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Three Account Types and Why You Need to Know About Them
Episode 12017th October 2023 • Financial Life Planning for Busy Parents • Mike Morton, CFP®, RLP®, ChFC®
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What if I told you that you could be paying thousands of dollars in unnecessary taxes every year on your savings? You might think I have some savvy financial trick up my sleeve to save you from Uncle Sam, but the opposite is actually true. In this episode, it's all about the basics. Basic account types, that is: The Three Musketeers: Taxable, Tax Deferred, and Tax Free  

Taxable Accounts: The Draining Leak in Your Pocket

Taxable accounts include your checking, savings, and brokerage accounts. The unfortunate characteristic of these accounts is that every year, like clockwork, a portion of your hard-earned money gets siphoned off to pay taxes. Imagine this as a leak in your financial bucket, slowly draining your resources.  

Tax Deferred Accounts: Delayed Taxation

With these types of accounts, you haven't paid taxes on the money yet. Think of traditional 401(k)s, IRAs, and similar accounts. While it might seem like you've got a pot of gold, remember, a chunk of that treasure belongs to the government. You're merely holding it in trust until the taxman comes knocking.  

Tax Free Accounts: The Holy Grail

These accounts are the gems of the financial world. Once you've paid your taxes, your money gets to grow, flourish, and multiply without being haunted by the specter of taxation. Roth accounts, such as Roth 401(k)s, Roth IRAs, 529’s and the beloved Health Savings Accounts (HSAs), fall into this category. Once you've entered the realm of tax free accounts, you've found the holy grail of personal finance—a place where your money can thrive without the relentless bite of taxes.  

Which is Best?

In the world of finance, understanding these account types is akin to wielding a shield against the ever-present taxman. By choosing the right account types, you can strategize and minimize the amount you pay in taxes, leaving more money in your pocket.  

Let's Review an Example

To drive this point home, consider the following real-client scenario: Joe (not his real name) is a diligent saver with most of his funds parked in his brokerage account. While he had managed to save, he hadn't optimized where he was putting that money. A large portion of his savings sat in taxable territory, meaning he was hemorrhaging money in taxes every year. The story of Joe is not uncommon. Many individuals find themselves in similar situations, unknowingly losing substantial amounts to taxes, all due to a lack of understanding about account types. Need more convincing? Take a look at the following chart to see the difference between taxable, tax deferred and tax free accounts. Using the following assumptions, it is clear that choosing the right account type makes a significant impact on your overall savings.
  • Compounding Growth: 6% Growth + 2% Dividends (8% total)
  • Income Tax Bracket: 24%
  • Capital Gains Tax Bracket: 15%
 
ROTH 401k Traditional 401k Brokerage
Year Brokerage Roth 401k Brokerage Traditional 401k Brokerage Traditional 401k
0 $4,600 $22,500 $10,000 $22,500 $27,100 $0
1 $4,946 $24,300 $10,752 $24,300 $29,138 $0
2 $5,318 $26,244 $11,561 $26,244 $31,329 $0
3 $5,718 $28,344 $12,430 $28,344 $33,685 $0
4 $6,148 $30,611 $13,365 $30,611 $36,218 $0
5 $6,610 $33,060 $14,370 $33,060 $38,942 $0
6 $7,107 $35,705 $15,450 $35,705 $41,870 $0
7 $7,642 $38,561 $16,612 $38,561 $45,019 $0
8 $8,216 $41,646 $17,861 $41,646 $48,404 $0
9 $8,834 $44,978 $19,205 $44,978 $52,044 $0
10 $9,498 $48,576 $20,649 $48,576 $55,958 $0
11 $10,213 $52,462 $22,201 $52,462 $60,166 $0
12 $10,981 $56,659 $23,871 $56,659 $64,690 $0
13 $11,806 $61,192 $25,666 $61,192 $69,555 $0
14 $12,694 $66,087 $27,596 $66,087 $74,786 $0
15 $13,649 $71,374 $29,671 $71,374 $80,410 $0
16 $14,675 $77,084 $31,903 $77,084 $86,456 $0
17 $15,779 $83,250 $34,302 $83,250 $92,958 $0
18 $16,965 $89,910 $36,881 $89,910 $99,948 $0
19 $18,241 $97,103 $39,655 $97,103 $107,465 $0
20 $19,613 $104,872 $42,637 $104,872 $115,546 $0
SUBTOTAL $21,088 $104,872 $42,637 $104,872 $115,546 $0
Pay Taxes when you sell -$2,252 $0 -$4,896 -$25,169 -$13,267 $0
After Taxes $18,836 $104,872 $37,741 $79,702 $102,279 $0
TOTAL $123,707 $117,444 $102,279
So, what can you do if you suspect you might be in a similar predicament? The first step is awareness. Understanding the nuances of account types arms you with the knowledge needed to make informed financial decisions. From there, it's all about devising a plan to move your money strategically, exploring tax deferred options where applicable, and aiming for the coveted tax free accounts. While it might seem overwhelming, remember, financial freedom is often a journey of small, intentional steps. And with each step, you're one stride closer to keeping your hard-earned money where it belongs—in your pocket.

