Taxes and Investment Accounts- What You Need to Know

Let’s start by simplifying some things about investment accounts.

For one, most accounts are very similar in that they can hold different types of investments. In that way, most investment accounts are really brokerage accounts that can hold, buy, or sell stocks, bonds, mutual funds, exchange traded funds (ETFs), cash, and so on.

The big differentiator between most investment accounts is taxes. The account type and name typically pulls its name from the tax code, and denotes what happens when there are different activities within an investment account.

First up is a regular old taxable brokerage account.  The account owner is taxed on income generated within the account in a given year. So, if your investments pay interest or pay dividends in a given year, that is taxable income to the account holder. If you sell an investment at a gain, that is capital gains income to you in the year that the activity happens. One thing that's a little unique about a regular old taxable brokerage account is that you can own it jointly with someone, or it can be titled in the name of a trust. That's a little different than some of the retirement specific accounts we'll talk about shortly, where the account has to be owned by one individual. The other thing to know about a taxable brokerage account is that there are no tax implications (meaning you don't generate any taxable income) when you put money into the account or you take money out. And there are no limits to how much you can contribute or distribute from this account type.

OK, so let's talk now about pre-tax retirement accounts. I'm gonna lump a couple of different accounts in here for the sake of simplicity. Although each could have their own write-up. Traditional IRA, pre-tax 401(k), pre-tax 403(b), and other pre-tax employer retirement accounts. These are investment brokerage accounts that you fund or contribute to using pre-tax dollars. That means, in most cases, when you contribute to an IRA or a 401(k), you are contributing on a pre-tax basis and you're not paying federal or state income taxes on those dollars at the time you contribute. So for example, if you earn $100,000 of gross pay in a year and you contribute $20,000 to your pre-tax employer 401(k), your gross income for federal tax purposes is $80,000. All of the investment income within a pre-tax retirement investment account is not taxable along the way. So any interest or dividends or capital gains that are incurred in your account don't count as taxable income to you at that time. This is what we call tax deferral, so you have tax-deferred growth within this account. However, you know you've gotta pay taxes eventually. And the way these pre-tax retirement accounts work is that you end up paying tax on every dollar that you distribute from the account in retirement. So if you contribute to your employer 401(k) during working years, grow the balance through a combination of investment returns and additional contributions, and then you withdraw $20,000 of that balance in a particular year in retirement, you have $20,000 of taxable income in the year that you withdraw.

And then a Roth account is the third type for tax purposes. You can have a Roth 401(k) Roth 403(b), and a Roth IRA. I like to think of Roth accounts as after-tax accounts. You are making after-tax contributions to these accounts, meaning that you don't get a tax break or tax deduction when you contribute. So if we use the same example from above, where you have $100,000 gross pay in a year, and you contribute $20,000 to your Roth 401(k), your taxable income in that year is still $100,000 because contributions to a Roth 401(k) don't reduce your taxable income in the year you contribute. Similar to pre-tax retirement accounts, any investment income is not taxable to you, so the account grows tax-deferred. And then when you withdraw from your Roth account in retirement, it's tax-free to you. So there are no taxes upon withdrawal, as long as you follow the withdrawal rules.

There are a couple of withdrawal rules to be aware of particularly for retirement accounts. One is that generally there are taxes and / or tax penalties if you withdraw from retirement accounts before your age 59 1/2, which is what the IRS considers to be your retirement age. There are some exceptions to this and nuances to the rules, but generally, it's a good idea to keep this age in mind.  So when you are thinking about which account types to contribute to, generally it's a good idea to make sure that you don't need the money before retirement if you're going to contribute to a retirement account.

There are also limitations to how much you can contribute to some of the different retirement account types. For employer plans like 401(k), 403(b), etc.. They tend to have a fairly high contribution limit in a given year. For IRAs and Roth IRAs, the contribution limit is smaller and depends on what your income is like in a given year.

So, when you're trying to decide between the couple of different account types to contribute to, I would think about some of the following things.

- Do I get an employer match on my contributions to an employer plan?  If yes, that would be a good reason to make at least a certain amount of contribution to your employer’s 401(k), 403(b) or similar plan.

- Am I in a high tax bracket now during my working years, and do I expect to be in a lower tax bracket in my retirement years? If yes, this would be a good reason to contribute to a pre-tax retirement account now. Where you are reducing or deferring some of your wage income during high tax bracket working years, and paying taxes when you distribute or withdraw from that retirement account in your lower tax bracket retirement years. 

- Do I have earned income? If you don't have earned income through a wage, self-employment work, or similar, you can't contribute to a retirement account.

- Am I in a low tax bracket now? If yes, contributing to a Roth retirement account may be a good idea. If you're in a low tax bracket, you're not getting a lot of tax benefit by deferring your wage income through a pre-tax retirement account contribution. You might as well contribute to a Roth account that will grow tax-free and you can use tax-free in retirement.

Recognizing that everyone's situation is different and there's no one right way to do this - here's my financial order of operations if you've got some money that you’re looking to invest.

- Number one would be to get free money. So that means contributing at least up to the match in your employer retirement plan.

- Contribute to a health savings account (HSA) if you're eligible for that. There are unique tax benefits to an HSA even beyond a Roth IRA.

- Contribute to a Roth IRA

- Max out your employer retirement plan - whether pre-tax or Roth.

- Contribute to a taxable brokerage account 

Other account types not in the scope of this write-up that have special purposes: 

• Less common retirement accounts that apply to people in specific situations

  • Sep ira - for small business owners and employees

  • Solo 401(k) - for single-member business owners

  • Simple IRA / Simple 401(k) - typically for small business owners and employees

  • Inherited Ira or inherited Roth IRA

  • 457(b) - deferred compensation plans

• Health Savings Accounts (HSA) - allow you to save for out-of-pocket medical expenses, HSAs have triple-tax benefits (tax deduction on contributions, grow tax-deferred, and then distribute tax-free if for qualifying expenses).

• Pensions - retirement plan that pays out a specified dollar amount over your lifetime

• Annuities and whole life insurance - complicated products that provide a mix of life insurance and investments. In most situations I don't recommend these products as they are complicated, not easy to understand, are expensive, aren't great investment products, and don't typically provide the life insurance that clients need

• Accounts that help you save for kids

  • 529 accounts - Saving for education

  • 529 able accounts - Saving for kids (and adults) with special needs

  • UGMA / UTMA accounts - custodial accounts for minor children

  • Trump accounts - New account type allowing to save minor children

Important Note: Tax rules are complex and subject to change. The information provided here is general in nature and should not be relied upon as tax advice. Always review decisions with your CPA or qualified tax professional before taking action.