This blog is based on Cadeau’s educational series, Proven Wealth Strategies. For more information, visit cadeau.provenwealthstrategies.com.
Every financial product on the market is categorized into three types: taxable, tax-deferred, and tax-free. Too often, people believe their rate of return is the determining factor when figuring out where to put their money, but there are many other factors to consider. Let’s start by breaking down these three categories.
The first category is very common. It contains money that you will be taxed on every single year. You’ll know because you’ll receive a 1099 at the end of the year with the IRS saying that you owe taxes based on the interest that you earned. Savings accounts, CDs, mutual funds, and bonds are all taxable investments.
If you’re paying taxes, especially if you’re in the top 25% of wage earners, why would you put money into one of these accounts? It’s liquid. This means that we want at least some money in these types of accounts regardless of taxes. We don’t want a large amount of money within this type of account for tax reasons, but we want enough to maintain liquidity.
401ks, IRAs, SEPs, 457s, and 403Bs all fall into the tax-deferred category. These can also be referred to as “qualified accounts.” This is how it works: You make $100,000 of income. You then choose to defer $10,000 of that income into your 401k. This causes the amount of reportable income tax at the end of the year to decrease down to $90,000. In reality though, the taxation of that $10,000 is just postponed for an unknown time at an unknown tax rate.
Throughout history, tax rates have steadily increased. This can make tax-deferred investments a rather risky move to make since your postponed $10,000 might be subject to an exponentially higher rate. The rates associated with these accounts are subject to the government’s needs.
Hands down, the most well-known type of investment in this category is the municipal bond. But it shouldn’t be, because it really isn’t tax-free. Free from federal income tax, municipal bonds are often labelled tax-free, but they’re not necessarily free from state income tax. Additionally, the interest that you earn from a municipal bond is categorized as “provisional income,” which results in your social security becoming taxable. When you retire then, that interest that you earned will cause you to pay more in taxes.
The only true tax-free account is a ROTH-IRA. However, there are two limits that keep you from putting unlimited amount of money into this type of account. The first of which limits the amount of money you can put into the account each year. Often, this amount depends on your age. According to the 2019 ROTH-IRA contribution limits, you will only be able to put $6,000 to $7,000 towards an account per year. The second limit? If you make over a certain amount of money, you cannot put money into a ROTH-IRA. If you’re filing single, the full contribution maxes out at $120K. If you’re married, the limit rests at round $189K. If you make anything over that amount, you are not eligible for a ROTH-IRA.
Regardless of which investment you go with, it will be within one of those three categories. Generally, to accumulate wealth and practice good finances, you should have money in all three accounts, rather than your sum total in one. If you put all of your money into a single type of account, you’ll experience too much risk. The goal should be to get as much money as possible into a tax-free account.
Chris Jacob is a Registered Representative with Saxony Securities, Inc.. Securities offered through Saxony Securities Inc. (SSI). Member FINRA, SIPC. Non-security products and services or tax services are not offered through SSI. Cadeau is not affiliated with SSI.