• Test-Driving Investment Vehicles – Non-Qualified Accounts, Traditional IRAs, Roth IRAs, and Employer Sponsored 401(k) Plans

    by Jennifer Scheck Associate Financial Planner | July 16, 2023

    My oldest son graduated from college this spring and began his career at his first full-time job in early July. We have been having fun, fruitful discussions about investments, spending plans and goals as he begins this next stage of life and considers housing options, purchasing his first car and funding investments. 

    One topic he wanted to discuss was investment options, including contributing to a Roth IRA, traditional IRA, employer sponsored 401(k) plan and a non-qualified account. We kicked those tires and took a test drive of these investment vehicles so he could make empowered and informed decisions as he faces these very important initial life choices.

    Which investment vehicle is right for you? It depends. Several variables will guide your route to determine which accounts are appropriate for your circumstances, including your Modified Adjusted Gross Income (MAGI) as a single or joint filer, whether your employer offers an employer-sponsored plan such as a 401(k), maximum contribution limits and the tax implications or benefits of different accounts. Here’s a map. Take the keys and see how these basic accounts can drive your investments!

    Non-Qualified Account 

    Non-qualified accounts include checking and savings accounts, and investment accounts. A non-qualified investment account is funded with after-tax contributions and has neither an annual contribution maximum nor MAGI restriction. You can invest as little or as much as you prefer and withdraw at any time. The funds are typically invested in stocks, bonds and mutual funds.

    Distributions from these accounts are not taxed, however, these accounts are taxed annually on capital gains on the growth of the contributions, as well as dividends and interest. These taxable amounts will be provided to you annually on a composite 1099-DIV tax form. In years where markets are down, a capital loss could be realized during a tax year on these investments and will also appear on your 1099 form. This will be documented on your tax return as capital loss. If losses exceed gain in a tax year, current laws allow a maximum deduction of $3,000 of net capital loss. Any loss exceeding $3,000 can be carried over to subsequent tax years to offset gains in future years. The is referred to as Capital Loss Carryforward.

    PROS: No contribution limit; No income restriction; No penalties for withdrawals

    CONS: Taxed annually

    Traditional IRA

    A Traditional IRA is an Individual Retirement Account and is a tax-sheltered investment vehicle. The tax benefit of these accounts is that the investment grows tax deferred. Any capital gains, dividends or interest incurred are nottaxed annually. Taxes are postponed, or deferred, until you take a distribution at retirement after age 59½ which is then taxed as ordinary income. This income will be reported to you on tax form 1099-R. You are to take distributions after age 59½ without penalty, and you are to take distributions beginning between ages 73 and 75 depending on your date of birth and current tax laws. The latter are called Required Minimum Distributions or RMDs.

    Unlike non-qualified accounts, contributions to a traditional IRA are made with pre-tax dollars which can reduce your taxable income as an above-the-line deduction in the year the contribution is made. However, if you are enrolled in an employer-sponsored retirement plan such as a 401(k), the deductibility of these contributions may be reduced or excluded completely. In 2023, the deductibility is reduced for single filers beginning with MAGI of $73,000 and eliminated once income reaches $83,000. For joint filers, the phase out range is $116,000 to $136,000. Your Modified Adjusted Gross Income (MAGI) does not limit your eligibility to contribute to an IRA; Your MAGI only impacts the of the contribution.

    An important restriction is that an individual must earn income to contribute to either a traditional IRA or Roth IRA, and your contribution cannot exceed your earned income. Additionally, the maximum amount you can contribute to your traditional AND Roth IRA accounts combined is capped annually. In 2023, the maximum amount you can contribute is $6,500. Beginning at age 50 there is a catch-up provision which enables an increase in the maximum annual contribution for those who are closer to retirement age. In 2023, the additional catch-up contribution is $1,000, so a total of $7,500 can be contributed for those ages 50 and older who are receiving earned income.

    PROS: Funded with pre-tax dollars with possible deductibility; no income limit; tax deferred growth

    CONS: Earned income required; maximum contribution limits; required minimum distributions; 10% penalty for withdrawing prior to age 59½

    Roth IRA

    A Roth IRA is an Individual Retirement Account that enables tax-deferred growth tax-free withdrawals at retirement after age 59½. Like traditional IRAs, capital gains, dividends and interest incurred are deferred and not taxed annually. Unlike traditional IRAs, an attractive feature of the Roth IRA is that distributions made in retirement after age 59½ are tax free. Moreover, you can take tax free distributions of principal, which is the amount you contributed, at any time. You can also take tax free distributions of earnings five years after the Roth IRA is opened and funded. Additionally, Required Minimum Distributions (RMDs) of Roth IRAs are not mandatory until after the death of the owner and required only of the beneficiary. This income is also tax free to the beneficiary, another attractive feature to consider for long-term estate planning.

