I recently had someone tell me that they couldn’t make as much money in their IRA or 401K as they could if they just left their investment dollars in a regular taxable account. Huh?
Typical investment places include bank accounts, stocks, bonds, mutual funds, ETF’s. Money saved and invested in these places can be your taxable funds, as well as IRA’s and 401K’s.
The simplest and safest place to put your money is in a bank CD. You will earn a pittance in interest, but your money will be safe. Both your taxable money and you IRA money will earn the same interest rate. At the end of the year, interest earned in your taxable account must be included in your yearly taxable income, but the interest in your IRA will not be taxed.
Likewise, you can purchase $300 worth of stock from Company X with either your taxable money or your IRA money. Let’s say you picked a great stock and your money nearly doubled! You choose to take your profit and you sell Company X for $500.00. You now owe taxes on $200.00 if this was in your regular account. That same $200 profit earned in the IRA will not be taxed.
401k’s work essentially the same way. Generally, there is a more limited investment choice of mutual funds for your 401K dollars which will make an exact comparison a little more difficult. The concept is the same. If a mutual fund goes up; every account that has invested in that fund will go up whether it is a 401K, IRA, or regular account.
Whatever investment you have in a taxable account will be taxed the year you receive that money. This includes dividends and interest that may be reinvested. Whatever investment you have in a Traditional IRA or 401K will not be taxed UNTIL you actually take funds out at retirement. If you have these funds in a ROTH IRA or 401K, you may never pay taxes on them.
So to be clear – whether you invest in regular accounts, IRA’s, or 401K’s, you money will grow at the exact same rate. What changes will be the tax you pay. But that is for a later blog.