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Types of Investment Accounts for each Stage of Life

By:  Henry VanBuskirk, CFP®, Wealth Manager

Investing is a broad concept that has a wide array of definitions that differ depending on whom you ask.  If you ask a recent college graduate, parents in their early 40s with two young children, and an elderly retired couple to define what investing means to them, you will probably get three wildly different answers. They all have different goals, and their investment accounts need to match those goals. My goal with this article is to help define some of these different investment accounts and why they would be used. There are many different types of investment accounts, and it may be overwhelming to keep tabs on the goals and rules for each account type. While I’m not going to go through every single investment account type in existence, I am going to help define some of the more common and lesser-known investment account types and why they would be used in each stage of life. Let’s start with the recent college graduate.

College graduate:

Say you are a recent college graduate of 24 and you started working for ABC Company. You probably aren’t thinking much about your retirement (…that’s 40 years from now…). You probably are thinking about making sure you can pay rent on time and hoping your date on Friday night goes well. The recent college graduate would probably answer, “I have a 401(k) at work, social security when I’m older, and I’ll be fine. There are a few stocks I like, and I follow the market, but I don’t have enough money to set aside to focus on investing. I don’t need to focus on investing right now.” The sentiment towards investing is understandable, but there are a lot of things that this college graduate can do now. This could be the prime time in this person’s life to start thinking about investing. Assume that ABC Company offers a match of 4%, you make $50,000, your salary never increases, and you contribute 10% to the 401(k).  Below is how much you would have at your projected retirement at age 65 assuming a 7% rate of return.   

Now compare this to someone at ABC Company who is 40 years old, makes $100,000 per year, their salary increases by 5% per year, and contributes 10% to the 401(k) each year. We will use the same 7% rate of return assumption.

The college graduate (24-year-old), who makes half as much as the 40-year-old, would have more saved in retirement. This is due to what Einstein calls “The Eighth Wonder of the World”, compound interest. 

A Traditional 401(k) also would offer tax-deductible contributions that would lower your pre-tax income, would you lower your tax bill, and the investments would grow tax deferred. The catch is that you would be required to take distributions in retirement starting at age 72. This is called the required minimum distribution (RMD). The college graduate is probably not thinking about RMDs right now, but what they are thinking of is getting a break on their taxes and saving for their future retirement. There is also a Roth 401(k)that does not allow for tax-deductible contributions, the earnings would grow tax-deferred, but you would not be required to take any distributions ever (not all plans offer this option).

Now assume that ABC Company offers a High Deductible Health Plan. Since you are a 24-year-old, you probably are in good health and would be okay signing up for a high deductible health plan.  Doing so would give you access to a lesser-known account, a Health Savings Account (HSA). This account type offers the trifecta of tax savings:

  • Tax-deductible contributions
  • Tax-free growth
  • Tax-free distributions when used for qualified health expenses

Think of this account as a Traditional 401(k) where you don’t have required distributions. If you don’t use it for qualified health expenses, then distributions are taxed at ordinary income tax rates. There is also a limit to how much you can contribute to an HSA in any given year (for 2022, $3,650 for individual coverage and $7,300 for family coverage). As we illustrated before, time is your friend when it comes to investing.

Parents in their early 40s with two young children:

Now assume that you are a 43-year-old parent with two young children, ages 5 and 6. You may be thinking about what’s best for your children. Fortunately, there are investment accounts that you can consider for their goals as well. Some investment account types that would fit this bill are Uniform Transfer to Minors Act (UTMA) accounts, Uniform Gift to Minors Act (UGMA) accounts, and Roth IRAs.

Uniform Transfers to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts are accounts where you can set aside money each year to invest for a minor. The adult family member is the custodian (person in charge of the account) and when the child reaches the age of majority (normally 18 but can be as high as 25 in some states), the account legally changes ownership to the child. There are very few differences between a UTMA and a UGMA, which is why I lump them together and will refer to them as a custodial accounts. A custodial account is taxed with the following schedule:

  • The first $1,100 of unearned income is free from tax
  • The next $1,100 is taxed at the minor’s tax rate
  • Earnings above $2,200 are taxed at the parent’s tax rate

It generally would require filing a tax return to report any gains or losses attributed to the investment account’s performance. The taxation in a custodial account is not dependent on whether or not the child or grandchild uses it for qualified education expenses. The UTMA or UGMA account after the child or grandchild reaches the age of majority becomes a non-qualified investment account. This means that it is taxed at the more favorable capital gains tax rates.

