Investing beyond an IRA
June 29, 2006 5:13 PM   Subscribe

How can I invest more than $4000 per year toward my retirement without annually paying taxes on the gains?

I've got a traditional IRA with Vanguard, and it's set up with an automatic investment plan that maximizes my IRA contribution ($4000/year for me). I currently save about twice as much as that in a short-term savings account, and I now have a comfortable emergency fund built up. I'd like to stop putting the extra money into the savings account and instead put it toward retirement.

I know I can just buy mutual funds, but I'd rather buy them in a retirement arrangement so all my gains aren't lost to taxes.

Some details:
• I have no retirement plan through my company.
• I do freelance design, so I might be able to open an account aimed toward small business owners. I currently do not have a business license, but I'm trying to get that in order as the business grows.
• Renter, one mortgage on raw land that I intend to build on in 5-10 years, 30 years old, married, wife has CA state pension plan, no kids (in case any of that matters).

posted by letitrain to Work & Money (16 answers total) 3 users marked this as a favorite
Roth IRA - you'll pay taxes on what you invest, but not on what you make or when you take it out.
posted by Pressed Rat at 5:37 PM on June 29, 2006

Roth IRA won't help as he's already maxing his contributions to a regular IRA.

You might look into a SEP-IRA; this will let you contribute up to 25% of your freelance income (up to a maximum of $42,000) to a tax-deferred account.

You don't have to pay taxes on the gains each year in a regular investment account, though -- you only pay taxes when you sell. (You do have to pay taxes on dividends but these are usually a fairly small portion of total gains.) Exchange-traded funds (ETFs) are generally considered more tax-efficient for reasons I once read about but don't really understand.
posted by kindall at 5:47 PM on June 29, 2006

Another vote for SEP-IRA. Setup is dead easy, there's no special paperwork (you don't even need to wait for the business license), and the contribution limit is a generous 25% of your Schedule C income. There are other options like SIMPLE, Self Employed 401(k), etc., but they're more complex to setup, have ongoing management fees, etc. Grow into those later. Whereas SEP-IRA is just another flavor of IRA. It's designed for people like you.
posted by nakedcodemonkey at 5:54 PM on June 29, 2006

Best answer: Roth IRA actually *will* help as you'd be able to effectively invest the same amount post-tax as you'd be able to invest pre-tax with a traditional IRA. If you are eligible for a Roth IRA, you definitely want to go with that instead of a traditional IRA. You can effectively invest ~25% (or whatever your withdrawal tax bracket will be) more without into a Roth IRA than a traditional.

SEP-IRA is a good option that if you're self-employed you're eligible for, as the growth is tax advantaged and there's pretty much no setup involved.

Even better (and probably worth the effort of looking into) is a SIMPLE-IRA, which also gives both the business and the employee additional year-end tax benefits, so if you're looking into business-paperwork anyway, this is just one more reason.

kindall: you're right that capital gains are only assessed on sale, but the issue that letitrain brings up is that most actively managed mutual funds generate a lot of trades over the course of the year - each of those you end up paying as regular income as if you bought and sold them yourself. If you're investing in funds (which probably makes sense if you're looking for long-term growth) it makes sense to go for either indexed funds or ETFs (ETFs can sometimes be more tax efficient because they allow "in-kind" trades which don't trigger capital gains (not considered realization of gains).

Individual stocks are can be very tax efficient, because you can control when you sell, but it takes a modest amount of capital and work to diversify, rebalance, and trade tax-efficiently (you can sell a stock at the end of a year that's done poorly, and buy it back 31-days later to get capital losses that can be used to offset gains and carried forward multiple years).
posted by lhl at 6:16 PM on June 29, 2006

Yeah. Set up a Roth IRA instead of a traditional.

And if you want to contribute more toward retirement look at an individual 401(k). Contrary to what nakedcodemonkey said, it wasn't hard for me to set up. I waited until Dec 30 last year to do it (the last day for 2005) and got it done that afternoon over the phone with Schwab. Just a few name/address/ssn forms. The contribution limit for that was $42,000 last year. It's pre-tax, so it can save you a bundle if you had a good year.
posted by nonmyopicdave at 6:28 PM on June 29, 2006

If you are self-employed, you set up a SEP IRA and can have the best of both worlds. You can contribute up to 25% to your SEP and deduct it from your Schedule C income. This takes the place of a 401(k) retirement plan you would get from an employer. In addition you can contribute $4000 to an after-tax Roth IRA. Both will accumulate tax deferred.
posted by JackFlash at 6:49 PM on June 29, 2006

Oops, I meant the SEP will be tax deferred. The Roth will be tax exempt forever.
posted by JackFlash at 6:51 PM on June 29, 2006

Response by poster: OK, so SEP-IRA it is. Now I just have to earn enough to make the 25% a big enough chunk.

