What’s a little long-term commitment, really? Isn’t it deciding what to commit to that panics us? Well… at least we can rest assured when it comes to retirement and college savings. Tax-protected growth accounts are the perfect match.
Inside these accounts — the 401(k), IRA, 529 and Coverdell — our investments grow free of federal income tax… that is, as long as we stay with them until retirement or college. Infidelity here gets us a big tax bill and steep penalty. Staying faithful gets us higher returns and a bigger nest egg, faster.
The bliss of tax-protection lasts only while we’re married to these accounts, though. We’re still vulnerable to tax on our contribution before we get in and on our withdrawal after we leave, but not on both… usually.
Among these accounts, the 401(k) is a head-turner even our mothers would love. Typically, we pay tax on the way out but get big benefits on the way in. Our annual contribution goes in un-taxed. It’s treated like a deduction to lower the amount we’re taxed on… and our income tax. Tax benefits can be big. We can set aside up to $15,500 annually and $20,500 for 50-and-overs. Employers can also contribute and often pay in more as we do.
But, don’t stop there. Why not go for the underdog too — the IRA. Both the traditional and Roth are also available to non-working spouses. Each spouse can contribute up to $4,000 and $5,000 at age 50-plus. We have until tax day of the following year to do it.
The traditional IRA works like a 401(k) except contributions stop being deductible at joint income of $103,000, higher if a working spouse has no 401(k). When contributions aren’t deductible — so taxed before going in — the Roth becomes the better choice. Its contributions can’t be deducted anyway, and, unlike the traditional IRA, withdrawals are tax-free and can be taken any time. But, when Roths disappear at joint income of $166,000, the only option becomes the traditional IRA with non-deductible contributions. Sure, tax is paid both on the way in and the way out, but the key benefit of higher returns remains.
The 529 and Coverdell are similar accounts for college savings. Like a Roth, contributions are not deductible but tax-free when withdrawn for education. For financial aid, both the Coverdell and 529 are considered assets of the parent, not the student. While Coverdell money can also be used for lower education expenses, its annual contribution limit is a low $2,000.
The 529 is flexible and limits are high. We can choose any state’s plan, yet our child can attend college anywhere. Plans vary, but a Texas 529 can be started for as little as $25, and in most 529s, anyone can contribute. Annual contributions can go as high as $12,000 without triggering gift tax. Other flexible features of the 529 include easy transference to a sibling and cash-out options in the case of a scholarship.
We ain’t getting any younger. To meet retirement and college goals, we’ve got to commit for the long haul anyway. So, we might as well go to the dance with the higher returns of tax-protected growth. But, to keep them, we gotta go home with the one that brung us.