remember, taxes are the single greatest cost to an investor, so be wise with whatever you choose to put in a taxable account.