Transcripts

Matt:

Three accounts walk into a bar and the bartender says, wait, is this some kind of a financial planning joke? Hey, it’s Matt I am co hosting with Mike Morton on the ever evolving named financial life planning for busy parents with young kids and also siblings, maybe parents who are older than them who also they want to care for and who may have resources and something like that. I don't know, Mike, was that close?

Mike:

All of the above? Yes, Correct. For everybody who has money, or who want money.

Matt:

You know, they're always prompting you these days. It's like, you've got to engage with your audience, ask them questions, get them talking. Here's one, why don't you hit us with a five word version or less of a business partner?

Mike:

I got it, right. It's life planning. There you go.

Matt:

It was like, you know what you're gonna get if you watch this movie, Snakes on a Plane tonight, you're gonna get alright, you want to talk about your kind of kidding about three accounts walk into a bar, you want to talk about three different account types. This is actually I snuck a peek at your notes on this. No. This is more interesting. This is going to hit a lot more than people think then it sounds like on the surface, what do you want to talk about?

Mike:

So I kind of want to get back to basics, but we'll also throw in some nuances and some stories and stuff. But this is back to basics on account types. And there are three types of accounts even though there's a variety of names out there, 401K's for through breeze brokerage checking savings, deferred comp for these sounds. We go on and on that how many do you want?

Matt:

So what you're saying is there are Edwards there are Jacobs and then there are people who are not into weepy preteen vampire drama.

Mike:

Yes and Matt just took us completely sideways.

Matt:

I assume that I assume, wait, vampires don't come in at this. You lost me.

Mike:

Yeah, well, you just lost everybody. So let's go back, you know, even though you have all these names for all these different types of accounts, there's three different versions or account types, even though they come in a variety of names. And those are this, okay? There's taxable, there's tax deferred, and there's tax free. Alright, so those are the three major categories of accounts, either it's a taxable account, where you are just paying taxes every year, those will be a taxable account. It's a tax deferred, account deferred, you have not paid taxes on the money in that account yet, and tax free, where you've maybe paid taxes already, but at least you will never pay taxes again on that money. So those are three account types taxable, tax deferred, and tax free. Alright.

Matt:

For people who may be wondering, like, what's in this for me? Why is it important to understand the distinction? Okay, what's, what's the matter?

Mike:

Yeah, what's important is because it's all about taxes. So a lot of the work that I do, you know, more and more, I realized that it just comes down to taxes, like everything we talk about has a tax implication and it matters for you, because you're paying taxes to the government, in one way or another and there are a variety of strategies and rules that you can avoid paying some of those taxes. And so the more you can avoid paying taxes, the more dollars are in your pocket. And that's why, you know, it pays to know about the different account types. And then we can get into, you know, of course, some stories and why you want to really pay attention to it and be smart with your money and make your money work for you and not just for the government.

Matt:

I want to urge people to pay attention to this because I have a sneaking suspicion. I don't think this is like conspiracy theory Matt time, I think this might be real. My wife and I talk constantly about how we don't understand the economics of other people's lives, we don't understand why other people seem to be able to afford all kinds of things that feel like, wow, can you afford this? Like, they're going on trips and they're like, doing activities, and their houses look swanky or not that we care about swanky. You know what I mean? Like, it just seems like people are going to like go to lots of big sporting events and it feels like treat yourself from Parks and Rec. It's like people are treating themselves and we don't understand why do they seem to have so much more money and now you're making me suspect that they understand the differences between account types in a way that we don't and they have more money than we do. We're like bleeding money from our pockets, is this real?

