IRAs, 401(k)’s, Capital Gains & How to Use Them

My last post detailed how the stock market functions on a simplified function, and how diversification compensates for volatility, now we’re moving forward into the platforms that you building your portfolio upon. We now look at Roth IRAs, Traditional IRA & 401(k)’s, but we’re also going to look how taxes effect different investing methods.

Up to now, most of my writing has been on abstract simplification of investing to establish a mental framework on how investing works in theory. Now we can take that knowledge and start seeing the options that you can apply those concepts into and begin making steps forward towards prudent investing with long-term impact.

Long-Term Investing Accounts:

In order to buy a share of Common Stock, a Mutual Fund, Bond, or ETF, you need to open an investing account. The process is quite simple these days in that all you have to do is find an online brokerage company, (like E-Trade, TD Ameritrade, Capital One Investing, Robin Hood, or many others) and open an investing account just like if you were going to open a bank account. It in many ways does look and operate like any checking and savings account, but with the added dimension that you hold not only cash but liquid investments in it.

Financial term: Liquid.
Liquid just means something that can be quickly converted into cash. A share of Apple stock is considered highly liquid since you could sell off your share to a buyer in seconds and you would have cash in your account that you could then pull out. A house on the other hand is not very liquid since the process of listing your house up for sale and finding a buyer could take months before you could turn your house investment into cash.

When you open an investing account, you then connect your bank checking account to the investing account and first add cash to your investing account. Every brokerage has their own way of operating and give access to different things, but in general, once your investing account has cash, you then use the brokerage’s services to go into the open market to start investing. With the services that are out today, buying shares is relatively easy; if you already know what you want (like buying Apple stock), usually all you have to do is find a search bar and write in the Apple stock ticker symbol: AAPL. Apple’s stock page would then pop up, and depending on the brokerage’s site, you’ll be provided with many different details about Apple including many financials stats, trading trends, and most importantly, the current selling price of the stock. If you just want to buy right now, all you have to do is select “buy” and the amount of share you’d like. So if you wanted 2 shares of Apple, and the current price is at $170, then you’d pay $340 plus brokerage fees (usually a flat rate of around $7-$12 with online brokerages), that is as long as you had $340 in cash within your investing account. Once you’ve bought the share of stock, it will now sit in your investing account, which then the account will keep track of and state the current liquid value of all your investments.

Capital Gains:

Not to scare you off, but we have to talk about taxes; particularly about Capital Gains Tax.

As with most tax rules, they not only can be quite complicated, but they also there are many factors that impact people differently, and not only that but the rules change with new tax laws. Just keep that in mind that I have to oversimplify it because there isn’t a “right” answer for everyone. Even with all that, there are some principles to understand that will have a huge impact down the road.

Capital Gains is the profit you make from an investment. So if you bought a share of Apple at $100, and then later sold it for $170, you would have a capital gain of $70. This only applies when you actually sell your share of Apple. So if you look at your investing account and see the $100 share of Apple is now selling for $170, you don’t yet have capital gain, but it just shows you how much increase your investment is worth.

The opposite is also true in that if you bought a share of General Electric at $30 and you sell it at $17, you would have a capital loss of $13.

Capital Gains Tax:

Now that we understand the basic definition of Capital Gains, we have to move into taxes.

There are generally two categories of Capital Gains Tax: short-term & long-term. Short-term capital gains is any investment that you owned for less than a year before you sold it. Long-term is any investment you held for longer than a year before selling it.

This distinction is important because short-term is taxed at the same rate as ordinary income. So if you’re single, and make between $9,525 and $38,700 in taxable income (including your now Capital Gains), your short-term Capital Gains (remember, the profit value of what you sold) would be taxed at 12% just like the rest of your income is.

However, what if you had long-term Capital Gains? Well, if you were still in that 12% tax bracket listed above, and you had long-term Capital Gains, you would pay $0 on those Capital Gains!

Once you have more than $38,700 in taxable income (including Capital Gains), your Long-Term Capital Gains will have taxes on it, but at a reduced rate. With the most currently that you’d have to pay is 20% even if you’re in the 37% income bracket. If you’re just over a tax bracket (like at $38,701) you can then use your Capital Losses to offset the gains and bring your taxable income to being below $38,700 and thus having $0 in Capital Gains Tax.

This is how Warren Buffett claims he pays a lower tax rate this his own secretary, since most of his income comes from long-term Capital Gains. This is also why many executives have a lower base salary, but a rewarded with stock options since they have lower tax implications.

Capital Gains Summary:

Capital Gains is the net profit you make from selling an investment. If you’ve been holding the investment for over a year and if your taxable income is less than $38,700, you won’t pay anything in taxes on the profit you make. If you end up making a lot more money, or made a lot of profit on your investments that you can’t get under $38,700, you will get taxed at a lower rate than if it was simply income. You can also use losses to offset your income to reduce taxes.