    Like a non-qualified account, contributing to a Roth IRA is made with income that has already been taxed. This is net income and often referred to as after-tax dollars. Therefore, contributions are not tax-deductible as an above-the-line deduction. For this reason, if you are contributing to an employer-sponsored retirement plan that has made your traditional IRA contributions no longer deductible, contributing to a Roth IRA is the preferred vehicle for additional contributions.

    Unlike traditional IRAs, Roth IRAs do have restrictions based on Modified Adjusted Gross Income (MAGI). Roth contributions are eligible only to those whose income is below a specified MAGI. In 2023, the phaseout begins at $138,000 for single filers with maximum MAGI of $153,000 ($218,000 and $228,000 respectively for joint filers). You will want to consider contributing to a Roth IRA especially in lower income earning years when eligible to take advantage of this investment vehicle.

    For some individuals, it may make sense to implement a Roth Conversion strategy, which moves funds from an IRA to a Roth IRA. This may be a taxable event for all or part of the converted dollars. You would need to consider several variables to determine if this would be beneficial for your situation. 

    PROS: Tax-deferred growth; no penalty and tax-free distributions of principal; no penalty and tax-free distributions for accounts open at least five years; tax free distributions of principal and growth after age 59½; tax-free distributions to beneficiaries; no required minimum distributions

    CONS: Earned income required; income limits; contribution limits

    Employer Sponsored 401(k) Retirement Plan

    A 401(k) account is an employer sponsored investment plan that employers may offer employees as an incentive to invest in retirement and to take advantage of pretax and after-tax contributions, as well as possible employer funding match benefits. Each 401(k) plan is unique to the employer and can offer both traditional and Roth account options. The maximum annual contribution (combined traditional and Roth) is significantly higher than what is allowed for IRA accounts. In 2023, the maximum contribution is $22,500 of your earned income. Like with IRAs, employees beginning at age 50 are eligible for a catch-up provision. In 2023 the 401(k) catch-up contribution is $7,500, for a total employee maximum contribution of $30,000 for those age 50 and older. The combined employee contribution and employer contribution cannot exceed $66,000 in 2023.

    The employer match benefit that some employers offer is a great opportunity to increase funds in your 401(k). For each dollar you contribute to your 401(k), your employer may wholly or partially match your personal employee contribution up to a certain percentage of your salary. Historically, employer contributions to a 401(k) were only allowed within the traditional pre-tax 401(k) account, however, the Secure Act 2.0 passed in late 2022 enables employer matching to be as Roth contributions if preferred. While these laws give employers the to incorporate these options into their 401(k) plan, they are not to do so. Additionally, if you choose for the employer match to be contributed to the Roth IRA, the contribution will be taxable to you in the year of the contribution.

    It is important to understand your company’s retirement plan. Your employer may have a vesting period for the company match portion of your 401(k) contributions as incentive to remain employed or may rescind the match if you end your employment. The vesting period is specific to each plan and identifies when you become the owner of those funds contributed by your employer. Should employment end, the contributions made by your employer may in part or in whole no longer be eligible to you if they were not fully vested. Your personal employee contributions and earnings are always available to you when you leave your employer, as well as any employer contributions. When considering changing jobs, you will want to consider the impact of potentially losing the company contributions that are not yet fully vested.

    The Secure Act 2.0 has impacted employer sponsored plans in other ways. Beginning in 2025 employers will require automatic enrollment and automatic escalation provisions by eligible employees with a minimum contribution percentage of 3% and an annual increase of 1%. The intent of this law is to encourage adequate retirement savings habits of employees. However, the employee can opt out at any time. Additionally, the Secure 2.0 Act also states beginning in 2024 that employers can match their employees’ student-loan payments with contributions to their retirement accounts. Be sure to stay informed of any law changes or plan modifications implemented by your employer. 

    PROS: Funded with pre-tax dollars or after-tax dollars; pre-tax contributions are fully deductible; tax deferred growth; possible employer match; higher contribution limits than traditional IRAs or Roth IRAs; no MAGI limits for traditional or Roth account contributions

    CONS: 10% penalty for withdrawals prior to age 59½ or age 55 if separated from service and the specific plan allows it; lose any unvested employer contributions at separation of service; contribution limits; not offered by all employers

    Below is a summary of these four investment vehicles and their tax implications: 

    Tax Implications
    Retirement Vehicles Contributions Growth Distribution
    Non-Qualified Account After-tax; Non-deductible Taxed annually Capital gains tax as applicable;
    Ordinary income tax on dividend and interest as applicable
    Traditional IRA Pre-tax; Fully deductible; Partially or fully deductible if participating in 401(k) plan  Tax deferred Ordinary income tax on distributions after age 59½
    Roth IRA After-tax; Non-deductible Tax deferred Tax free after age 59½; Tax free distribution of principal; Tax free distribution of earnings if account is at least 5 years old
    Qualified 401(k) Plan Depends whether it is traditional or Roth. Pre-tax or after-tax; Deductible or non-deductible Tax deferred Ordinary income tax on distributions after age 59 ½ (or as early as age 55 in some cases) for traditional 401(k) and tax free for Roth.

