Category: finance

Money has to be held in some form or the other. It could be cash, physical gold, land, or more conveniently accounts. The blog post is only about the last one.

Normal accounts (or non-retirement accounts) – held at banks

1. Checking account –
   1. Post-tax contributions
   2. Earnings are realized immediately and taxed as ordinary income
   3. Account will never go down in value (insured by FDIC for up to the first 250K $)
   4. money is highly liquid – can be deposited/withdrawn at any time (and absolute limits on deposit/withdrawal are usually of the order of 10, 000$ per day)
2. Savings account
   1. Post-tax contributions
   2. Earnings are realized immediately and taxed as ordinary income
   3. Account will never go down in value (insured by FDIC for up to the first 250K $)
   4. Money can be deposited anytime but can only be withdrawn six times per month

Investment accounts (for lack of a better term) – held at stock brokers
These can be held as retirement or non-retirement accounts. Tax treatment of contributions/earnings/withdrawals depends on the type of parent account they are part of.

1. Money market account
   1. Post/Pre-tax contributions (depending on whether its a pre-tax account or post-tax contribution account)
   2. Earnings are realized and taxed as ordinary income
   3. Primarily used for holding money temporarily before it is used for stocks or bonds (or more exotic things like options)
   4. The account can go down in value, though it happens rarely
2. Brokerage account
   1. The account which holds holdings in stocks/bonds
   2. Earnings are not realized till a sale happens and then taxed as ordinary income or capital gains/losses depending on the holding period

Retirement accounts – held at stock brokers

Retirement accounts provide certain tax advantages (like tax-free or tax-deferred growth), usually, these accounts come with a restriction like money cannot be withdrawn at all till the age of 59.5 years or can be withdrawn before that by paying a penalty (account-specific details are given below).

IRA = Individual retirement account, just like a bank account, anyone can open it at pretty much any broker.
401K = employer-sponsored account, can be opened only by the employer and contributions can only be made directly via paycheck [and employer contributions], the choice of funds to invest is also controlled by the employer, sometimes, employers provide a match to encourage employees.

1. Traditional IRA
   1. Direct contributions have a maximum limit (5,500$ annual limit in 2013 for people below the age of 50).
   2. Contributions are tax-deductible if income is less than a certain limit (limits are pretty low, though).
   3. Earnings are tax-deferred but taxed as ordinary income on withdrawal.
   4. Money can be withdrawn after the age of 59.5 (or before with a 10% penalty unless it’s a case of financial hardship).
   5. On leaving an employer, its 401K plan can be converted to a traditional IRA account.
   6. See more gory details on the Wikipedia page.
2. Roth IRA
   1. Direct contributions have a maximum limit the same as traditional IRA but the income limit to make contributions is much lower.
   2. Indirect contributions can be done via rolling over 401K money (if the employer allows) or backdoor Roth IRA (contribute to Traditional and convert to Roth).
   3. Earnings are tax-free.
   4. Contributions can be withdrawn after a seasoning period (5 years) with no penalties (provided there is a reason – like financial hardship).
   5. Earnings can be withdrawn after the age of 59.5 tax-free or by paying both tax and penalty (10%) before that age.
   6. Roth IRA is the only retirement account with no RMD (required minimum distribution clause).
   7. See more gory details on the Wikipedia page.
3. Pre-tax 401K
   1. Contributions are pre-tax (max employee annual contribution limit $17.5K – must come directly from paycheck), and employer contributions are not counted towards this limit (they are subject to a total retirement contribution limit which hovers around $50K).
   2. Earnings are tax-deferred.
   3. Withdrawals are taxed at ordinary income tax at the time of withdrawal.
   4. Some 401K plans don’t allow any withdrawal (even for financial hardship) till the age of 59.5
   5. An employer decides which funds will be available for a 401K plan.
   6. See more gory details on the Wikipedia page.
4. post-tax 401K
   1. Contributions are post-tax. (same limit at pre-tax 401K)
   2. Earnings are tax-deferred.
   3. Contributions are withdrawn tax-free, and earnings are taxed at ordinary income tax at the time of withdrawal.
   4. Some people prefer post-tax since they can effectively contribute more money into the account.
5. Roth 401K
   1. Similar to Roth IRA in the sense that contributions are post-tax (for most people) and earnings are tax-free.
   2. Withdrawal through is controlled by the employer and might not be possible without leaving the employer or attaining the age of 59.5.
   3. Usually, it’s a good idea to convert post-tax 401K to Roth 401K (or Roth IRA) if that choice is available in the employer’s plan.
6. Some other exotic options like SEP IRA, and 403(b) plan – I don’t know these and they won’t be covered here

