First things first, Goldilocks is a thief – let’s just get that out of the way. But have you ever happened to notice the other, less obvious way that Goldilocks got it all wrong?
In the story, she comes across a house in the forest, knocks, and then strolls right on in and makes herself home. Apparently, she was in pretty bad shape as she is unable to resist taking advantage of the bears’ humble lifestyle.
First, she tries each of their three bowls of porridge, opting for the one that is just the right temperature – not too hot and not too cold.
After getting her fill, she begins to tire – you know how that post-meal nap time feels – and beings exploring the house to find three chairs ripe for the testing. Again, the middle option is found to be “just right!” The chair, however, disagreed and immediately broke into pieces.
Still tired, and now a bit frazzled, perhaps, she finds her way upstairs to the bedroom where three beds await. The first is too hard, and the second is too soft. Once again, finding that the middle option lulls her to sleep. Can we just take a moment to point out that no accomplished burglar would do such a thing!
I’m sure you know how the story goes, so I’ll spare you the rest, but suffice it to say the bears come home and there is a lot of complaining before Goldilocks makes her escape.
So, what’s the lesson?
Don’t go breaking into houses owned by bears? No – she clearly gets what she wants and gets away.
Always pick the middle option first? Yes, that seems to be the message the 19th-century author tries to send – but is it a good one?
Together we will explore that answer as it relates to your – you guessed it! – finances, but more specifically, we will look at how it refers to the type of accounts you can use to store and grow your wealth.
How to Think About Your Accounts
There are two groups of accounts to consider when thinking about where to store and grow your wealth. The first revolves around liquidity and the other tax status.
- Liquidity is the ten-dollar term that refers to whether you can actually get your wealth out and what might stand in the way. Think of a checking account vs. a Certificate of Deposit (CD).
You can access your money in a checking account at any time, right? You just write a check, and money will move from your account to wherever you “paid to the order of.” A CD, on the other hand, has a specific maturity date, and you cannot access the money until that date comes, which could be anywhere between a week and three years.
Another non-liquid place to store and grow your wealth is in real estate. While this is not precisely an “account,” it effectively does the same thing.
- Tax status speaks to whether and how the funds in the account will be taxed. Is the income taxed as it comes in, or is it taxed when you actually withdraw the funds? Can you grow balances without paying tax at all, even when you retire and use the funds? And so on.
Both of these are important, and we may attack the liquidity question in another post, but today, we are going to focus on tax status. You may be thinking, “Yes, Let’s talk about reducing or eliminating taxes.” Still, I want you to remember this, taxes are an important part of the picture, but are never the whole picture when making your financial decisions.
What Types of Accounts Are There?
When it comes to the taxability of accounts, there are three basic types. They are all taxed in different ways, and the tax rules that apply can get reasonably complex, depending on your situation. For this reason, please consider this as a starter’s guide, and if you have a specific question, feel free to reach out to me directly at firstname.lastname@example.org. Now, back to our account discussion.
1. Taxable Accounts – These accounts are most common, and you will recognize them as your checking, savings, and any brokerage accounts that you hold in title of yourself or your revocable trust.
The money you put into these has likely already been taxed. For example, when you get paid at work, you pay a tax on that money, and whatever remains goes into your checking or savings account. Therefore, the funds in those accounts have already been taxed.
But, what about the earnings in those accounts? Checking accounts don’t pay any interest, but savings accounts do, and brokerage accounts can be fully invested in the markets, which can create tremendous growth over time. The income these accounts generate is taxed when it is received. So, when the bank pays you interest or a mutual fund pays a dividend, you will owe tax on those earnings in the year it is paid.
If the value of what you own in a taxable account – say, a mutual fund – goes up, that is called a capital gain. You are not taxed on this gain until you sell the mutual fund. So, you can let profits build for years and years without paying any tax, but eventually, you will owe the IRS and the state a portion of your gains when you sell.
The Gains earned in funds that have not yet been sold are called “unrealized gains” and gains that you get after you sell a fund are called “realized gains.”
If you think about the three types of money in these accounts – the money you put in, the money you got in earnings, and the money you got in capital gains – you can see that all of it is taxed at some point.
The money you put in was taxed when you earned it originally. The interest and dividends are taxed when received. And, the capital gains are taxed when they are realized.
