How do 401(k)s, IRAs, and HSA Savings Accounts Work? – Ecologic America

How do 401(k)s, IRAs, and HSA Savings Accounts Work?

A 2017 study found that the average tax burden for US wage earners is nearly 32% of pretax earnings.[1] Let’s call it a third. While many might argue that taxes are necessary, taxes can also destroy your momentum when you’re building toward a secure future. Fortunately, there are a few tax-advantaged ways to save build wealth or to save for future medical expenses.

The difference between tax-free and tax-deferred

When discussing tax-advantaged savings programs, it’s important to note the difference between tax-free and tax-deferred programs.

Tax-free does what it says on the tin. You don’t pay taxes on money you contribute to tax-free savings. However, there are some rules that need to be followed, including maximum contributions you can make or how the money can be used.

A tax-deferred savings plan is an account that allows contributions without a tax burden but which is taxed when you withdraw the funds. Often, withdrawals from tax-deferred accounts are taxed at a lower tax rate because your income may be lower later in life, placing you in a lower tax bracket.

Maximum allocation for tax-sheltered retirement plans

In the following sections, we’ll detail the most commonly used tax-advantaged savings plans but it’s important to understand that each plan is subject to contribution limits. Additionally, the IRS defines a maximum allocation amount for all tax-sheltered plans in a given year. Contributions above the limits of each plan or that exceed the combined maximum allocation can be subject to a tax penalty.

Currently, the annual maximum allocation for all tax-sheltered retirement plans is $56,000, but this number has been increasing periodically over recent years. Because each type of account has contribution limits, many people saving for retirement use several types of tax-sheltered retirement plans to help them reach their goals.

401(k), 403(b), and solo 401(k) retirement accounts

Most people are familiar with a 401(k) retirement account. Many employers offer 401(k) accounts as a benefit along with health insurance, group life insurance, or other types of benefits. In most industries where employers offered pensions in the past, the 401(k) has become the replacement, providing a way for employees to plan for their own future. For non-profits that choose to offer the benefit, an equivalent program is available for employees, called a 403(b). Government workers may have similar options, including 403(b)s, 457 plans, or Thrift Savings Plans.

All of these plans work in a similar fashion to the more common 401(k), which is where we’ll focus.

401(k) tax-deferred contributions

One of two main benefits to 401(k)s is the ability to make tax-deferred contributions. The money you put toward your 401(k) is contributed from pre-tax earnings. A dollar you contribute now is a dollar, not the sixty-seven cents you might have left if you had to pay taxes on that dollar before you invested. You’ll pay taxes on your investment later, but not until you withdraw from your account. In the interim, every dollar you invest is a full dollar which can supercharge your investment growth over time when compared to an investment made with after-tax earnings.

If this seems too good to be true, don’t worry about the government not getting their fair share. Because your 401(k) account can grow more rapidly with tax-deferred contributions, it’s likely that the government will get more money by taxing you later than if they taxed you now. A dollar you earn at age 30 is only $1.00 that’s subject to tax. If you invest that $1.00 in a 401(k) at an average annual return of 10% per year, that dollar becomes $28.10 by the time you’re 65. The $28.10 is subject to tax when withdrawn from your 401(k) account. If your 401(k) performance mirrors the broad market, your 401(k) benefits both you and the government; both will have more money – but in the future.

401(k) contribution limits

The IRS limits how much you can contribute to your 401(k) in a given year and these limits may be adjusted annually. For example, the maximum contribution amount for 2019 increased by $500 over 2018 and is now up to $19,000.

If you are age 50 or older, you have the option to contribute up to an additional $6,000 per year, which is called a catch-up limit.

401(k) employer match

As a way to attract and retain employees, many companies offer an employer match for your 401(k) contributions; your employer puts money into your account as well. An employer match for a 401(k) can work in several ways.

Here are some examples of how an employer match might be structured:

  • An employer might match a percentage up to a limit.

Example 1: Employer matches 50% but only up to 3% of salary.

In this case, the employer is putting in $0.50 for every $1.00 you contribute, but with a cap of 3% of your salary. If you earn $40,000 per year, the most the employer will contribute is $1,200 – but it’s $1,200 in free money that can grow significantly over time.

  • An employer might match directly up to a limit.

Example 2: Employer matches 100% but only up to 7% of salary.

Here the employer is contributing $1.00 for every dollar you contribute but capping the matched contribution at 7% of your earnings. If you earn $40,000 per year, the maximum the employer will contribute is $2,800.

In both cases, if you contribute a small amount you could be leaving money on the table. Using the first example, if you only contribute $1,000, your employer will only contribute $500. You lost $700 as well as the future earnings of that $700 by making a smaller contribution yourself. The same concept applies to the second example, in which you would lose $1,800 by only making a $1,000 contribution. You’ll also lose the future gains on the $1,800.

Company match formulas can vary, so check the details with your plan administrator and try to structure your contributions in a way that qualifies for the maximum matching dollar amount available from your employer. It’s free money.

401(k) automatic payroll deductions

Another attractive feature of a 401(k) is that you can set up automatic payroll deductions. Using automatic deductions allows you to fund your account in a way in which you probably won’t miss the money. You can’t miss what you’ve never had and by making automatic contributions you keep the amount you contribute out of harm’s way. The IRS won’t tax it (yet) and you won’t spend it.

When using automatic payroll deductions, you also benefit from dollar-cost averaging, which means you invest at regular intervals over time without regard to short-term market movements. Ups and downs in price smooth out over time becoming average buying prices. For most investors, this is considered the safest way to invest because it eliminates costly guesses on when to buy or sell.