One account that can help pay for future college expenses is a 529 plan. 529 Plans (sometimes referred to as college savings plans) are a great investment vehicle if your child goes to college or a private school. This is because the earnings are tax-free, and distributions are tax-free as long as the funds are used for qualified education expenses. The downside is if the distribution is not for qualified education expenses, then the earnings are taxed at ordinary income tax rates and a 10% penalty is assessed. If your child has goals of wanting to be an astronaut, doctor, or another profession that requires post-secondary education, it may be a good opportunity to talk to them about what needs to happen to realize that goal. Maybe during Christmas, you have the child open a letter that has a $100 check made out to a 529 plan. The kid would naturally have questions. You could then give them the same gift every Christmas and show them the 529 plan statement on how you are working together to make that goal a reality.

Another way to save for a minor child would be a Roth IRA. Roth IRAs are available to anyone that has an earned income below $144k for single taxpayers or $214k for married filing jointly. This isn’t just for people 16 and older that work part-time after school. You can have even younger people than that contribute (with the parent’s help as custodian) to a Roth IRA provided that they have earned income.  Earnings on a Roth IRA are tax-free, as long as it has been longer than 5 years since you first contributed to a Roth IRA account, and you have reached age 59.5. There is a 10% early withdrawal penalty if funds are withdrawn before age 59.5 and it is possible that you would owe ordinary income taxes on the earnings received. Your basis in the Roth IRA is never subject to taxation.

For example, I worked with a client who owned an educational toy company, and her 2-year-old was a ‘toy tester’. She gave the 2-year-old a salary, and then matched that salary in the form of a Roth IRA. Think outside the box, but also make sure everything is well documented since you are reporting all of this to the IRS. We are all about tax saving strategies at BFSG, but we will never recommend illegal tax avoidance strategies.

An elderly retired couple:

The elderly couple isn’t thinking about accumulating and is instead thinking about maintaining their lifestyle and passing on their successes to future generations in their household. This is also the time when you are taking required minimum distributions (RMDs) from your Traditional 401(k) or Individual Retirement Account (IRA).

This elderly retired couple has a sizable estate and are concerned about making sure their grandchildren can attend college. They can put the RMD funds (net of taxes) into a 529 Plan that would grow tax-free and withdrawals can be tax-free if the funds withdrawn from a 529 Plan are used for qualified educational expenses. With a 529 plan, you can build an educational legacy for your grandchild while taking advantage of tax and estate planning benefits.  

What some of our clients do when they don’t need the money from their RMDs (not a bad problem to have) is that they journal the net distribution from their Traditional 401(k) or IRA to their brokerage investment account.  The brokerage investment account is non-qualified (no favorable tax treatment) that can be used for any purpose.

However, don’t let Lloyd Christmas have that chance at your estate. Make sure the brokerage investment account is titled properly – preferably in the name of your Living Trust.

Upon the elderly retired couples passing, the brokerage investment account would pass to their heirs (as dictated in the Trust), and they would receive a step-up in cost basis at death. For example, assume you put $100,000 into a brokerage investment account and it grows to $150,000 10 years later. If you close out the brokerage investment account, you would owe long-term capital gains taxes on the $50,000 gain and you would receive $150,000 minus what was paid in long-term capital gains taxes. If you instead leave the account open and pass away with the $150,000 brokerage investment account, your heirs would receive the account and can choose to take the $150,000 tax-free.

Conclusion:

Regardless of what demographic group you are a part of, there are investment accounts for you and a team of CERTIFIED FINANCIAL PLANNERSTM at BFSG that can help you along your life journey.  Let us know what we can do to help. 

Sources:

  1. https://www.bankrate.com/retirement/401-k-calculator/
  2. https://www.fidelity.com/viewpoints/wealth-management/hsas-and-your-retirement
  3. https://www.nerdwallet.com/article/investing/utma-ugma
  4. https://www.bankrate.com/loans/student-loans/roth-ira-for-college/
  5. https://www.savingforcollege.com/article/can-i-pay-my-mortgage-with-529-plan-money
  6. https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
  7. https://www.courts.ca.gov/partners/documents/probguide-eng.pdf

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Confirmation Bias is Real: Fake news, filter bubbles, selective recall, mass delusion

Muhammad Ali, “I don’t always know what I’m talking about, but I know I’m right.”

This quote from the greatest of all time, Muhammad Ali, sums up our next behavioral bias, “Confirmation Bias”. In other words, we start with a view of a particular topic and then search for information that upholds that view. From real-world examples in sports and the news, to how this bias may impact your investment portfolio, confirmation bias is real.