Retirement Accounts:

Understanding how Capital Gains is incredibly useful for how investing impacts your taxable income, but one of the things we talked about is the Time Value of Money & the value compounding growth has on wealth. What do we do if we’ve been prudent in our investing for years and end up with over $1 Million in our investing account and it’s now time to start living off this wealth? Sure you could try to only pull out less than $38,700 but that is assuming that the same tax incentives are in place 30-40 years from now.

Thankfully, there are a few alternatives that are aimed to assisting you towards your long-term investing goals, each has their own unique benefit.

Individual Retirement Accounts:

With most brokerage firms, when you go to open an account, you can open the normal Individual investing account, or you can open an Individual Retirement Account (IRA). It operates the same as the normal investing account, in that you can go into the stock market to buy and sell stocks and ETFs, but the tax implications are significantly different. These IRAs and other Retirement accounts are designed in some fashion to reduce tax liability either for the present term or for the future.

There are generally two main types of IRAs: Traditional IRA & Roth IRA. A Traditional IRA allows you to reduce your taxable income today as you put aside money for tomorrow, meanwhile a Roth IRA doesn’t save you money today, but allows you to cash out in the future tax free.

Pre-Tax & Post-Tax:

Before we can talk about these different accounts and the unique value they provide, we need to make the distinction between pre-tax income and post-tax income.

When we looked at a normal investing account, you deposit funds into an account, invest your funds in different kinds of assets, then later sell them to make a profit. Once you sold your assets and had a profit, you were taxed on that profit (or maybe you had low enough income that you didn’t have to pay taxes on it). You may wonder why you weren’t taxed on the whole sale of the asset, and that is because you already paid taxes on the base investment.

If you put $100 into your investing account, and bought $100 share of Apple, then sold it at $170, you would pay Capital Gains on the $70 in the year that you sold the share of Apple. But that $100 was already taxed in the year you deposited it in your investing account, because that came from your wages, and thus you paid income tax on that $100 initially. This is what is called “post-tax” investing.

Pre & Post tax explained:

When you invest funds from what earned from work, those funds are actually worth a bit more in the government’s viewpoint and have already taken their share from it in your normal income tax. This means that if you were under $38,700 in taxable income and were paying 12% tax, your $100 investment was technically $113.65 which then the government is taking 12% of that out and leaving you with $100. This is again an example of post-tax.

Pre-tax means the opposite in that if you deposit $100 into an investing account, that $100 is reduced from your taxable income, and therefore $100 of wages you earned this year will not be taxed this year. You will have to pay taxes when you pull it out in the future though, because life just isn’t fair.

Traditional IRA:

A Traditional IRA is a pre-tax retirement account. This means it has an added benefit over a normal investing account in that what you contribute to this account is tax-deductible. This comes in handy since it provides you yet with another way to reduce this year’s tax bill not just in total value, but could move you into a whole different tax bracket if you’re on the bubble.

A reason to use a Traditional IRA over other options is particularly useful for those who currently are in a higher tax bracket and expect to be in a lower tax bracket during retirement. This is because what you are doing is deferring your tax implication to the future. If you have $100 in pre-tax dollars today that you’re planning to invest, and if you’re currently you’re in the 32% tax bracket, you’d be paying $32 in taxes on it. But if you put that $100 in a Traditional IRA, then pull it out during retirement when you’re in a 22% tax bracket, you’d be paying 10% less at $22 in taxes on that $100 (whatever you sell is taxed at the normal income rate for the whole thing, your base investment and the capital gains though). Plus it means you have more money today and you get to put off taxes for the future.

Roth IRA:

A Roth IRA is the inverse function of a Traditional IRA. It is a post-tax retirement account, which means you can’t deduct contributions into it from your taxes today. That means whatever you put into a Roth IRA is still part of your taxable income. The twist though is when you finally sell your investments in retirement, you pay $0 in both that base pay and the capital gains!

If we look at the first investing post I made on the Time Value of Money, I gave an illustration of how a 19 year old invested $2,000 per year for years and then stopped with a total investment of $16,000. When she was 65 years old, that $16,000 turned into $2,288,996. If all that was done within a Roth IRA, that means she won’t have to pay taxes when she sells off her investments and starts to live off of that in the future. She just had to pay income taxes on that first $16,000.

A Roth IRA is also beneficial for those who are in a lower tax bracket currently and expect to be in a higher tax bracket in the future; that way you pay taxes now while taxes are cheap and you get to cash out when taxes would have been high otherwise.

Limitations:

There are limitations with these retirement accounts however. First is that they are called “retirement” accounts for a reason; they are designed for you to put money aside for many years down the road to set you up when you stop receiving wages. Therefore you can’t pull money out of these accounts until you are 59.5 years old (why the half year is added, idk) without getting hit with tax penalties. Also there is a limit on how much you can put into these accounts per year. You can contribute a max of $5,500 per year in each of these accounts ($5,5000 Roth + $5,500 Tradition = $11,000 total max).