401(k) investment choices

Most 401(k)s offer mutual funds that are sorted by risk and anticipated return. The advantage of using mutual funds is that your investment is automatically diversified amongst many companies and perhaps many industries. Because you can’t purchase individual stocks within the plan, the risk of your investment going to zero is close to zero itself.

401(k) age restrictions and penalties

Your 401(k) comes with some rules. As an account intended for retirement, you can’t withdraw before age 59 ½ without a penalty. Withdrawing prior to that age results in a 10% tax penalty in addition creating a taxable event. You’ll have to pay income tax on the money you withdraw. There ways to borrow against your 401(k) but this practice defeats the purpose of having a 401(k). Very few situations warrant borrowing against your 401(k).

401(k) vesting schedule

Your employer may use a vesting schedule that applies to the employer match portion of your 401k. A vesting schedule means that only a certain percentage of the money is yours until you’re fully vested.

For example, if your employer uses a 5-year vesting schedule with 20% vesting increments each year, your vesting might look like this:

Year 1: 20% vested

Year 2: 40% vested

Year 3: 60% vested

Year 4 80% vested

Year 5 100% vested

If you leave the company before you are fully vested, part of the employer match is forfeited. Fortunately, not all employers use a vesting schedule, opting instead to use immediate vesting.

Traditional IRAs and Roth IRAs

An IRA is an Individual Retirement Account. Unlike a 401(k), your employer has no involvement. You open the account directly with a broker, investment firm, or mutual fund provider. An IRA can be used to rollover a 401(k) if you leave an employer and your new employer doesn’t have a 401(k) or you might choose to open an IRA in addition to a 401(k).

Because you are choosing the IRA, you can choose which types of investments or funds you’ll have in your IRA. You’re not limited by choice in the same way you are with a 401(k). However, you may be limited by the options available through the broker or mutual fund provider you choose. You’ll also be limited by the amount you can contribute. The 2019 limit for all IRA contributions is $6,000 for the year. 401(k) rollovers don’t count toward this limit and there’s an exception for people over 50, who can contribute $7,000 as opposed to $6,000.

IRAs come in two main types, each with its advantages:

  • Traditional IRA – A traditional IRA has similar tax advantages to a 401(k). The money you contribute to your IRA can be deducted from your earnings, subject to maximum limits and depending on your income. This makes your contribution tax-free, at least at the time you contribute. Like a 401(k), a traditional IRA is taxed when you withdraw from the account. The same penalties and age restrictions apply as with a 401(k); You’ll pay a 10% penalty for withdrawing before age 59 ½ in addition to paying income taxes on the withdrawal.
  • Roth IRA – A Roth IRA works differently. Your contributions to a Roth IRA aren’t tax deductible. However, when you withdraw from a Roth IRA, your withdrawals are tax free (including your gains). This is powerful stuff – but your allowable contributions for all IRAs are capped at $6,000 per year. A Roth IRA doesn’t have an early-withdrawal penalty for your contributions, unlike a traditional IRA or a 401(k). However, you’ll have to wait until age 59 ½ to take your earnings without a penalty. Also, If you have a six-figure income, you may not qualify to contribute to a Roth IRA.

Since a traditional IRA works similarly to a 401(k) in many ways, we’ll explore some possibilities with a Roth IRA.

Let’s assume you chose to funnel all your IRA contributions to your Roth IRA and max out the contribution limit at $6,000 per year. You’ve already paid taxes on this money. When you withdraw, you won’t pay any taxes or penalties.

$6,000 per year is $500 per month.

If you contributed $500 per month beginning at age 30 with a 10% average return, you’d have $1,626,000 by the time you’re 65. Your contributions were $210,000, on which you paid taxes. The remaining $1.4 million is yours tax-free. Your $210,000 is yours as well; you already paid taxes on it over the course of 30 years.

If you ever consider opening an individual investment account, take a close look at a Roth IRA. A traditional brokerage account will create taxable events every time you earn a dividend or sell a stock, fund, or ETF. A Roth IRA makes your earnings tax-free.

Health Savings Accounts

A Health Savings Account (HSA) is another powerful tool with tax benefits. Recent changes aimed at making health insurance more affordable have done the opposite for many households. An HSA can be an effective way to get healthcare costs back under control. HSAs are built to work in conjunction with a High Deductible Health Plan (HDHP). In the insurance world, a deductible is the part of a claim that you pay. Choosing a higher deductible means you are assuming more financial risk. Because the insurer doesn’t have to pay out for many small claims or until you reach your deductible limit, premiums are usually lower with an HDHP.

An HSA is a way to save money to meet your deductible or any other qualified expense, including expenses that may not be covered by your health insurance at all, like dental care or vision care. Contributions to your HSA are considered pre-tax contributions and aren’t subject to federal income taxes. In most states, HSA contributions are also tax-free. Alternatively, if your HSA isn’t offered through your employer or if you make extra contributions, your HSA contributions can be deducted from your taxable income. Interest or earnings on your HSA are also tax-free.

In 2019, you can contribute up to $3,500 to your HSA as an individual or up to $7,000 for a family. If you don’t use the balance, the remainder rolls over to the next year, creating a larger balance as you continue contributions. Healthcare costs can be difficult to predict, so contributing steadily puts you in a better position if or when you have large medical expenses.

Without an HSA, medical expenses not covered by insurance would have to be paid out of pocket with after-tax money. The IRS allows you to deduct some medical expenses, but not all, and limitations in IRS rules put most of the burden back on the taxpayer. If you are in good health and don’t expect large medical bills, an HSA combined with a High Deductible Health Plan deserves a closer look because your savings for an extensive list of medical expenses are tax-free.