Understanding the Tax Treatment for Various Types of Investment Accounts
Developing the right savings strategy for retirement can be a confusing process. After working with clients for several decades, we've found there is still a tremendous amount of mystery around where people should be saving. More importantly, understanding the general tax treatment for the savings vehicles they rely on to help them reach their retirement goals.
The purpose of this blog post is to provide general education on the tax treatment of the most common and popular retirement investment account types. Unfortunately, tax laws and retirement regulations are broad and complex, so the information below is educational and not direct advice. It's essential to consult with a qualified professional (like us at Burney Wealth Management) to understand how these rules and strategies might apply to your situation.
Taxable Investment Accounts
Taxable investment accounts are the least restrictive of the available options, meaning they aren't required to be used for any specific purpose and they also don't need to be offered to you by an employer.
Most Common Account Types: Individual Brokerage Account, Joint Brokerage Account
Purpose: General saving and investing, retirement savings
Accessibility: Today, almost anyone can open a brokerage account. They don't need to be offered by your employer and typically cost nothing to open.
TIP: Make sure you have an emergency cash reserve fund of at least 3 months of living expenses before opening a brokerage account since investments can fluctuate in value over short periods.
Here are some of the most critical points for investing in taxable accounts:
Key Features of Taxable Investment Accounts
1. Contributions are made with money that has already been taxed: Money received from a paycheck or cash accumulated in a bank account that you'd like to invest for higher growth potential.
2. While funds are invested, you pay taxes based on the type of activity: Here is a list of some of the most common tax activity occurring inside of taxable accounts:
- Dividends paid from stock investments
- Interest earned from bond investments
- Short-term capital gains from investments held for less than 1 year and sold at a gain
- Long-Term capital gains from investments held for greater than 1 year and sold at a gain
TIP: The tax rate you pay on the above activity is very dependent on your overall income level and tax situation. A good advisor will help construct a portfolio that minimizes taxes with an eye toward the account's long-term growth.
3. Withdrawals from taxable accounts are not taxable events in and of themselves: The simple act of taking money out of the account is not taxable, like some of the other account types we'll learn about below. However, any investment activity needed to generate cash to distribute from the account is still taxable based on the type of activity listed above.
Pre-Tax Investment Accounts
Pre-Tax Investment Accounts
Pre-tax investment accounts are a little more complex than taxable investment accounts. Unlike taxable accounts, these are explicitly earmarked for retirement savings and come with certain restrictions.
Most Common Account Types: Traditional IRA, Traditional 401(k), Traditional 403(b)
Purpose: Retirement savings
Accessibility: IRA's are opened with an investment company, and 401(k) and 403(b) plans are typically offered through your employer
Disclaimer: There are many important rules and restrictions related to retirement accounts, including limitations on how much you can contribute and when you can freely access the funds. For example, you cannot withdraw funds from pre-tax retirement accounts before age 59 ½ without penalty unless you meet specific criteria.
Here are some of the most important considerations for investing in pre-tax retirement accounts:
Key Features of Pre-Tax Investment Accounts
1. Contributions are made with money that is pre-tax, meaning it is not taxable in the year the deposit is made: This can be a point of confusion since the term "pre-tax" isn't always clear to everyone. Here is how pre-tax contributions typically occur:
- Through your employer, who deposits a certain percentage of your pay into your pre-tax retirement account before income taxes are deducted from your paycheck. For example, if you make $50,000/year and contribute 10% of your pay into a pre-tax retirement plan, only $45,000 of your income will be taxable that year, and the remaining $5,000 goes into your retirement account without incurring taxes.
- By yourself, when you make an eligible contribution to a pre-tax IRA, and then get to deduct the amount of the contribution from your income when you file your taxes.
- Both of these events eliminate the income tax liability on the amount of the contribution for the year it is made
Tip: Many employers will "match" your contribution into your pre-tax retirement account up to a certain percentage of your pay. Make sure you take advantage of this!
2. While the funds are invested, you DO NOT pay tax on the investment activity: This means that whatever income is generated, whether it's investment gains, dividends received, or interest earned, you do not pay tax (except for some rare and minor exceptions that are beyond the scope of this post). You pay tax later when funds are withdrawn from the account, and this is why these account types are often known as "tax-deferred" retirement accounts.
3. Withdrawals from pre-tax retirement accounts are taxed at your ordinary-income tax rate in the year distributions are made. You didn't pay taxes when you made contributions, you don't pay taxes on any investment activity that occurs inside of the account, so the IRS gets their "cut" by fully taxing you on amounts taken out of the account when you begin to spend from it to fund your retirement living expenses.
Roth Investment Accounts
Roth Investment Accounts
Roth accounts are the most tax beneficial of all account types, but with additional restrictions and planning considerations relative to taxable and pre-tax accounts.
Most Common Account Types: Roth IRA, Roth 401(k), Roth 403(b)
Purpose: Retirement savings
Accessibility: Roth IRA's are opened with an investment company, and Roth 401(k) and 403(b) plans might be offered through your employer
Disclaimer: There are many important rules and restrictions related to Roth retirement accounts, including limitations on how much you can contribute, how long the funds must remain in the account (known as the 5-year rule for Roth accounts), and when you can freely access the funds. For example, you cannot withdraw funds from pre-tax retirement accounts before age 59 ½ without penalty unless you meet specific criteria.
Here are some of the most important points for investing in Roth retirement accounts:
Key Features of Roth Investment Accounts
- Contributions are made with money that has already been taxed. For example, cash that has been accumulating in a bank account that you'd like to invest for retirement via a Roth IRA, or money deposited directly from your paycheck into your Roth 401(k) or 403(b) account.
- While the funds are invested, you DO NOT pay tax on the investment activity: This means that whatever income is generated, whether it's investment gains, dividends received, or interest earned, you do not pay tax.
- Withdrawals from Roth investment accounts are tax free! This is the main benefit of Roth accounts and what makes them so appealing when considering the best tools to use for long-term planning. While taxes are paid up front before funds are contributed, you get to reap the rewards of tax-deferred growth and tax-free distributions.
Important Questions to Consider When Deciding Where to Save for Retirement
How should I prioritize which of the above account types I save into based on my goals and income level?
We like to think of all these accounts as being "tools in the toolbox" of what we're able to access to help our clients meet their long-term goals. An important part of the process for determining where to save and when include discussing the following with our clients:
- Do we anticipate tax rates to be higher or lower in the future?
- Do we expect your income level to increase, decline, or stay relatively stable in the future?
- How much of your expected retirement income will come from these accounts versus fixed income sources like Social Security and pension income from an employer?
- How do I navigate the various rules and restrictions of each account type?
This blog post is meant to provide general and educational information but only scratches the surface when it comes to pages of IRS code regulating these accounts and tax laws. Make sure you educate yourself on these rules in order to avoid penalties and other costly mistakes. A consultation with a qualified advisor could be a good first step in making sure you're not missing anything.
How do these decisions impact other areas of my financial life now and in the future?
No important financial decision should be made in isolation, which is why we're big believers in a comprehensive approach to long-term decision making. The decisions you make around where to save for retirement can impact things like your marginal tax rate, the tax rate you pay on Social Security benefits, what you pay for health insurance and Medicare premiums, and the tax rate you pay on your investment portfolio income.
Advisory services are offered through the Burney Company, an investment adviser registered with the U.S. Securities & Exchange Commission. Registration as an investment Adviser does not imply a certain level of skill or training.