If you have been a Mountain PEAK client for more than a day, you have probably heard us talk about the three tax pockets. Tax diversification is an important part of financial planning, and we try to ensure that our clients have money in all three tax pockets. Some of you may not remember the difference between each tax pocket, so we are going to go over them again today.
The first tax pocket is the most well-known, the Taxable Pocket. Almost every working American has a checking or savings account which is considered a taxable account. A brokerage account is also considered a taxable account. That means that any earnings, such as interest and dividends are taxed each year. The income is reported to you on Form 1099 so that you can include the income on your tax return for the year.
The next tax pocket is the Tax-Deferred Pocket. Most working Americans have money in tax-deferred accounts as well. The 401(k), 403(b), and 457(b) plans are considered tax-deferred accounts. Also included in this tax pocket are Simplified Employee Pension (SEP), SIMPLE IRA Plans, and Traditional or Rollover Individual Retirement Arrangements (IRA). This means that taxes are postponed until the money is taken out of the account. The funds going into these accounts are pre-tax, and the money is not taxed until it is withdrawn from the account.
The last tax pocket is the most underutilized pocket. It’s the Tax-Free Pocket! Roth IRAs are considered tax-free. Municipal bonds also fall into the tax-free category. The money going into these accounts is after-tax dollars, and the growth and earnings in the account can be withdrawn tax-free! Another overlooked tax-free account is the College Choice 529 Plan. 529 plans are designated for qualified education expenses. The contributions are not tax deductible; however, the earnings grow federal tax free. As of January 1, 2018, tax-free withdrawals may also include up to $10,000 in tuition expenses for private, public, or religious elementary and secondary schools (per year, per beneficiary). The State of Indiana has a special (refundable) tax credit equal to 20% of the annual contributions to a College Choice 529 account, up to $1,000 per year.
Hopefully this refresher has been helpful. Investing your money is very important, but where you invest that money can be equally important. If you feel you are missing out on any of the tax pockets, feel free to give us a call!