Let’s sift through the number soup of financial terms
401(k)… 403(b)… 501(c)3… it’s easy to see why so many people get confused about the alphabet soup that is modern financial vernacular. What was originally intended to help clarify the rules around different types of income and taxes has ballooned over the years into a numerical jumble that can leave many folks scratching their heads.
The good news is, only a handful of these terms are particularly relevant for most investors. Learning the basics of those can help dispel much of the confusion.
First, where did all these terms come from?
Each of these numbers corresponds to a different section of the Internal Revenue Code (IRC). The IRC refers to Title 26 of the U.S. Code, which is described in the preface as the official “consolidation and codification of the general and permanent laws of the United States.” Title 26 covers all relevant rules about income, gift, estate, sales, payroll, and excise taxes.
Although the IRC contains nearly a dozen different categories with over one million words, a few key sections pertain to retirement accounts, charities, college savings, real estate, and insurance. So, let’s take a look at each of these.
Understand retirement accounts
A 401(k) is a company-sponsored retirement account that lets employees contribute income and allows employers to match those contributions. There are two basic types – traditional and Roth – with the primary difference being how they are taxed. In a traditional 401(k), employee contributions are made pre-tax, reducing the employee’s taxable income. Employee contributions to a Roth 401(k) are made with after-tax income. As a result, withdrawals are tax-free.
A 403(b) is very similar to a 401(k) in that it allows employees to save money for retirement through payroll deductions. The primary difference is that 403(b)s are designed to serve employees of public schools and tax-exempt organizations. A participant’s investment choices may also be more limited with a 403(b) than with a 401(k).
A 457 is another similar retirement savings plan. It’s available to employees of state and local governments as well as some nonprofit organizations. Like both the traditional 401(k) and 403(b), it allows employees to deposit a portion of their pre-tax earnings and reduce their income taxes for the year.
A 401(a) is another employer-sponsored retirement plan that allows dollar or percentage-based contributions from the employer, the employee, or both. They are most commonly used by governments and nonprofit organizations.
Charitable organizations have tax categories
The 501(c)3 classification refers to a specific tax category in the IRC for nonprofit organizations. Organizations that meet the requirements for 501(c)3 status are exempt from federal income tax. Most eligible organizations fall into one of three categories: charitable organizations, churches and religious organizations, or private foundations. Organizations that qualify for the 501(c)3 designation can tell donors that all donations made to them are tax deductible.
The 501(c)4 code provides tax exemption for two different socially conscious groups: Organizations like civic leagues, which are not organized for profit, but which function exclusively to promote social welfare, and local employee associations where the net earnings are devoted to charitable or educational purposes. While 501(c)4 organizations are tax exempt themselves, donations by individuals to these groups are generally not tax deductible like a donation to a 501(c)3 organization.
Save for college
The tax-advantaged 529 savings plans were originally designed to help pay for postsecondary education costs but have since been expanded to cover both K-12 education and apprenticeship programs. There are two major types of 529 plans: education savings plans, which grow tax-deferred and provide for tax-free withdrawals (as long as they’re used for qualified education expenses), and prepaid tuition plans, which allow users to pay current tuition rates for future attendance at designated colleges and universities. The 529 plans are sponsored by all 50 states and the District of Columbia and can be purchased either directly from a state or via a broker or financial adviser.
Real estate in business
Section 1031 of the IRC provides for deferring federal taxes on certain real estate exchanges. It’s used by business owners or investors who are selling one property and reinvesting the proceeds in other properties. As such, it’s not available to buyers or sellers of personal homes for their own use.
Understand insurance
Finally, a 1035 exchange is a provision of the IRC that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or similar endowment. Although the rules will vary by company, both full and partial 1035 exchanges are permitted under the IRC. Typically, however, section 1035 exchanges require that the transaction involve the same type of insurance product.
Navigate the numbers
As you might expect, the Internal Revenue Code has hundreds of other provisions and guidelines across its many categories, dealing with everything from “miscellaneous excise taxes” to “coal industry health benefits.” But the codes and plans outlined above cover the most relevant topics for most individuals and families. Still, getting lost in the sea of numbers and acronyms that make up so much of today’s financial terminology can be easy. So if you have questions – whether about optimizing your tax strategy, planning for retirement or more – reach out to our professional team of financial advisers today.
Hunter Yarbrough, CPA, CFP, is an executive vice president and financial adviser with CapWealth. He is passionate about taking a holistic view of personal finance, including investments, taxes, retirement, education, estate planning, and insurance. For more information about Hunter and CapWealth, visit capwealthgroup.com.