There's nothing like having cash on hand. But if you've paid off most of your college loans and your emergency fund is topped off, investing your cash is the only way you can make sure it will grow over time.
When interest rates on savings accounts are low, consider taking some risk and investing in the market. Doing so can help you reach a goal, such as saving for retirement or a house down payment.
A great way to dive in is a brokerage account or Roth IRA, each of which has its benefits and disadvantages. Before you invest, however, pay special attention to the taxable nature of the former and the tax benefits of the latter.
Defining a Roth IRA
A Roth IRA is an investment vehicle that allows you to both save for your retirement and reduce the taxes you pay on your investment earnings. The Roth IRA is a somewhat unique investment vehicle because it offers tax-free income at retirement. Also, the Roth IRA gives you flexibility as to when you can dip into your savings in that you pay taxes on your cash before you invest it in this financial asset. Consequently, the earned income that you contribute is not tax-deductible, but an account withdrawal is a tax-free one.
What's more, under some circumstances, if your account is open for five years or more, you can withdraw a portion of your gains without penalty. One such circumstance is making a down payment when you purchase your first home.
For 2021, the IRS says any individual under the age of 50 can contribute a maximum of $6,000 per year to one or more IRAs. For account holders age 50 or more, the maximum is $7,000. For an employed person, these contributions may consist of wages, salaries, commissions, bonuses and other amounts paid to the individual. Alimony, child support or another form of a divorce settlement can also be contributed to a Roth IRA.
If, however, you are single in 2020 and earn $139,000 or more, you can't contribute to a Roth IRA. The limit for married couples filing jointly is $206,000 and for married filing single, $139,000. These maximums change periodically.
Roth IRA Tax Benefits
The tax benefits of a Roth IRA are many:
Tax-Free Growth: Because your account deposits consist of post-tax dollars – you pay taxes on the money before you deposit it – future withdrawals are tax-free. Consequently, Roth IRAs are of benefit if it's likely that your taxes will be higher during your retirement years than they are currently.
No Minimum Account Distribution: Unlike a 401(k) or traditional IRA, a Roth IRA has no required minimum distributions (RMDs), so you can maintain the account indefinitely.
Tax- and Penalty-Free Withdrawals: Your withdrawals from a Roth IRA, or qualified distributions, are tax- and penalty-free as long as the amounts are equal to or less than the amount of your contributions to the account. This is true regardless of your age, the time at which you made the contribution or the time during which your contributions remained in the Roth IRA account.
Qualified Account Earnings Withdrawal: The distribution of account earnings is qualified if it occurs at least five years after the Roth IRA owner established and funded the account, and if the distribution occurs under one of the following conditions:
- The account holder is 59 1/2 years of age or more when the distribution occurs.
- It occurs five or more years after the owner established the Roth IRA account.
- The distributed account assets are used to purchase a first home for the account holder or member, subject to a $10,000 limit.
- The Roth IRA holder is disabled when the distribution occurs.
- The beneficiary of the Roth IRA assets receives the distribution after the Roth IRA holder's death.
Tax-Free Account Withdrawal: Once you reach age 59 1/2, your withdrawals of contributions are not subject to either taxes or penalties. Your earnings on those contributions, however, are subject to tax, but not a penalty. From an accounting perspective, because Roth withdrawals occur on a first-in first-out basis, your contributions are withdrawn first. So, earnings remain untouched until all contributions are withdrawn.
No Forced Withdrawal: You can leave your cash in a Roth IRA indefinitely. So, you can pass that cash to your heirs tax-free. The money is taxed when the beneficiary makes a withdrawal.
Read More: How Does the Roth IRA Work?
What's a Brokerage Account?
E*Trade, Charles Schwab and other brokers offer general brokerage accounts for those who want to invest for retirement or another goal and see owning stocks as a means to achieve those objectives. As an investor, you deposit money with the brokerage firm, which places trades on you behalf.
While the brokerage executes the orders, the assets are yours. Consequently, you claim any resulting capital gains earned on the account assets as taxable income.
In its simplest form, an online broker provides a secure interface that an investor can use to place trade orders for which the broker charges the investor a fee. But broker services vary greatly in terms of the analytical tools they make available to investors, the speed with which an order is executed, the scope of assets traded and the ability of an investor to trade on margin.
Brokerage Accounts and Tax Benefits
A brokerage account is a type of taxable investment account. These accounts have no tax benefits, but they offer fewer restrictions and more flexibility than does a tax-advantaged account, such as a Roth IRA. For instance, you can withdraw cash from your brokerage account with no tax implications or penalties.
The tax implications of a brokerage account relate to whether an asset's growth is classified as a long-term or short-term capital gain. For instance, if you hold an investment in your brokerage account for a year or more before you sell it, earnings on the investment are long-term capital gains that are subject to a 0, 15 or 20 percent tax rate, depending on your tax bracket. If, however, you hold the investment for less than a year, earnings on the investment are short-term capital gains and subject to as much as a 37 percent tax rate.
A good way to minimize your taxes is to put your investments in the right type of account. In general, investments that are subject to lower tax rates are better suited for taxable accounts, such as a brokerage account. Conversely, those investments that are subject to higher tax rates are good candidates for tax-advantaged accounts, such as a Roth IRA account.
- Internal Revenue Service: Topic No. 409 Capital Gains and Losses
- CNBC: Where to Invest First: Roth IRA or A Taxable Brokerage Account
- Internal Revenue Service: Roth IRAs
- Internal Revenue Service: Retirement Plans FAQs - Contributions
- Internal Revenue Service: Amount of Roth IRA Contributions You Can Make in 2020
- Internal Revenue Service: Publication 590-B
- Internal Revenue Service: Retirement Topics - IRA Contribution Limits
- ETrade Financial: Home
- Charles Schwab: Home
- Investopedia: Brokerage Company
- Investopedia: What Is a Capital Gains Tax?
- Congressional Research Service. "Traditional and Roth Individual Retirement Accounts (IRAs): A Primer," Page 9. Accessed July 24, 2020.
- Internal Revenue Service. "Traditional and Roth IRAs." Accessed July 24, 2020.
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Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.