What if I told you that you could be paying thousands of dollars in unnecessary taxes every year on your savings? You might think I have some savvy financial trick up my sleeve to save you from Uncle Sam, but the opposite is actually true. In this episode, it's all about the basics. Basic account types, that is: The Three Musketeers: Taxable, Tax Deferred, and Tax Free

 

Taxable Accounts: The Draining Leak in Your Pocket

Taxable accounts include your checking, savings, and brokerage accounts. The unfortunate characteristic of these accounts is that every year, like clockwork, a portion of your hard-earned money gets siphoned off to pay taxes. Imagine this as a leak in your financial bucket, slowly draining your resources.

 

Tax Deferred Accounts: Delayed Taxation

With these types of accounts, you haven't paid taxes on the money yet. Think of traditional 401(k)s, IRAs, and similar accounts. While it might seem like you've got a pot of gold, remember, a chunk of that treasure belongs to the government. You're merely holding it in trust until the taxman comes knocking.

 

Tax Free Accounts: The Holy Grail

These accounts are the gems of the financial world. Once you've paid your taxes, your money gets to grow, flourish, and multiply without being haunted by the specter of taxation. Roth accounts, such as Roth 401(k)s, Roth IRAs, 529’s and the beloved Health Savings Accounts (HSAs), fall into this category. Once you've entered the realm of tax free accounts, you've found the holy grail of personal finance—a place where your money can thrive without the relentless bite of taxes.

 

Which is Best?

In the world of finance, understanding these account types is akin to wielding a shield against the ever-present taxman. By choosing the right account types, you can strategize and minimize the amount you pay in taxes, leaving more money in your pocket.

 

Let's Review an Example

To drive this point home, consider the following real-client scenario: Joe (not his real name) is a diligent saver with most of his funds parked in his brokerage account. While he had managed to save, he hadn't optimized where he was putting that money. A large portion of his savings sat in taxable territory, meaning he was hemorrhaging money in taxes every year. The story of Joe is not uncommon. Many individuals find themselves in similar situations, unknowingly losing substantial amounts to taxes, all due to a lack of understanding about account types.

Need more convincing? Take a look at the following chart to see the difference between taxable, tax deferred and tax free accounts. Using the following assumptions, it is clear that choosing the right account type makes a significant impact on your overall savings.

 

ROTH 401k

Traditional 401k

Brokerage

Year

Brokerage

Roth 401k

Brokerage

Traditional 401k

Brokerage

Traditional 401k

0

$4,600

$22,500

$10,000

$22,500

$27,100

$0

1

$4,946

$24,300

$10,752

$24,300

$29,138

$0

2

$5,318

$26,244

$11,561

$26,244

$31,329

$0

3

$5,718

$28,344

$12,430

$28,344

$33,685

$0

4

$6,148

$30,611

$13,365

$30,611

$36,218

$0

5

$6,610

$33,060

$14,370

$33,060

$38,942

$0

6

$7,107

$35,705

$15,450

$35,705

$41,870

$0

7

$7,642

$38,561

$16,612

$38,561

$45,019

$0

8

$8,216

$41,646

$17,861

$41,646

$48,404

$0

9

$8,834

$44,978

$19,205

$44,978

$52,044

$0

10

$9,498

$48,576

$20,649

$48,576

$55,958

$0

11

$10,213

$52,462

$22,201

$52,462

$60,166

$0

12

$10,981

$56,659

$23,871

$56,659

$64,690

$0

13

$11,806

$61,192

$25,666

$61,192

$69,555

$0

14

$12,694

$66,087

$27,596

$66,087

$74,786

$0

15

$13,649

$71,374

$29,671

$71,374

$80,410

$0

16

$14,675

$77,084

$31,903

$77,084

$86,456

$0

17

$15,779

$83,250

$34,302

$83,250

$92,958

$0

18

$16,965

$89,910

$36,881

$89,910

$99,948

$0

19

$18,241

$97,103

$39,655

$97,103

$107,465

$0

20

$19,613

$104,872

$42,637

$104,872

$115,546

$0

SUBTOTAL

$21,088

$104,872

$42,637

$104,872

$115,546

$0

Pay Taxes when you sell

-$2,252

$0

-$4,896

-$25,169

-$13,267

$0

After Taxes

$18,836

$104,872

$37,741

$79,702

$102,279

$0

TOTAL

$123,707

$117,444

$102,279

So, what can you do if you suspect you might be in a similar predicament? The first step is awareness. Understanding the nuances of account types arms you with the knowledge needed to make informed financial decisions. From there, it's all about devising a plan to move your money strategically, exploring tax deferred options where applicable, and aiming for the coveted tax free accounts.

While it might seem overwhelming, remember, financial freedom is often a journey of small, intentional steps. And with each step, you're one stride closer to keeping your hard-earned money where it belongs—in your pocket.