Mike:

Yes, that's absolutely real. Yeah, because I've followed you down the street Matt and there's literally dollars coming out of the your pants pockets. That's why I like walking around behind you.

Matt:

That's the best version of what can be coming out of my pants. Wait, hold on so is this real? Like, I mean, do people really truly lose? You have a lot of clients, are people really losing money from their pockets as we speak right now?

Mike:

Yeah, so let me tell you a story. I do want to get back to some of the names, right? Because you might be wondering which kinds of accounts show up in these different categories, so we can get back to that. But let me tell you a story. I was meeting recently with, let's call him Joe. And this is very typical Matt. So I give a questionnaire when I'm first meeting somebody, just tell me a little bit about yourself and a little bit about your finances where you've got some money and stuff like that. So he has about $400,000 in the brokerage account, checking savings brokerage account, they're very good savers. Joe and his wife are very good savers. And so they've saved about $400,000 or so in their brokerage checking and savings accounts. A little bit of like $100,000 or so in 401K accounts, they've got employers, so $100,000-150,000 in 401k's and that and those would be traditional 401k's and then nothing in Roth accounts or any IRAs. Okay, and they've been working there. I think this couple is in like their 30s and have been working for 10 years or so. So they built up like some state and they're very good savers. So now you can see that’s great, they've got $500,000-$600,000 saved, but a vast majority of it is in their brokerage account, which is a taxable account. So every year, whatever investments, they have interest dividends, that they make trades, all gets taxed every single year $400,000. They have about $100,000 in the 401k tax deferred, and nothing in individual retirement accounts and nothing in tax free Roth accounts. And so they've missed an opportunity, you know, over the past years to be saving in tax free accounts, saving on taxes, getting more of that money growing for the next 30, 40, 50 years in 401K's, Roth IRAs, other tax free accounts, and that's going to cost them $100,000 easily over that time.

Matt:

So two things, one, this is really painful. Everything you're saying here is very painful. This is actually not a secret to Mike, it is a secret to our listeners, I'll divulge it. Joe? Joe is not me. I know this is actually a client, this is not me. But Joe's situation may bear some resemblance to my situation and I feel bad because I host a financial planning podcast with you, Mike. This is bad. Do as I say not as I do. But yeah, this is really making me think that my first fear might be very real. Because what you're outlining with Joe, I'm not sure if the numbers quite line up in our situation with Joe's but yeah, I'm probably literally paying thousands of dollars more in taxes every single year. So if I'm paying $5,000 in taxes more than I have to be, there's that swanky vacation that our neighbors are taking or there's that amount of college savings that I'm not putting away. Here's the reason, I'm being dumb about taxes. Well, thanks. Thanks for that. Okay, I feel I feel awful. But I imagine I shouldn't feel that bad because I imagine that many of our listeners are probably in the same boat, is this really common?

Mike:

This is very common, especially for good savers, Matt. So I know you're a good saver. And so you save money and people that are good savers, naturally, you know, have a paycheck coming in, and they're like, hey, I need to save a thousand a month or whatever it is. And you just siphon it off. And it ends up in that checking savings. And then you get investments in that brokerage account and so that's what good savers do. But what we want to do is be smarter with our money and get it into these accounts that the IRS the US government has put special tax provisions on to save you, the American from paying an exorbitant amount of taxes, just pay the taxes. I always say, pay the taxes that you owe to the government, but you don't need to leave them a tip.

Matt:

Right, right, right. Well, I know you wanted to get back to laying out a little bit more of the nuts and bolts of what kinds of things we're talking about here, so I'm going to ask this to you in kind of the Jeff Foxworthy way. It's like, if this is true, you might be a he's allowed to call people right next no, I'm not going to do that. So how would you know tell us a little bit more about the nuts and bolts like what would be the telltale signs that your Joe?

