Building Blocks

Preferred Tax Treatment



Tax Preferred Accounts

     The Federal government has established several types of tax-advantaged accounts to encourage retirement savings.  These accounts have become especially important with the questionable viability of Social Security to fund retirement.  When these accounts are used in conjunction with long-term investment plans, wealth accumulation gains additional advantage, often providing a multiple of the value provided in a standard account.

     While these accounts provide great value when applied correctly, there are a few trade-offs.  These include penalties for early withdrawal, mandatory withdrawals, and spending rules.

     Each account type has specific regulations regarding investment.  Capacity to utilize each account is often dependent upon income level.  Contribution rules and limits, administration, and investment choices may all have specific requirements that must be followed.

     Rather than detail each specific account type, this section will provide an overview to various accounts.  Investors should research applicable accounts in more detail and consult with a tax professional prior to investment funding.

Types of Preference

     There are three types of preferential treatment, with specific accounts that take advantage of one to three of these preferences.

   1.  Tax-Deductible:  Contribute before-tax dollars

   2.  Tax-Deferred:  Tax-free growth

   3.  Tax-Free:  No tax on distributions

Tax Deductible

     Tax deductible retirement accounts are often labeled as “traditional” retirement accounts.  These accounts allow contributions on a pre-tax basis, and they also grow tax free, thus capturing two of the three possible preferential tax treatments.  Each type of account has regulations defining the extent of tax preference, contribution limits, distribution requirements, any required fund use, and penalties for non-compliance.  Included in this category are traditional IRAs, traditional, Solo, and Simple 401(k)s, SEP and Simple IRAs, 403(b) and 457(b) accounts.

     Health Savings Accounts (HSAs) have all three tax preference attributes.  For those with an ability to utilize an HSA, the account offers great potential.  To take advantage of an HSA, account funds must be used for medical expenses.  Further, the account owner must have a High-Deductible Health Plan (HDHP).  In the right situation, the HSA account becomes a high value supplemental retirement account.

     Often, employees have a highly advantaged account opportunity that offers “free money.”  Many employers will match employee contributions to a retirement account at some level.  Employees should attempt to maximize this matching contribution as an investing priority.

Tax Free Distribution

     Most tax-free distribution accounts are funded with after-tax dollars.  They also capture tax-free growth to capitalize on two tax preferences.   Once funded, these accounts are no longer subject to future taxation, provided the owners remain in compliance with regulations.  These regulations may include required distributions, use of funds, reporting requirements, and penalties for early withdrawals or non-compliance.

     529 plans provide a specific use example of a tax-free distribution account.  The account owner may designate anyone as the beneficiary of the 529 account.  Subject to regulatory limits, funds may be contributed to the account, where they will grow tax-free.  Provided the account remains in compliance and the funds are utilized for qualified educational expenses, withdrawals of both principal and earnings can be made tax-free as well.

     Tax-free distribution opportunities include Roth IRAs, Roth 401(k)s, reverse mortgage payments, capital gains on personal home sale up to IRS limits, and municipal bond interest payments. 

     Matched 401(k)s and Roth accounts are highly recommended investment vehicles.

High Financial Impact

     Effective use of tax preferred accounts allows account holders to realize much greater net returns on investments.  Consider the example below, comparing a taxable, tax-deductible, and tax-free distribution account starting with $1,000 and investing an additional $1,000 every year for 50 years.

  *Assumes 30% tax rate during contributions, 27% tax rate for withdrawal

  *Assumes 10% annual rate of return

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