The 4 Types of Money- and What Types Are Tax-Advantaged

What types of money do you have? And no, I don’t mean credit cards, debit cards, cash, and checking 😁

When you get income, you have a choice of where to put it. There are 4 different types of money, each in a different “bucket”. What bucket does your money go into? 🤔

The first two buckets are your “right-now” money. That’s money that passes through your hot little hands; you don’t generally hold on to these two types of money 🤑

Free money is money you don’t have to work for; that’s winning the lottery, your grandma’s yearly $25 check for your birthday, your partner taking you out to dinner… 🎁

The last type of free money is what your employer matches into your 401(k). (This is the exception to the rule that the first two buckets are money that you spend.)

Taxed money is what we use to pay for our lifestyle. We earn money; and we pay taxes on it because Uncle Sam always gets his share. Then we use the rest to pay for our mortgage/rent, car, food, Netflix, etc. What’s in the savings account is also taxed money 🚗🏠🚴🎸🍺💵

The last two buckets are the money that we put away for a while. That’s usually our retirement money 👴🏼 👵🏼

Tax Deferred money is the money we contribute to our “tax-advantaged” retirement accounts. (You’ll see why I put “tax-advantaged” in quotations in a bit!)

These are our 401(k), 403(b), 457(b), and IRA accounts- the accounts that our employers usually set up for us. This bucket also includes real estate investments, and investments in the stock market, but we’ll talk about employer-sponsored retirement accounts (ESRAs) first 👨🏼‍💼

So what does “tax deferred” mean? It means that when you put money into ESRAs, it’s not taxed first!

You get a nice tax deduction- a reward from Uncle Sam for being responsible and saving for Your Future. You put money into this bucket, it’s not taxed, and it grows and grows tax-deferred for as many years as you want 💸

But remember, Uncle Sam always makes his buck- so what’s the catch? The catch is a pretty big one, and it’s why I always put “tax-advantaged” in quotations. When you take your money out of this bucket… it’s all taxed. Every penny- both your initial contribution, as well as everything you’ve made over the years due to the power of compound interest 😨

And what will your tax rate be, when you need this money? Well, no one can predict the future exactly… but consider the increased national debt due to the Great Recession; a minor income tax reduction in 2018; and the CARES Act of 2020. I’m going to bet that tax rates will be much higher than currently, long before I retire! 📈

Real estate and stock market investments work a teeny bit differently. Your money gets taxed before you buy real estate or invest in the market, but you don’t pay taxes as that money grows. And then, when you sell your investments, you pay capital gains taxes on this. This is usually lower than your income tax rate, so that’s Uncle Sam’s way of throwing you a bone: “You paid your taxes and then invested, so when we tax you again on the sale of your investment, we’ll take a wee bit less.” Aw, thanks! 😍

So, you access your tax-deferred money from this bucket, either from retirement accounts or investments. It’s grown and grown over the years… but you have to pay taxes on all of it. That stinks! Luckily, there’s a fourth bucket we can use to protect some of our money from Uncle Sam 😅

The fourth bucket is your Tax Free Distribution money. That’s what we contribute to Roth accounts and TFIAs (tax-free indexed accounts). This money gets taxed first; technically, it gets taken out of your Taxed Money bucket, then you put it into a Roth or TFIA.

You do pay taxes on this money on the front end- let me repeat, Uncle Sam always gets his share- but this bucket has the real tax advantage.

Because once that money is put into your Tax-Free Distribution bucket, it grows and grows. And when you need that money, you’re not going to care what your tax rate is! Because that money comes out of your bucket tax-free in your retirement 🤯🤑

When your money doubles… triples… quadruples… and more due to the power of compound interest, you’ve already paid your taxes. Uncle Sam can’t get any more from you! ✔️💰

So what’s the “best” bucket? Free money, of course! But Grandma’s checkbook isn’t going to sustain you forever, right? And if your Grandma’s checkbook will… is she adopting?! 🤣

In all seriousness, all these buckets have their place ⚖️

Free money is, well, free! Most of it ends up getting taxed, like lottery winnings or a 401(k) match, but not having to work for it is a pretty sweet deal 💲

Your taxed money is amazing because that’s what you live on! I like food with my dinner, so I will keep putting money into that bucket, for sure 🍎

Your tax-deferred vehicles are great because they give you a tax deduction in your current tax year, and they are managed by your employer as long as you’re with that employer. That makes it easy to manage 💵

And your tax-free distribution accounts give you the most bang for your buck. You pay taxes on your initial contribution, and then Uncle Sam leaves you alone forever 💸

There are lots of smart ways to divvy up your money into these buckets in order to meet your financial goals. But make sure you are being conscious of which bucket you’re putting each of your dollars into 🤔

Now That’s Smart Money 🧐