Understanding Tax Implications for Investment Accounts
Understanding the different types of retirement accounts and their respective tax statuses is fundamental for effective financial planning and tax planning. This article offers a comprehensive overview of the four primary tax categories for different accounts each having distinct implications for investment growth and withdrawals.
The reason understanding these terms is important as they impact how contributions, distributions, and earnings are taxed as well as other important considerations regarding the account.
The four primary account tax categories are:
- Taxable Accounts
- Tax Deferred Accounts
- Tax-Free Accounts
- After-Tax Accounts
Taxable Accounts
Contributions = Not Deductible
Tax Deferred Growth = Depends
Withdrawal Taxation = Gains
Withdrawal Flexibility = Most
Taxable accounts are simply accounts that have transactional tax implications meaning that there could be tax implications anytime you withdraw, buy, sell, or gift money from it.
How do you know if you have a Taxable account?
Taxable accounts are one of the most basic accounts out there and practically everyone in the US has at least one of these. As an example, your checking and savings accounts are taxable accounts.
Taxable accounts go by many different names: brokerage accounts, investment accounts, and non-qualified accounts. The easiest way to determine if your account is a taxable account is looking at the titling of the account. If you do not see “IRA” or some reference to your retirement plan (401k, Retirement Savings, 403b, etc.), then the account is likely a Taxable Account. Additionally, if the account is a joint account or Trust account, it is a Taxable Account.
Tax Implications of Taxable Accounts
Taxable accounts have three main tax components to them:
- Cost Basis: Cost basis is the amount of money that you have already been taxed on within the account. It can represent the amount you originally contributed to the account, or it can represent income or capital gains that have been received, taxed, and reinvested. You are not taxed on Cost Basis if you withdraw from the investment and that amount can be accessed Tax-Free.
- Income: When stocks issue dividends or bonds pay interest, that is the income that is generated in the account. Dividends and interest are taxed in the year received. The applicable tax rate depends on the source of the income. For example, qualified dividends are taxed under a different rate than interest paid from corporate bonds.
- Gains or Losses: When you sell your investments for more (or less) than your cost basis, you have a gain (or loss) that has tax implications. The tax implications vary based on holding periods and your total portfolio combined gains or losses.
Possible Taxable Account Outcomes
| Reduces Taxes | No Tax Event | Increases Taxes at Preferential Rate | Increases Taxes at Marginal Rate |
| Investment Losses | Return of Basis | Qualified Dividends | Ordinary Interest |
| Tax Free Interest from Municipal Bonds | Long-Term Capital Gains | Short-Term Capital Gains |
Special Rules & Considerations
Capital Gains Distributions: If you own a fund that invests in stocks or bonds for you (Mutual Funds or Exchange Traded Funds), you may receive capital gains distributions which is a pass through of the capital gains the fund has realized in the underlying holdings. It is important to understand this because it can cause a taxable event even if you do not sell the fund and even if you do not have a gain.
Step Up in Basis: Under current law, when taxable account pass to heirs, they may be eligible for a “step up in basis” which adjusts the basis of the stock to the value of the position at the date of death. For example, if you bought company XYZ for $10 per share and it is now worth $100 per share, your heirs will receive the stock with a basis of $100 per share. If you were to sell it instead during life, you would have to pay taxes on $90 of capital gains.
Charitable Giving: An effective way to maximize the value of appreciated investments is to donate them to charity. Donating appreciated investments to charities can have tax advantages above and beyond simply donating cash. See this article for more information: Donating Appreciated Stocks to Charities – Gilbert Wealth
Gifting Cost Basis: If you gift an investment to someone else, in general, they will inherit your cost basis as well. The rules of how the recipient of the shares are taxed depends on the value at the time of gift and the value at the time of sale.
The standard definition of a taxable account is that it is an account that is “not tax-advantaged” but as you can see here, they do have some significant tax advantages if used correctly.
Tax-Deferred Accounts
Contributions = Deductible
Tax Deferred Growth = Yes
Withdrawal Taxation = Full
Withdrawal Flexibility = Limited
Tax-Deferred Accounts are accounts where the taxation of earned income (wages, self-employment, etc) was put off to the future by saving into a tax-deferred account. In short, by using a tax-deferred account, you reduced your taxable income today with the tradeoff that you will be taxed in the future when you withdraw money from the account.