     

    Additionally, here is a summary of contribution limits and penalties in 2023:

    Contributions Limits & Penalties (2023)
    Retirement Vehicles Annual Maximum Contributions Withdrawal Penalty
    Non-Qualified Account Unlimited No penalties; May incur additional capital gains tax for liquidating funds
    Traditional IRA

    $6,500 

    $1,000 catch up age 50+

    10% of withdrawal if less than age 59½; Distribution taxable as ordinary income
    Roth IRA

    $6,500

    $1,000 catch up age 50+

    Ineligible if MAGI >$153K single or > $228K MFJ

    10% of withdrawal if younger than age 59½ and account is less than 5 years old;

    No penalty if account >5 years old
    Qualified 401(k) Plan $22,500
    $7,500 catch up age 50+
    10% withdrawal if less than age 59½ or age 55 if plan allows 

    Now that you are equipped with some basic information, let’s test drive some examples while referring to your map.

    Route 1: 18-year-old college student earning part-time income totaling $5,000.

    This individual could invest up to their entire earned income of $5,000 in a Roth IRA or traditional IRA. Roth IRA would be preferred since tax deductibility is irrelevant for this income amount. 

    Route 2: 20-year-old earning income totaling $40,000. The employer does not offer a 401(k) plan, or the employee is not yet eligible.

    This individual could invest up to the maximum $6,500 into a Roth IRA or Traditional IRA. They could also make contributions to non-qualified accounts.

    Route 3: 40-year-old individual with MAGI of $100,000 participating in employer-sponsored 401(k) plan.

    This individual could make a maximum personal contribution to their 401(k) plan of $22,500 and take advantage of any eligible employer match specified by their plan up to $66,000 in total. If $22,500 is contributed to the traditional 401(k), this will be an above the line deduction and reduce their taxable income. If contributed to the Roth 401(k) account, it will be taxed in the current year. In addition, they could contribute to a Roth IRA and/or Traditional IRA for a total sum of $6,500. The traditional IRA contribution would not be tax deductible at this MAGI, so a contribution to the Roth IRA would be preferred. As cash flow allows, additional excess funds could be invested in a non-qualified account which has no maximum contribution limit nor MAGI restriction.

    Route 4: 55-year-old individual with MAGI of $200,000 with employer-sponsored 401(k) plan.

    This individual could make a maximum personal contribution to their 401(k) plan of $30,000 ($22,500 plus $7,500 catch-up) and take advantage of any eligible employer match specified by their plan up to $66,000 in total. If the $30,000 is contributed to the traditional 401(k), this will be an above the line deduction and reduce their taxable income. If contributed to the Roth 401(k) account, it will be taxed in the current year. Their MAGI exceeds the Roth IRA contribution maximum, so they are not eligible for direct contributions to a Roth IRA. They are eligible to contribute to a traditional IRA however, the contribution is not tax deductible since they are participating in a 401(k) plan. As cash flow allows, additional excess funds could be invested in a non-qualified account which has no maximum contribution limit nor MAGI restriction. 

    Which investment vehicle are you driving off the lot? It depends. 

    • As a rule of thumb, you want to build an adequate cash reserve in a savings account.
    • You then want to contribute as much as possible to your collective accounts to save for retirement, targeting 15% to 20% of your gross income.
    • If you are participating in a 401(k) plan, you want to contribute at least the amount which will make you eligible for your full company match, as well as work toward contributing the maximum amount allowed annually.
    • You will also want to consider maximizing your contributions to a Roth IRA. If you anticipate your current tax bracket will increase over time, you will want to consider contributing more heavily to Roth vehicles.
    • If you are in high earning years and anticipate your tax bracket to decrease in the future, you will want to consider pre-tax, tax-deductible contributions that would decrease your taxable income.
    • If you have additional excess funds after meeting retirement and qualified account maximums and eligibility, you can always consider non-qualified investment account contributions for additional savings. 

    Just like cars, sometimes the weather dictates whether you take a Jeep or a convertible, or in the Midwest a reliable, all-wheel drive option in the snow. Each financial situation is unique with multiple variables and assumptions. Moreover, this article is not comprehensive of all investment types and options. Additionally, the map changes annually, so make sure you have the most recent values and confirm any tax law changes.

    If you would like to discuss your financial situation and the investment vehicles that may be most beneficial to you, please contact us to schedule a free, no-obligation complimentary consultation. Additionally, if you have a young adult entering this exciting stage of life, we encourage you to have them sign up for our Financial Foundations course offered annually at Syverson Strege to explore these and other important decisions. We look forward to meeting with you and empowering you with information to make financial decisions that drive toward your goals.

     


     

     

     

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