BFSG Shorts: Confirmation Bias

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Deadline for CARES Act and SECURE Act Amendments Extended

The original due date of the CARES Act and SECURE Act amendments for qualified plans, other than governmental plans, was the last day of the first plan year beginning on or after January 1, 2022, which means December 31, 2022, for calendar year plans. This has been extended to December 31, 2025, regardless of plan year end. However, the deadline for governmental plans (414(d) plans, 403(b) plans maintained by public schools or 457(b) plans) is 90 days after the close of the third regular legislative session of the legislative body with the authority to amend the plan that begins after December 31, 2023.

This does not restore the availability of Coronavirus Related Distributions or larger loan limits but refers to the amendments that document the provisions used to operate the plan. Check with your TPA or document provider to confirm if the amendments for your plan were already filed or if the extended deadline will apply to you.

Upcoming Compliance Deadlines

December 2022

1st: Participant Notices – Annual notices due for Safe Harbor elections, Qualified Default Investment Arrangement (QDIA), and Automatic Contribution Arrangements (EACA or QACA).

30th: ADP/ACP Corrections – Deadline for a plan to make ADP/ACP corrective distributions and/or to deposit qualified nonelective contributions (QNEC) for the previous plan year.

Discretionary Amendments – Deadline to adopt discretionary amendments to the plan, subject to certain exceptions (e.g., anti-cutbacks).

Required Minimum Distribution (RMD) – For participants who attained age 72 in 2021 (and attained age 70 on or after July 1, 2019), the first RMD was due by April 1, 2022. The 2nd RMD, as well as subsequent distributions for participants already receiving RMDs, is due by December 30, 2022.

January 2023

31st: IRS Form 945 – Deadline to file IRS Form 945 to report income tax withheld from qualified plan distributions made during the prior plan year. The deadline may be extended to February 10th if taxes were deposited on time during the prior plan year.

IRS Form 1099-R – Deadline to distribute Form 1099-R to participants and beneficiaries who received a distribution or a deemed distribution during prior plan year.

IRS Form W-2 – Deadline to distribute Form W-2, which must reflect aggregate value of employer-provided employee benefits.

Save or Toss? Proper Plan Record Storage a Must!

As the year comes to a close, you may wonder what plan records must be kept and what items can be tossed. Historical plan records may need to be produced for many reasons: an IRS audit, a DOL investigation or simply questions from participants about their benefits or accounts to name a few.

The Internal Revenue Service (IRS) takes the position that plan records should be kept until all benefits have been paid from the plan and the audit period for the final plan year has passed. This additional audit period is important to note. It may seem that with the final payout the plan is gone, but the reality is that the plan can be selected for audit for 6 years after the plan assets are paid out and your final Form 5500 is filed. The items that are typically needed in the event of an audit are:

  • Plan documents and amendments (all since the start of the plan, not just the most recent)
  • Trust Records: investment statements, balance sheets and income statements
  • Participant records: Census data, account balances, contributions, earnings, loan records, compensation data, participant statements and notices

Under the Employee Retirement Income Security Act (ERISA), the following documentation should be retained at least six years after the Form 5500 filing date, including, but not limited to:

  • Copies of the Form 5500 (including all required schedules and attachments)
  • Nondiscrimination and coverage test results
  • Required employee communications
  • Financial reports and supporting documentation
  • Evidence of the plan’s fidelity bond
  • Corporate income

In addition, ERISA states that an employer must maintain benefit records, in accordance with such regulations as required by the Department of Labor (DOL), with respect to each of its employees that are sufficient to determine the benefits that are due or may become due to such employees. These items don’t necessarily have a set time frame, so you may want to consider keeping these items indefinitely. Documentation needed may include the following:

  • Plan documents, amendments, SPD, etc.
  • Census data and supporting information to determine eligibility, vesting and calculated benefits
  • Participant account records, contribution election forms and beneficiary forms Documentation related to loans and withdrawals

It is the plan sponsor’s responsibility to ensure documentation is kept regardless of which service providers are used during the life of the plan. Establishing a written process regarding how long to keep documentation is important as well as giving careful thought to whether the records will be electronic or paper. This ensures that, as staff members change over time, your processes will remain consistent and all necessary information will be handled appropriately. When storing plan records electronically, consider a naming convention that will make documents accessible to the proper personnel and easy to locate.

Security of the information should be considered as well to protect the confidentiality of personally identifiable information or PII. Many types of plan records include items considered PII, like social security numbers, dates of birth or account numbers. This information should be kept in a secure manner to avoid the possibility of identity theft and fraud. Take the necessary steps to ensure that the plan’s service providers also have adequate policies in place to protect participant’s PII as well.