Health And Retirement Accounts

Posted by: Joseph Kuo | April 3, 2019

Piggy bank
Since the Great Depression, the government has taken various actions over the years to provide safeguards and promote savings. The most well-known safeguards come in the forms of Social Security benefits and Medicaid. While the exact benefits and how to qualify for them may be a bit complicated, most people generally know what they are. On the other hand, various vehicles for savings can be both complicated and confusing. This is especially true because some “savings” vehicles are really applications of income tax law that people have figured out how to deploy. This series of articles is a primer on the commonly used retirement savings vehicles.

Broadly speaking, when we talk about retirement savings vehicles, we mean financial accounts that allow for tax deferral or, rarely, permanent tax deferral (i.e. tax-free). The idea is, since there is a tax advantage to saving money, you are more likely to save for the future. These vehicles generally fall into the categories of company-sponsored plans and individual plans.

Individual Retirement Accounts

Most people have heard of IRAs or Individual Retirement Accounts. These are accounts that individuals can open through banks and brokerages. You qualify to contribute to an IRA if you have earned income or are married to someone with earned income.

Traditional IRA

The main type of IRA that most people know of is the traditional IRA. A few key points of the traditional IRA are the following:

  • You can put pre-tax income into a traditional IRA if your household income is below a certain threshold. Pre-tax contribution means that, for the current year, you don’t pay tax on income you put into the traditional IRA.
  • You pay taxes on that same pre-tax income when you take it, and any earnings from its growth, out of your IRA.
  • The income threshold that determines how much pre-tax income you can contribute is published by the IRS annually.

There’s a limit on how much you can contribute to an IRA each year, plus a catch-up contribution if you are 50 or older. The IRS publishes this limit annually. If you over-contribute, there is a 6% penalty on the over-contributed amount EVERY YEAR, so you will want to fix that ASAP.

If you have earned income, YOU CAN ALWAYS CONTRIBUTE TO IRA. Even if you do not qualify for pre-tax contribution, you can still make post-tax contribution.
Post-tax contributions are not taxed again when you withdraw from traditional IRA.

Roth IRA

There is another type of IRA called a Roth IRA. In addition to many of the same restrictions as traditional IRA, Roth IRA contribution is cumulative with traditional IRA contribution. This means that, if the contribution limit is $5,500 per year, the sum of your traditional IRA and Roth IRA contributions cannot exceed $5,500.

The key differences between traditional IRAs and Roth IRAs are:

  • With a Roth IRA, you always contribute post-tax income. That means that you don’t pay taxes on anything you take out of a Roth IRA, whether contributions, growth, or earnings. This means you don’t pay taxes on the appreciation of stocks, dividend distribution, and interest from bonds of those Roth IRA funds. It is one of the few vehicles that PERMANENTLY reduces tax.
  • Unlike a traditional IRA, when you exceed household income limit for contributing to a Roth IRA, you cannot contribute to a Roth IRA.
  • However, you can convert funds in your traditional IRA to a Roth IRA regardless of income. Doing so does not incur penalties for early withdraw (if you don’t yet qualify for an IRA withdraw) but will incur ordinary income tax on pre-tax contributions and earnings. This is not straight forward so please consult with your tax or financial planning professionals to see whether this makes sense for you.

Health Savings Account

Health Savings Accounts or HSAs have become popular over the past decade or so. To qualify for an HSA, you must have a high-deductible health insurance plan. Most health insurance plans will say whether it’s high-deductible or not, so you know whether you qualify. Some key points for HSAs are:

  • You contribute pre-tax income to an HSA.
  • Earning and growth of the money in an HSA is tax deferred; you don’t pay taxes while the money stays in the account.
  • If you use money in the HSA for qualified healthcare expenses, the money comes out tax free.

This is the only account that provides TRIPLE FREE TAX

  1. The contribution is pre-tax.
  2. The gains in the account are tax-deferred.
  3. Any withdraw is tax-free if used for qualified healthcare expenses.

As our average life-span increases, chances are high that we will incur significant healthcare expenses later in life. An HSA is an excellent vehicle to contribute to over the long term. Ideally, if you are young and healthy, you would enroll in a high-deductible health plan and contribute to an HSA. If you do incur healthcare expenses while you are young, pay for it out of your cash flow if possible. Invest your HSA funds and let it grow for the long term. When you retire, everything in your HSA comes out tax free for your healthcare needs.

These are high-level descriptions of individual accounts and there may be other factors important to you, such as how heirs inherit these types of accounts or the health of you and your family. Please consult with a financial professional to decide the savings account structure appropriate for you and your family.

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