The reason I went with the Traditional as opposed to the Roth is the tax savings. Since I have no 401(k) at work, I can take the entire $4000 off my taxable income.

I hadn't thought about the Roth allowing me to invest more - I understand the concept, but I had always bought into the "grow your money before taxes" line of thought. I may have to re-think that.
posted by letitrain at 7:23 PM on June 29, 2006

Response by poster: I missed nonmyopicdave's answer. I'm looking into the individual 401(k) now, too.
posted by letitrain at 7:35 PM on June 29, 2006

Best answer: You are correct that it is good to "grow your money before taxes". If you have no other retirement plan, the IRS allows you to do that with a traditional IRA, but that is limited to $4000 per year. With a retirement plan, either employer 401(k) or self-employment SEP, you can save much more tax-deferred, but if you do, you give up the smaller traditional IRA tax deferral. So given the retirement plan, the $4000 IRA must be after-tax -- so you may as well put it in a Roth and never pay taxes again.
posted by JackFlash at 7:39 PM on June 29, 2006

Although under certain circumstances the individual 401(k) can allow larger contributions than a SEP, it has slightly more complicated rules. Also, the number of institutions offering 401(k)s and the type of investments allowed are much more limited. For example, Vanguard and Fidelity, two of the largest institutions, do not support individual 401(k)s, as far as I know.
posted by JackFlash at 7:56 PM on June 29, 2006

Yeah, I don't mean to be dissing on the Roth IRA, I have one myself. And the Roth is a better deal than traditional if your time horizon is long enough.
posted by kindall at 7:57 PM on June 29, 2006

If you are going to have kids, you need to incorporate educational costs into your long-term financial plan (because they'll want to go to college before you'll be eligible to retire), and 529 accounts are a very nice way to grow that particular tranche of your portfolio with significant tax protections. You and your wife can put more than $20,000 a year into the accounts, and grow it tax-deferred (tax free if actually used for educational expenses under current law, due to expire in 2010, and thereafter taxed at the child's rate).
posted by MattD at 8:05 PM on June 29, 2006 [1 favorite]

Response by poster: Thanks, JackFlash. That clears it up for me. If I go with the SEP-IRA, I lose the ability to deduct the $4k, which in turn makes the Roth a much clearer first choice.

MattD: we're probably not going to have kids, but that's good to know just in case.

Thanks everyone.
posted by letitrain at 8:58 PM on June 29, 2006

Keep in mind that there are some phase out rules. If you are filing a joint return and your income is below $75,000 you can still contribute to a deductible IRA and a retirement plan at the same time. Between $75,000 and $85,000 you can contribute partially to the deductible IRA and partially to the non-deductible Roth IRA. Above $85,000 you would use only the Roth IRA. If your income exceeds $150,000, then your ability to contribute to the Roth begins to phase out and you have to fall back on a traditional IRA but with after-tax dollars.

In all cases you can contribute the $4000 to some sort of IRA or combination of IRAs, but whether traditional/Roth and deductible/non-deductible varies with income. If your wife works, she can also contribute $4000.

Regardless, you should set up some sort of retirement plan (SEP, SIMPLE or 401(k)) to shelter more of your self-employment income. As nakedcodemonkey said, the IRS doesn't care if you have a business license. That is only an issue between you and your local jurisdiction.
posted by JackFlash at 10:54 PM on June 29, 2006

letitrain, just got around to following up on this, before you dismiss SEPs entirely I highly recommend you do check with a CPA or other tax professional on this.

As opposed to what JackFlash mentioned on giving up your Traditional/Roth IRA deferrals, my research has suggested differently (that the SEP is considered a qualified pension plan and you can contribute to both).

You might want to follow up with the relevant IRS sources starting from here:
Can a person make a contribution to a SEP-IRA and a Roth IRA, too?

Yes, you can make a contribution to a SEP-IRA and a Roth IRA. See Chapter 2 of Publication 590, Individual Retirement Arrangements (IRAs), for the requirements to contribute to a SEP and a Roth IRA. However, your SEP IRA contribution and Roth IRA contribution can not be made to the same IRA.
posted by lhl at 6:11 PM on July 3, 2006

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