Mike:

So a couple of telltale signs, one would be the situation I just described. You have more money in your checking savings and brokerage accounts than you do your 401 K's, your IRAs, your tax deferred tax free accounts. Second thing is where you're saving, we've done episodes on kind of the waterfall like where to save that next dollar, make sure that you're maxing out the employer benefits. Okay, so like, wherever you're employed, make sure you really look through those benefits. I do this for all my clients, your benefits package, let me read through it and I find stuff in there, it's hey, are you taking advantage of XY and Z, and they're like, I’ve never even looked at this stuff. So make sure you look through your employer benefits. There's a lot of stuff, especially larger employers put a lot of things in there, you can take advantage of, especially saving money, make sure you're maxing out if you're a good saver. And you can make sure you're maxing out your 401K's your 403B's make sure you're maxing out your individual retirement accounts, you know, on top of those. So those are a couple things that you would know, if you're in this category where your money is currently saved. And then this year 2023-2024, where you're going to be saving your money.

Matt:

That is helpful. I actually just, it's interesting. When you say employer benefits, I am with you, because they're sneaky. And they're not always in the kind of like you laid out the three account types, right. And it's not always the most obvious places. I worked for a large company for many years. And when I became an employee, I discovered that it was for like $1 a month, it was some insanely low rate that they would take out of my paycheck, and they would give me $100,000 of life insurance. That was a nice benefit. That was really great and you've talked a lot about how you love health savings accounts, there's all kinds of sneaky things that they will help you set up. And some of them are obvious, like the 401k type stuff. And some of them are a lot less obvious. And I'll tell you ever since I went to a part time basis, so that I could spend more time working on things like this, I've kind of done exactly what you just said, I let those things slide. I don't think I have life insurance now. Right. But this is so bad, you know, like, this is a whole different show, we need to have a whole different show where it's like the thing is Matt is doing that you should not do we get to do 20 shows out of that, anyway, so what you're saying is, it's actually it's not that hard to know to find that like you might be basically spending thousands of dollars a year on taxes that could be yours that you could be spending on other things. It's not that hard to discover that. Here's a question for you. How hard is it to fix?

Mike:

Well, unfortunately, it's really hard to fix if you find yourself in Matt's situation or Joe's situation where you've got all this money now in these taxable accounts. So that's why looking forward and making sure you're taking advantage of the benefits and the account types that you do have access to this year and next year. But there are ways of doing it man, I run across a lot of people, you'd be familiar with this. Mike, I can't possibly save more money, in fact, we're spending more money I've got now teenagers and they're eating me out of house and home. See, my boy is now 15 and it's like you have a normal dinner. But then I come down in the morning and the fridge is empty. Literally the entire fridge is empty. And I'm like what happened between 9pm and 6am?

Matt:

I know what happened. Okay, first of all, your son is too tall for this, but I think he's a hobbit. I think it's like six meals a day. Yeah, we've had one breakfast. Yes, but what about second breakfast? Okay, this is there's so much second breakfast happening here. It's alright, anyway, kids are eating you out of house at home.

Mike:

Kids are eating you out of house and home. The sports activities are just getting so much more expensive. Remember when they were like six and it was like 50 bucks to join the league.

Matt:

That’s because we were we were neglecting our children. Yeah. Hey, Timmy, go play baseball. It's like all I have is this board with the rusty nail in it, sounds great kid!

Mike:

That'd be fun, yeah, so you enter this, these different periods where it's harder to save money. So I have a lot of clients that I can't take full advantage of, I'm taking advantage to get the free match and I'm doing what I can there. But I don't have more money to save, you know, into my individual retirement account. So this is where you get in this quote unquote, money laundering. Hey, don't worry if you can't, you know, put more into the 401k, it doesn't have to come out of your paycheck but I understand you need to live on your entire paycheck like things are now expensive during this period. So instead, you've got some taxable savings, you've got that $400,000 just sitting in that brokerage account. Now mentally, you've it out, you're like that's for retirement, I don't have that money to spend like it's saved out there. So I understand that but what you could do is in your paycheck, take $10,000 from your paycheck, shove it in the 401k. So now you've reduced your pay check, you're like, Mike, I can't live on a reduced paycheck, okay, but take the $10,000, get a reduced paycheck, and then take $10,000 from your brokerage account, put it in your checking account. And now you spend that on your everyday expenses for this year. Okay. And that's why we call this money laundering, your paychecks gone down, you're getting the full 401k, and you're spending from your brokerage. So it's as if you took $10,000 from your brokerage and shoved it into this tax deferred tax free account, and now that $10,000 will be growing tax free or tax deferred forever. And instead of growing in the taxable account where it was, so that's how you can work on trying to fix this overtime. Are you ready to create your ideal lifestyle? Let's discover what's most important to you and design a plan to have more of that in your life. Go to meet Mike morton.com, all one word, meet Mike morton.com.