Retirement accounts (summary)

Which plan should a person go for?
See my next blog post for the same.

1. Contributions – Money being put into an account is called a “contribution” to that account.
2. Earnings – Money “earned” in an account. Usually, as an interest or dividend on the money contributed but can also include things like bank bonuses.
   As a concrete example, a person opened a new bank account and “contributed” 1000$ in the account, the bank gave him a 150$ bonus and by the end of 31 Dec, the account earned and interest of 35$, the “earnings” will be 185$ (150 + 35).
3. Withdrawal – Money “withdrawn” from an account of one type into an account of a different type. Movement of money between accounts of the same type is not withdrawal.
4. Realized and Unrealized gains – Suppose a person buys stocks worth of 1000$ and it gains 5% in one month, the gain of 50$ in this case would be “unrealized” till the person decides to sell the stocks, at which point, the gain is “realized”.
   Why does this matter? As per the contemporary IRS rules, gains are taxed on realization based on tax laws at the time of the realization.
   Note: In the case of bank accounts, earnings are realized as soon as the bank pays interest at the end of the month.
5. Pre-tax contribution – A contribution made from the pre-tax money, the money from which state and federal income tax have not been deducted.
6. Post-tax contribution – A contribution made from post-tax money. Such a contribution won’t be taxed again (provided the person is careful), the earnings on it might/might not be taxed depending on the type of account earnings were generated in.
7. Tax-deferred growth – An account where earnings are not taxed till a withdrawal is made from the account (what if 10% money is withdrawn from the account? well, that is account specific and will be covered in a different blog post)
8. Tax-free growth – An account where earnings are not taxed ever – usually these accounts have certain constraints like age at the time of withdrawal should be more than 59.5 or money should be held in the account for a certain period of time or both. Trivia: Mitt Romney holds money in one such account.
9. Equity – A piece of ownership of land or company
10. Share/Stock – A piece of ownership of a company
11. Bond – A piece of ownership of a debt given to a company. Safer than stock but yields lower return.
12. Options/Futures/Currencies/Shorting/Margin trading – A collection of exotic complicated financial instruments which I don’t fully understand. Please refer to one of the references if you are interested.
13. Municipal Bonds (munis) – The earnings on these bonds are not subjected to federal and state taxes as long as they are from the same state as the buyer’s state of residence. High earners love these.
14. Ordinary income tax – A tax which applies to regular income  like salary and interest paid by the banks. This tax has both state and federal tax components.
15. Capital gains tax – A tax which is applied to the appreciation in value of an equity (like stock or house), this tax is either short term (if holding period of equity is less than 365 days) – where it is counted as part of ordinary income or long-term – where it gets a preferred treatment and is taxed on a lower rate (more on this in another blog post).
16. Required Minimum Distribution (RMD) – A lot of retirement accounts mandate that the owner must start withdrawing a certain amount of money from the age of 70.5, the minimum withdrawal limit is controlled by IRS [source].
17. Expense Ratio – A percentage of money which a mutual fund eats into every year. Eg. if expense ratio is 1% than a contribution of 1000$ with 10% gain will become 1090$ at the end of the year.

Trivia: Reason being 59.5 being the retirement age is detailed here.