Four Kinds of Money- Part 1

Four Kinds of Money

What Kind of Money are You Using in Your Savings Plan?
by Minya K. Irby | Living Well | Wednesday, August 14, 2013 

When planning for your savings or retirement, you should know what kind of money you’re working with. Believe it or, not all money is the same. No, not all money will produce the same results. No, the end does not justify the means. In many cases, the means to the end may come with some unforeseen problems and penalties if the plan for your money is not strategic. 

We often listen to misinformation about money and investing that is passed around like a bad cold. What may initially sound credible is not always the case, because what most people don’t understand is that there are four different kinds of money when it comes to saving and investing for the future—1) free money, 2) tax-deferred money, 3) taxable money and 4) tax-free money. Please know that if you don’t understand the kind of money you’re using, Uncle Sam does, and he will exact his cut. In this two-part article, I’ll first discuss free money and tax-deferred money.  

Free Money

I’ve mentioned this kind of money before in a previous article- free money. As a kid, you received free money all the time when you opened your birthday cards, earned an outstanding report card, or when you received a visit from that favorite uncle who always had a little something extra in his pocket for you. In other words, free money is the money we are gifted or we inherit, but if you haven’t received any financial gifts lately, and that favorite uncle didn’t leave you anything substantial behind when he passed away, the only other way to receive free money is through the employer matched portion of your 401(k). 

Many employers will match a percentage of your annual gross earnings up to a certain amount of money. For example, if you earn $40,000 a year and your employer’s matching program is 2% annually up to $7,000, you’ll receive $800 a year in free money until it has accumulated to $7,000. To capitalize on the free money you then have to contribute at least $800, but some of us may contribute more. However, while some of us may think we’re being wise by contributing above the $800, in actuality we have now shifted from free money to tax-deferred money.  

Tax-Deferred Money

Now tax deferred money is tricky because it looks a lot like free money, but the tax bill is waiting for you at the end. Tax-deferred money (when we don’t understand it) can be financially crippling for us come April 15th and can cause unnecessary stress, anxiety and pressure. When we invest, the growth on tax-deferred money is usually tax-free. But then...we do something. We usually move it or spend it, and what first seemed like a blessing becomes a nightmare. While you may understand the penalties and interest that comes with touching your retirement money before age 59 ½, what you may not understand until you do it- is that whatever amount you draw out now becomes part of your income and has to be reported when filing taxes- and in most cases, you’ll find that you owe the IRS at the end of the year. 

On the other hand, it’s not all bad news, because tax deferred money when used strategically can actually help you control the amount of money you spend in taxes while providing you with an opportunity to save more because of the tax deferral. It’s also important to know what tax deferred money looks like. It’s typically your Traditional IRAs, Tax-Sheltered Annuities (TSA)/403(b), and any contribution above your employer sponsored 401(k) matching program.  

Stay tuned for the next article where I’ll discuss the other two types of money: taxable money and tax-free money.  

Photo credit: mustafabilgesatkin/iStock Images

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