IRA summary:

Both the Traditional IRA and the Roth IRA are just simply accounts: you can open it up like any other investing account and fill it with whatever assets you’d like. But each provides its own set of advantages that help you at different stages of life. The Traditional IRA will help you today in that allows you to reduce taxable income today (which in theory also frees up more money for you to invest since you got taxed less), and puts off the tax bill for when you have considerably more wealth and in a lower tax bracket. The Roth IRA is helpful for maximizing growth potential in that you pay taxes now on a small investment and then cash out a larger investment tax-free.

401(k) & 403(b)

IRAs are great for taking extra funds available and putting it towards long-term growth, but most employers also provide their own program as well that is definitely worth having if available to you. The 401k Plan from for-profit entities, or 403b Plan from non-profit entities are similar to the Traditional IRA in that they provide a pre-tax investing account. So again that means that whatever you put into it is put in before your paycheck and thus is not reported in this year’s tax statement. These plans are typically set up as a percentage of wages that you decide upon. This means you can open a 401k account and designate that you want 5% of your wages to be deposited to your 401k automatically. There is a cool psychological factor to this in that since it’s done automatically and is a small percentage of income, you typically don’t ever even realize you’re making the contributions and so the temptation to stop contributing isn’t as present as it is when you have to actively invest funds into an IRA.

Employer Matching:

There is one huge benefit that makes the 401(k) an almost necessity for those who have this option and that is the employer match. Each employer has their own system with its own rules on contributions, but the majority of employers that provide a 401(k) have some form of matching incentive. This means literally free money! What happens typically is your employer will state a matching percentage with a couple criteria, like how much percentage of your own contribution will they match and for how long. Unfortunately, this option isn’t as readily available for 403(b)’s. Some non-profits provide it, but there are a few legal constraints that limit this option.

Matching Example:

Let’s say you wanted to invest 10% of your paycheck into a 401(k) Plan, and your employer says they will contribute 100% for the first 5%. If your paycheck was $1,000 this is what would happen: $100 would be taken out of your paycheck and put into the 401(k) and your paycheck would now be $900 (it will eventually be even lower because of tax withholdings and the like), but then your employer would then also deposit another $50 to your 401(k) for free, since that first 5% was 100% matched. If they matched 50% for that first 5%, then they would deposit $25, or if they matched 100% of 10% they would deposit $100.

This also means if they were matching 100% of up to 5% and you only contributed 1% of your own paycheck, that would mean you would deposit $10 and your employer would contribute $10.

This is why it is critical to find out how much your employer matches and to try to maximize your contribution so that you can get the most contribution from your employer.

Limitations:

Unlike IRAs, 401(k) plans don’t typically provide you with a whole lot of investing options. Since they are sponsored by your employer, what typically happens is the 401(k) is set through an investing firm and from there you are provided with a few investing portfolios to choose from. With an IRA, depending on the brokerage account or investing firm you are connected with, you pretty much have full control over what you invest in. Also like the IRAs, there’s an age limit at 59.5 for when you can start cashing out your 401(k) without penalty.

Investing accounts summary:

Yes I know it’s getting pretty complicated now, but now we’re seeing how to actually apply the fundamental principles of investing to real life.

Investment accounts are simply just bank accounts that you can then use the cash balance to buy other investments to hold onto. But there are a few kind of accounts that you can have and each has its own set of advantages:

Individual Investing Accounts allow you to make short-term investing to grow your wealth, and could even turn your excess savings into much bigger account to make big purchases a few years down the road. You could invest for a month before cashing out, or you can hold investment for 50 years; you have the freedom to do as you wish.

There are taxes though that come with this and that’s through Capital Gains Tax, and if you hold an asset for at least a year before selling, you can get a reduced tax rate then your income tax rate.

IRAs are ways to reduce your tax burden if you’re willing to commit to long-term investing (you can buy and sell repeatedly over the years, you just can’t pull the cash out of the IRA without the penalty). The Traditional IRA helps with taxes today and will lower your taxable income today, which may even lower you into a whole new level of a tax bracket. A Roth IRA on the other hand doesn’t provide tax provisions today, but will impact your taxes in the future to the point that you won’t have to pay taxes on the Roth deductions.

Along these is the employer sponsored 401(k) & 403(b) accounts that also lower taxable income today, but also provide the benefit of employer-matched contributions, which could mean automatic doubling of your investments for free by your employer.

Moving Forward:

Does it still seem pretty intimidating? Don’t worry, my next post is going to focus on the services that house these accounts and technology has improved to open up a whole new field in investing with automatic diversification.