How to navigate the alphabet soup of account types
IRA, 401(k), 529, HSA, 403(b), TSP, 457 – it’s almost like the finance industry is trying to confuse you with so many different account types. Let’s clear up some of the confusion by breaking down what each type of account is for, and whether you should think about using it.
Each of the accounts below is tax-advantaged in the sense that you won’t pay taxes on capital gains, dividends, or interest income from your investment earnings. They each have plusses and minuses, but all can fit into your overall investment strategy.
IRA – Individual Retirement Accounts – IRAs are usually your first choice account for retirement saving. They allow you to save up to a maximum amount each year for your retirement nest egg, and invest that money into most types of investments. Depending on the type of IRA you invest in, you’ll either pay taxes before you contribute (Roth) or when you withdraw (Traditional). There are limits that prevent you from saving into Roth accounts above a certain income level, and a 10% penalty applies if you withdraw before you’re 59.5 years old.
401(k) – Employer sponsored retirement account – If you have an employer that matches your contributions, this is your first choice for retirement savings; if not, it’s still a great way to save. 401(k)s are like the big brother to IRAs. Everything above about IRAs applies to 401(k)s except that the contribution limit is higher, there are no income limits to either Traditional or Roth contributions, and employers can make contributions to the account as well.
403(b) – Employer sponsored retirement account for schools, non-profits, and churches – Almost identical to 401(k)s except they are reserved for certain types of non-profit organizations and they have different rules around who can participate in the plan and when.
TSP – Employer sponsored retirement account for government agencies – The Thrift Savings Plan is also almost identical to the 401(k) except that it is reserved for US civil and military service men and women.
529 – State sponsored college savings plans – State-sponsored plans that allow individuals and families to save for college in tax-advantaged accounts. Most states create a government-sponsored investing authority that pools assets and invests for those that save into the plan. Investments grow tax-free and earnings can be withdrawn tax-free if used to pay for qualified educational expenses – usually college and grad school. Some states provide an extra bonus by allowing you to deduct contributions from your income to reduce state taxes as well.
HSA – Health Savings Account – These employer-sponsored plans are used in conjunction with high-deductible health care plans. They allow you to save up to a certain amount of pre-tax money each year that will grow tax free and that can be withdrawn tax-free for qualified medical expenses. This “triple tax advantage” can be extremely power if you have one of these accounts to make use of.
457 and other salary deferral plans – Some employers offer select employees the option of deferring their current salary to be paid out later. The deferred earnings grow over a specified timeframe in a trust or on the employer’s books. When the funds are taken out, they count as current income just 401(k) or IRA withdrawals would but without any other potential tax penalty.
Hopefully that helps clear up some confusion. While there are other accounts and entire books are written on each account type discussed here, you at least have the gist of it. At Farther, our goal is to do the detailed research for you to help you optimize your savings across account types and take the most advantage of each. You can sign up here to learn more.