Yikes, there’s no escape! In fact, there are very few ways to avoid paying tax entirely, but we will discuss one way in a moment, so stay tuned.
2. Tax-Deferred Accounts – These accounts typically have money that has never been taxed before but will be taxed in the future.
These are your retirement accounts like 401ks and IRAs, and typically, when you contribute, you get a tax deduction for the amount you put in. This is the same as not taxing these earnings. And, when your employer matches your contribution, they also get a tax deduction. So, the IRS has not received any taxes on the funds contributed.
Wow! No taxes to the IRS?! Not so fast. When you take money out, that’s where they get you. They will tax the money you withdraw as earnings in the year you receive it.
Again, there is no escape! You get a tax deduction when you put money in, but you pay taxes on the entire balance when you take it out.
3. The “No Longer Taxed” Accounts – Okay, that’s not an industry term. The industry term is Roth, and this can either be an IRA or, less often, a 401k.
In these accounts, you do not get a tax deduction when you put money in, so that’s money that you’ve already paid tax on. However, you must follow the rules for these accounts, so you don’t pay any tax on the earnings.
The bottom line, the only money in a Roth account that you paid taxes on was the original contribution. The earnings don’t cost a thing! This is one of the rare “free lunches” offered by the IRS. Free, that is if you follow the rules which broadly line up other retirement accounts – no withdrawals until retirement except under particular circumstances.
Each of these account types has its pluses and minuses, but it’s clear that the Roth account offers a pretty big plus in the form of income that is never taxed.
Which Is Best?
Like everything else, it depends on many factors. Here are three of the most significant:
- First, we need to consider when we will need the money. Both Tax-Deferred and Roth accounts require you to hold your funds in the account until a certain age or for a certain period of time. We don’t want to put money into these accounts that we think we may need before then.
- Second, it is always better to pay tax at lower rates, of course. So, if you expect a lower rate in retirement, tax-deferred accounts may be much better for you than taxable accounts. By paying tax later, in retirement when, you have a lower tax rate, you will get to keep more of your money than if you paid tax today.
- Finally, all of the laws that govern how these accounts work can change and probably will. Retirement accounts have been on the table for closing the federal deficit since any such discussion began. There is simply too much money there for Congress to ignore. So, even with a full understanding of the laws and a completely optimized strategy, it’s likely that by the time you need to withdraw your funds, the laws will have changed, leaving you unoptimized.
What Gets in the Way?
As far as accounts go and the types of complexity they bring, we have just brushed the surface. Everyone needs their own specific strategy for funding and growing their investments. There are simply too many things to consider fitting into a single post, but here are some of the major items that get in the way:
- We have a strong tendency to avoid taxes. Not only that, but many tax professionals pride themselves on “saving you tax dollars today,” and may not be considering the taxes they are creating for you tomorrow. Further, the tradeoff for avoiding taxes today in a Tax Deferred account is that you can no longer access those funds, without great cost, before retirement. Make sure you have enough funds for emergencies and for any known upcoming expenses available in your Taxable accounts.
- Large Taxable account balances can lead us to overspend. For some reason, money in our retirement accounts doesn’t feel as real as money in our savings or brokerage accounts. Be aware and in control of your spending at all times – it is one of the most important factors in your long-term financial success. And don’t let large balances in your Taxable accounts fool you into thinking you have “extra” money!
- Alternatively, balances in your Tax Deferred accounts are much smaller than they appear. This is because you have not yet paid any tax on them and every dollar you take out will be considered taxable income in the year you take it out. It’s a very good thing we don’t pay much attention to these accounts for this reason.
Here’s the Good News
Strive for balances in each of these account types.
As mentioned above, the laws around how these accounts work are in flux and likely to be that way through your retirement. For this reason, we cannot fully optimize this problem – we just don’t know what the rules of the game will be.
That said, as we get closer to retirement, we can feel more confident that rule changes will come late enough not to affect us as much. So, we should adjust our contributions as we get close to retirement to maximize both the liquidity and tax benefits that are offered. Further, while we are in retirement, we need to consider which accounts we use to fund our living expenses and in what order. These decisions should primarily be driven by the tax question but may also be affected by maximizing the inheritance we want to leave our children – which adds even more complexity.
Goldilocks chose the middle option consistently and had it all wrong. Instead, it can be much better to select all three options when they are available.
And I’ve always wondered if she was that desperate, why was she so picky?