6. Alternative IRA: the Roth IRA
The Roth IRA is considered to be a hybrid retirement and saving vehicle. This retirement account is to be funded using after-tax income dollars. The saver is effectively paying the taxes up front rather than in the future, and that allows even the withdrawals from Roth IRA accounts to be tax-free when the rules are followed properly. Figuring out the benefit of a Roth IRA versus traditional IRA accounts generally depend on a person’s tax bracket today versus the expected tax bracket in his or her retirement years. Generally a Roth IRA makes more sense for investors who expect their tax rate to be higher during retirement than their current rate. Again, there are phase-out limits as well above certain taxable income levels.
If you are an employee of a company, chances are high these days that if you have a retirement plan it is a 401(k) plan. These defined contribution plans allow eligible employees to contribute up to $19,000 per year, up from $18,500 in previous years, using pre-tax dollars. Similar to an IRA, assets in a 401(k) grow on a tax-deferred basis and are taxed when the person withdraws the funds.
What is so attractive about a 401(k) plan is that employers often match an employees contributions, either dollar-for-dollar or a portion of each dollar, up to a certain percentage of their income. That continued contribution and matching dollars get invested over time and enjoys the advantages of compound returns.
There are some risks and pitfalls to 401(k) plans. Many employees choose to liquidate their funds when they leave one company to go to another or if they are terminated. This early withdrawal gets taxed, and the IRS imposes a 10% penalty on funds that are withdrawn before eligibility.
8. Master limited partnerships
Master limited partnerships (MLPs) are a type of limited partnerships that are publicly, therefore provide the tax advantages of limited partnerships and the liquidity of publicly traded securities. Because most MLPs are in the oil and gas business, they often move along with the broader economy and the ups and downs of the oil and gas markets.
The tax advantages comes from the fact that the MLP’s distributions are not considered dividends. The breakdown varies from partnership to partnership, and there dozens of public MLPs trading today, with each distribution a combination of income and a return of capital. The income portion is taxed, but the return of capital is not taxed and acts to lower an investors cost basis over time. Any capital gains made in MLPs are subject to normal capital gains taxes, and these come with K-1s rather than dividend forms for your tax filings.
9. 529 / college savings plans
A 529 plan allows a family to set aside funds for a child’s college education. The IRS does not generally allow these to be used with pre-tax dollars, but the funds grow tax-free if they are withdrawn for specified and qualified education expenses. These funds can also be used as a family trust of sorts because any leftover funds that pass down to the child in the adult years grow without being taxed until the child’s retirement. There may also be gift tax consequences if there is more than $14,000 contributed to the 529 in a single year, and there are lifetime contribution limits per account. The tax reform has also allowed a more general use of 529 plans for other educational purposes long before college years.
10. UGMA/UTMA accounts
The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) allow for minors to own financial securities. Usually parents open such accounts on behalf of their children, add funds, and are the custodians of the accounts. The tax benefit of these accounts is that often a portion of the investment can be considered a tax-free gift. Another advantage is that child’s own tax rate can apply to these accounts rather than the parents’ rate.
While there are no restrictions on investment classes in a UGMA account, the funds are allowed to be spent on anything (even non-educational expenses) for the benefit of the child. Generally, donors to the UGMA/UTMA accounts can claim up to $13,000 per year, or $26,000 for couples filing jointly, as a tax-free gift. The downside here is a loss of control over the fund when the child reaches the age of maturity — then the account is theirs to spend however they see fit.