Investment Accounts

The type of account you invest your money in has important tax implications. Retirement accounts give you tax advantages but you get penalized for accessing funds before retirement age. A taxable account allows you access to the funds at any time, but you have to pay taxes yearly on dividends, interest and capital gains.

---

1. Retirement Accounts

Retirement accounts provide two main advantages:

1. Reduction in tax income (except for Roth IRA, and
2. Tax-deferred growth.

(a) 401K, 403B

These are employer-sponsored accounts. These accounts have 2 added advantages over IRAs. First, they typically offer matching contributions by the employer. This is essentially added income. Second, the maximum contribution is higher than for IRAs. The maximum contribution 2011 is $16,500. However, your investment options will be limited by the employer’s choices. Most 401K and 403B plans offer mutual fund options. If your employer offers a 401K plan, then you should take full advantage of it. Try contributing at least enough to get the maximum employer matching contribution.

If you leave your employer, you can convert your 401K into a Traditional IRA at no cost and with no tax changes. You may choose to do this if you are not satisfied with your 401K’s investment choices.

(b) Traditional IRA

IRA stands for "Individual Retirement Account." To open an IRA, you need to have “taxable compensation” which is the IRS’s way of saying income earned from work such as wages, salaries, or commissions. Income from property such as rent or from pension or annuity is not considered “compensation.” For more on this see IRS publication 590.

The maximum contribution for those under 50 is $5,000 for 2011. Those over 50 can contribute $6,000. Here is more on contribution limits.

(c) Roth IRA

A Roth IRA is different from a traditional IRA in the following ways:

•  You cannot deduct contributions to a Roth IRA.
• Qualified distributions are tax-free.
• You can make contributions to your Roth IRA after you reach age 70 ½.
• You can leave amounts in your Roth IRA as long as you live.
• The account or annuity must be designated as a Roth IRA when it is set up.

For more on the Roth IRA: http://www.rothira.com/learn/rules.php

Converting from a traditional IRA or 401k to a ROTH IRA

If you choose to convert your traditional IRA to a ROTH IRA you will have to sell out of the securities you own in the traditional IRA and pay taxes on the amount you convert. For example, if you convert $50,000 to a ROTH and your tax rate is 25% you will have to pay $12,500 on that amount all at once.

(d) 529 Plan

A 529 plan is a tax-advantaged investment vehicle designed to encourage saving for future higher education expenses. It is operated by a state or educational institution. Contributions to a 529 are not tax-deductable but the investment grows tax-deferred for federal taxes. Many states offer tax benefits as well. You can put as much as $300,000 per beneficiary in some states. For information about your state’s 529 advantages go to 529 Plan Detail by State.

The best website on saving for higher education is: http://www.savingforcollege.com/

---

2. Taxable Account

A taxable brokerage account allows you access to your invested funds at any time without a penalty. But, you must pay yearly tax on dividends, interest, and capital gains. You are allowed to deduct losses up to a yearly maximum of $3,000 if you are married filing jointly or $1,500 if you are married and file separately. If you have a capital loss that is more than the yearly limit on capital loss tax deductions, you can carry over the unused part of the tax-deductible capital loss to later tax years until it is completely used up.

Interest, ordinary dividends and short-term capital gains are taxed at the ordinary income tax rate (10% to 35%).

Long-term capital gains are gains on assets held longer than 1 year. The tax on those is zero if your income (including capital gains income) is in the 10 to 15% brackets. For higher brackets it is 15%.