Matt:

I am going to live on the air take our listeners inside behind the scenes into the factory where we produce, this is like the industrial complex, where we make financial life planning. Mike, everything you just said was amazing and I think it's going to be super useful to as you just said, to a lot of people, I urge us, we're going to do a follow up episode where we're going to walk through this very, very slow. It's the rescue plan for people who find themselves in Joe's situation, I urge us to do this, because there's actually a lot of really important pieces to this. It's not like you can't just do it but it does sound like, let me see if I can read that back. It sounds like it's not necessarily hard to get yourself out of this situation where you're, again, can't say this enough, spending thousands of dollars a year on taxes that you don't have to amd you're losing money. It's not hard. But it might be it might take a long time to dig yourself out. Is that true?

Mike:

Yeah, that's accurate. That's exactly right. And we shouldn't dig into it because there's other stuff I mentioned, the 401K's but you can do this with HSAs. I have a lot of clients that do that, too. So we should get into the details and go slowly and yeah, walk through that. Yeah, that's great.

Matt:

I totally think we should do that, because I think I almost think this is the kind of thing that you could almost put on your website as just like a step by step. But again, it does sound like from what I've heard from you, not just here. But when we chat, we do talk about other things than just these topics. Sometimes we do talk about these topics, it does sound like with all these things, there's, there's like details that you got to get right or you could just kind of compound your problems. So I don't think it's the kind of thing where you're like giving away the store for free here. Like I think I think you really could give an overview and when I've thought about this topic, again, I'm just asking you to read back if this is true, the sense I've gotten is if you invest a little bit of time, and you commit to Okay, I'm gonna get myself out of this and it's worth it. Because let's just take that number, $5,000 bucks a year, I'm gonna save myself $5,000 bucks a year, what is your hourly rate of pay? If you make $100 an hour, then you could spend 50 hours on this, but you're not going to, you're going to spend maybe five hours on this. And you're going to do it like once and then thereafter, you're just going have to follow through over time. So it’s super worth it like would you spend five hours and get $5000? You would say yes, right? Anyway, that's my pitch on this. Is that true? Is that right?

Mike:

Yeah, that's about that's about right, it does take a few hours of work, you have to figure out your situation. Again, we can walk through some different scenarios, but it's exactly the high level stuff we talked about. You want to take advantage of all of the benefits on the offer to you by your employer, and by the government. So that could be you know, your 401K or 403B, it could be individual retirement accounts, it could be HSA accounts, it could be other benefits, employee benefits. It can also be in there, Matt, another one, a sneaky one is after tax contributions to your 401k. We know the limit for this year is $22,500 as an employee, but a lot of larger companies allow additional contributions above that, and people don't know that and I find that often. So again, in that employee employer benefit package, there's stuff buried in there. So you really do want to spend a couple of hours, and go through everything and then come up with a plan, implement it, it takes a couple hours, and then check in every six months.

Matt:

This is so this is a huge psychological effect. I mean your gym takes advantage of this Your streaming platform takes advantage of it that it just seems like too much work to figure out like, how do I go and they make it a pain in the ass intentionally. This is a company strategy, right? Make things so they don't want you to do a pain in the ass thing. And the inverse of that is everything that behavioral economics and Richard Thaler had won a Nobel Prize literally for figuring out you know, if you want people to do certain behaviors, make it easy. Make it a default, make it step by step, break it down, just nudge people it's called, I sound like Trump here. It's called nudges. Yeah, that's literally what he calls his, like, nudge people. And that's, I think what this entire problem feels like to me is everything you just said, I'm familiar with this. And it just sounds like so much to bite off, like no more than I can chew. And what I want is to be a wind up toy. I'm not making a pitch for people to go out and hire you, per se.

