Twin Terms That Can Trip Investors Up

Thanks to Congress, a financial services marketplace that seems at times deliberately confusing, and a healthy dose of jargon, the financial planning arena is a land mine of bewildering terms and an alphabet soup of acronyms.

By my count, there are close to 20 different retirement savings vehicles one can use, while financial advisors can call themselves at least 20 different names. (Wealth advisor, wealth manager, financial advisor, financial planner, investment advisor … shall I go on?)

In many cases, there are important distinctions among these terms, but the lingo can't be helping--and could even be hindering--individuals' decision-making when it comes to their financial and investment affairs.

To help illustrate the point, I've compiled a short list of financial planning "twins"-- two terms that are so similar-sounding or that seem so conceptually similar--that often trip people up. I've also included a helpful shortcut for each pair, to help you cut through the verbal clutter.

Roth 401(k) versus Aftertax 401(k) To a layperson, these two 401(k) types sound different enough. But if you know a little about Roth accounts, you know that they, too, are funded with dollars that have already been taxed, just like aftertax 401(k)s. Cue the confusion.

The key difference, as I discussed in this article, is that contributions to Roth accounts, whether 401(k)s or IRAs, begin earning tax-free earnings from the start. Money steered into an aftertax 401(k) accumulates earnings on a tax-deferred basis as long as it stays inside the 401(k). Only after the money is removed from the confines of the account, thanks to the employee's retirement or separation from service, or an in-plan conversion option, can those aftertax 401(k) contributions be rolled into a Roth IRA and start earning tax-free investment growth. (The portion of the aftertax 401(k) that consists of investment earnings can be segregated into a traditional IRA that will be taxed upon withdrawal.)

Helpful Shortcut: If your company retirement plan fields a Roth 401(k) option as well as an aftertax 401(k), funding the Roth 401(k)--or a traditional 401(k) with pretax contributions--should always take precedence over aftertax 401(k) contributions. That's because the tax benefits of Roth/traditional 401(k) contributions are better, as outlined here.

Flexible Spending Account versus Health Savings Account In addition to their similar names, flexible spending accounts and health savings accounts both provide tax incentives (pretax contributions, tax-free withdrawals for qualified healthcare outlays) to encourage people to save for out-of-pocket healthcare expenses. So the confusion between these vehicles is understandable.

But there are some crucial differences. For one thing, flexible spending accounts (also called flexible spending arrangements) are employer-provided accounts, whereas it's possible to set up and manage a health savings account on your own, provided you're covered by a high-deductible healthcare plan. Another key difference--and one of the key points of confusion between the vehicles--is duration: HSA dollars roll over from one year to the next, while FSAs are meant to be spent in the year in which they're funded. Employers are now required to give FSA-contributing employees an escape hatch, giving them extra time to spend their dollars or rolling over up to $500 from one year to the next. But FSAs are definitely not intended as savings vehicles.

Not having to loot the HSA each year means that for investors with the financial wherewithal to do so, HSAs can be used as long-term investment vehicles rather than short-term savings options, as discussed here. The HSA contribution limit is also substantially higher than for FSAs--in 2017, it's $3,400 for individuals and $6,750 for families covered by HSAs, versus $2,600 for FSAs. Some employees may be able to contribute to both accounts: if their employer offers what's called an HSA-compatible FSA (or limited-purpose FSA), they can cover dental and vision costs with the FSA, while defraying other expenses with the HSA.

Helpful Shortcut: If you're eligible for both an HSA and an FSA through your employer, be sure to take advantage of any matching contributions your employer is making to encourage participation. If you have any out-of-pocket healthcare expenditures at all, you'll earn the matching contributions and be able to take advantage of pretax contributions and tax-free withdrawals. If your aim is to spend money from your FSA or HSA as you incur healthcare expenses, the differences between the vehicles are apt to be minor. But the HSA--in keeping with the "savings" in its name--is the only vehicle you can use for long-term investing. Senior analyst Leo Acheson discussed the best HSAs for investors in this video.

Fee-Based versus Fee-Only Advisor Here's another pair of terms that sound so deceptively similar that many investors unwittingly use them interchangeably. But there's an important distinction: commissions. Fee-only advisors charge fees for services but receive no commissions for recommending products. They may charge for their services as a percentage of the client's assets, on an hourly or per-project basis, or on a retainer basis. Fee-based advisors, by contrast, are compensated through both fees and commissions they receive because they've recommended a specific product.

Because their recommendations are decoupled from commissions, fee-only advisors court fewer potential conflicts of interest than fee-based advisors. Yet it's worth noting that fee-only advisors may have conflicts of interest, too, even if they're not being compensated for recommending specific products. For example, a fee-only advisor who's compensated by taking a percentage of your assets per year (1% is a common level) has a disincentive to advise you to make moves that would reduce your portfolio size--paying off your mortgage or buying an annuity, for example. Even so, not taking commissions, as is the case with fee-only advisors, removes one potentially potent conflict of interest from the equation.

Helpful Shortcut: The National Association of Personal Financial Advisors is a consortium of fee-only advisors who are also fiduciaries. You can use their website to search for advisors who work in your geographic locale or who have a specialty that jibes with your needs.

Self-Directed IRA versus 'Self-Managed' IRA At first blush, "self-directed IRA" sounds like a garden-variety IRA that you just happen to manage on your own, without the aid of an advisor. I've even heard investors say, "In my self-directed IRA, I own Fidelity Low-Priced Stock, an S&P 500 Index fund …"

However, a self-directed IRA is quite distinct from a self-managed IRA, even though the contribution limits, income limits, and baseline tax rules are the same for both vehicles. The key difference is the type of investments that typically go into a self-directed IRA. Most investors buy individual stocks, mutual funds, or ETFs within their IRAs, but they must use a self-directed IRA if they want to own nonpublic investments like real estate (actual properties, not REITs) or stakes in private companies. Self-directed IRAs are governed by very specific rules, the majority of which are designed to prohibit self-dealing--obtaining use from an asset that you're also receiving a tax break on. A classic example of self-dealing would be purchasing a rental property for an IRA that your son also happens to live in.

Helpful Shortcut: Before venturing into a self-directed IRA, the big question to ask yourself is how the investment you’re contemplating would interact with the other securities in your total portfolio, not just your investment portfolio. My view is that you use your investment portfolio to diversify the weird, idiosyncratic risks in the rest of your financial life, not add to them. Yet self-directed brokerage accounts often do the latter. Property holdings are among the most common holdings in self-directed IRAs, for example, but many people also have a lot of their net worth sunk into their primary residences. This article tackles other questions to ask before going self-directed for your IRA holdings.