Retirement 101: Know Your Investment Plan Options

APRIL 04, 2017
Future Proof, MD

In my daily conversations with medical colleagues, I often toss around certain terms without explaining them fully -- 401k, 403b, 457, IRA, HSA, 529, etc. The reason why these particular number-letter combinations come up so often is because tax-advantaged investment plans are by definition better than regular taxed investment plans -- unless you really like paying taxes. But even tax advantaged investment plans are not all created equal. Let's hit the basics and discuss the different types of investment plans.

WHY GIVE US A TAX BREAK?

The reason tax-advantaged investment plans exist is because the U.S. government has deemed certain financial activities to be more beneficial to society. For example, getting married, having kids, saving for retirement, health care, and education, just to name a few. Whether that's fair is up for debate, but for now, the powers that be have chosen to reward you handsomely (in the form of tax-savings) depending on what you put your money in.  Let's review them all ...

TAX-DEFERRED INVESTMENTS

Scenario: A patient comes into the ER in the middle of the night with right upper quadrant abdominal pain and was found to have acute cholecystitis on ultrasound. As the on-call surgeon, you get a call at home from the radiologist. You know you have to take the gallbladder out but you really don't want to come in until the morning. So you ask for a HIDA scan to confirm, hoping by the time that is done, it'll be time for morning rounds. You have postponed the cholecystectomy.

Similarly, you can think of tax-deferred investments as tax-postponed investments. For instance, when you contribute part of your income to your company-sponsored 401k, you avoid paying income taxes on that money this year.  But when you retire and start taking distributions from that 401k, Uncle Sam will come knocking. Here are some common tax-deferred investment plans:

  • 401k/403b/457s
  • Individual retirement accounts (IRAs)
  • Thrift Savings Plan (TSP) -- for federal employees.

TAX-EXEMPT INVESTMENTS

Scenario: Say the same patient who complains of right upper quadrant abdominal pain shows up. But this time, you decide to call in the whole team and take the gallbladder out. Sure it was a pain at 2 a.m. and everyone was grumpy. But the great thing is you only had to do it once. Once the gallbladder is out, you won't ever get called in the middle of the night for this patient's gallbladder again.

Tax-exempt investments are similar to that midnight cholecystectomy. For example, when you contribute money to a Roth IRA, you don't get to take a tax deduction on that contribution. Rather you pay ordinary income taxes on that money as you would your regular income. The tradeoff is that once that money is in the Roth IRA, it will never be taxed again, no matter how big that account gets. Here are some common tax exempt investment plans:

  • Roth 401k/403b/457s
  • Roth IRAs
  • Roth TSP
  • 529 plans for college savings

TAX-INVISIBLE INVESTMENTS

Scenario: The same patient shows up with abdominal pain. But instead of calling the surgeon, the ER team called interventional radiology to place a cholecystostomy tube. You never hear about the patient and sleep through the night in comfort.

OK, I made this one up, but the Health Savings Account (HSA) deserves its own category. The reason is this: You don't pay income tax on the money you contribute to an HSA plan. And as long as you use the money for healthcare expenses, you don't pay taxes when you withdraw either! While the government knows you received this income, it's choosing to treat it as if you never did -- hence "invisible." So far, the only tax-invisible account I'm aware of is the HSA, which I've discussed in detail previously HERE and HERE.

SUMMARY

There you go, a brief review of the different types of investment accounts. Keep in mind, these are designed with specific purposes in mind -- retirement, education, healthcare, etc. Choosing one or another may get complicated depending on your personal situation. But generally speaking, I lean toward tax-exempt and tax-invisible investments for my own investments. Another distinction worth noting is that these tax-advantaged investment plans are different from tax-advantaged investments, such as municipal bonds and annuities. But that's a whole different can of worms we can address at a later time.  

Thoughts and comments? Reach out to me at http://futureproofmd.com



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