Mike:

Why not?

Matt:

Because that would seem unethical, somehow, I don't know. Like, I could do what they want, do what you want. But what I really want is to go through that to have someone walk me through the census, the audit of like, here's where you're at. And let's break this down, here are the steps you need to take and then I want to time budget myself an hour this week, an hour inn our next week. I just want to break it down. And if I do that, it's not that hard. I'm literally trying to cut the cord on cable right now. If you're listening XFINITY first of all, screw you. Okay, second of all, Xfinity sent me a cable of a piece of equipment that I did not ask for. And they say they're gonna charge me for it. I want to cut the cord. But you know why I'm not yet. Because I have to do this process. I have to figure out what are the streaming platforms I have? What do I want? How much am I paying? Am I going to save money? How am I going to make all the services that I get through the cable company? How am I going to replace them? Do

Mike:

I got another I got an idea for you, man. Just cut the cord, get rid of everything. And then see how it feels for a week and then just add it back in and reacquire it.

Matt:

Yeah, that's such a great hack. I love it man. Again, it's such a good idea, there you go, Oh, my gosh, just saved you money. And during that week, here's how I make the hack. During that week, you are going to move into my house or I am going to move into your house and I'm going to complain to you about the fact that you don't have Netflix.

Mike:

No, I'm going to block your number.

Matt:

Great advice for speaking of which this has been really great advice. Anything you want to nail down on this three account types thing before we get out here because we obviously have a lot more to do on this topic.

Mike:

Yeah, let's go back to the beginning just really quickly taxable accounts. All right, your checking, savings, brokerage accounts, they get taxed every year so there's a drag on that and when I made spreadsheets you can find on my website we did a couple of weeks ago, the Roth versus traditional now got this one Roth traditional, the three brokerage tax deferred, traditional and tax free Roth, when you look at them, the taxable is terrible, you lose a couple of percent a year. And so if that's $100,000, that's one to two thousand bucks a year that you were just losing in taxes or you're spending in taxes. So those are taxable accounts, they're the worst place to save. Okay, now we have to save there, if you're a good saver, you're going to end up saving some money there. It's great. We want money in there because there's other benefits, it's accessible stuff and stuff like that, but they're the worst place to save money. Alright, so taxable accounts, checking, savings, brokerage accounts, tax deferred accounts, you have not yet paid taxes on this money so you're part of that chunk of money if you have $100,000 in a tax deferred account $75,000 of that is yours $25,000 is the government's. Alright, so it's not all yours, you haven't paid taxes on it yet. Those would be your traditional 401K's, traditional IRAs, rollover IRAs, inherited IRAs, traditional 403B's, okay, so those kinds of accounts you haven't paid taxes on, and then tax free accounts, some of our favorite because you rip the band aid off, you paid your taxes, the money is growing tax free, you'll never be taxed on it again. Those are Roth accounts, Roth 401K's Roth 403B's Roth IRAs, and our favorite HSA is also growing tax free and will be tax free. So those are the kinds of accounts that are tax free.

Matt:

Got it. And the takeaway that is really helpful information for me to take away is if this seems like a lot it is but it's actually I actually feel better now having talked to you about this and we obviously are going to do more, but I think that this sounds HACC global. And so if people out there are getting a little bit nervous, like I have a feeling that I'm missing several thousand a year, there is light at the end of the tunnel and that's that's awesome. All right. Mike Morton, thanks so much.

Mike:

Thanks, man. Thanks for joining us on financial planning for entrepreneurs. If you liked what you heard, please subscribe to and rate the podcast on Apple, iTunes, Google Play Spotify, or wherever you get your podcasts. You can connect with me at LinkedIn for Morton financial advice.com. I'd love to get your feedback. If you have a comment or question, please email me at financial planning pod@gmail.com. Until next time, thanks for tuning in. This recording is for informational purposes only and should not be considered for investment advice or opinions expressed as our of the date of recording. Such opinions are subject to change. We do not guarantee the accuracy or completeness of the data presented here.