There are two reasons to use a Tax-Deferred Account:
- Income Shifting: Income shifting just means you are using a tax-deferred account to move the taxation of income from one year (the year saved) to another year (the year withdrawn). For example, if you are currently pay a 35% tax rate on income earned but will only pay a 15% tax rate in retirement, saving to a tax deferred account save 20% on taxes owed.
- Tax Advantaged Growth: While investing in a tax-deferred account, you gain the benefit of being able to rebalance, and receive dividends and interest without paying taxes allowing you to grow your account faster without a tax drag compared to taxable investment accounts.
Tax Deferred accounts accessed before 59 1/2 may have a 10% penalty assessed (exclusions apply) and you are forced to begin taking withdrawals after your Required Minimum Distribution age.
Possible Taxable Account Outcomes
| Reduces Taxes | Increases Taxes | No Tax Impact |
| Contributions lower ordinary income taxation. | Withdrawals are taxed at ordinary income | Distribution of Cost Basis |
| Recognizing Gains on Investments | ||
| Recognizing Losses on Investments |
Special Rules & Considerations
Tax-Deferred Cost Basis: In Traditional IRA’s, you can accumulate cost basis in the account by contributing when you are over the income limits which is called a non-deductible IRA. If properly tracked, the cost basis is not taxed upon distribution but the earnings on any cost basis are pre-tax. See Latest Tax Resources – Gilbert Wealth
Aggregation Rules: IRA’s are subject to an aggregation rule which accounts for certain types of accounts as if they were a single account.
Tax-Free Accounts
Contributions = Not Deductible
Tax Deferred Growth = Yes
Withdrawal Taxation = Tax Free
Withdrawal Flexibility = Limited
In a tax-free account, your contributions do not reduce taxable income, but you will not be taxed on the distributions from the account no matter how much it has grown. This tax-free status passes along to heirs
Examples of tax-free accounts are Roth IRA’s, Roth 401k’s, Roth 403b’s, etc.
Like tax deferred accounts, tax-free accounts can have limitations on withdrawals pre-59 1/2, and are currently not subject to Required Minimum Distributions.
Special Rules & Considerations
Withdrawal Ordering: Roth IRA’s have a special ordering for withdrawals typically starting with contributions first and leaving the earnings last.
Pre-59 1/2 Access: Roth IRA’s can allow withdrawals up to the contributions made before 59 1/2 without the tax penalty.
After-Tax Accounts
Contributions = Not Deductible
Tax Deferred Growth = Yes
Withdrawal Taxation = Taxable or Tax-Free
Withdrawal Flexibility = Limited
After-Tax accounts are often confused with tax-free accounts particularly in qualified retirement plans like 401ks but they are very different. They are more like a combination of a tax-deferred and tax-free account.
In after-tax accounts, your contributions are not deductible, and your earnings grow tax deferred. However, unlike a tax-free account, when earnings are withdrawn, they are counted as ordinary income. Your contributions form a basis in your account that is never taxed again.
Examples of after-tax accounts are non-deductible Traditional IRA’s and 401k’s with an after-tax (not Roth) option.
FAQ
Annuities: Annuities are tax chameleons meaning they can take on different types of taxation depending on where they are placed. Annuities can be held on its own or within other account types like a Traditional IRA or Roth IRA.
- Non-Qualified Annuity: A non-qualified annuity is an annuity not held in a qualified account like a Traditional IRA or Roth IRA. When you own a non-qualified annuity, it acts much like an After-Tax account where contributions are not taxed upon withdrawal but earnings are taxed as ordinary income.
- Qualified Annuity: A qualified annuity is an annuity held inside a qualified account like a Traditional IRA or Roth IRA. When you own a qualified annuity, it takes on the tax implications of the qualified status it is in. If the qualified account is tax-deferred, any contributions and distributions will align to the tax-deferred taxation.
Insurance: Cash Value insurance sits on the edges of several categories as well due to unique rules that allow it to operate differently. Premium payments are typically not tax deductible but earnings can grow tax deferred.
Cash value insurance forms what’s called cost basis which is essentially everything you’ve paid into the policy. Cost basis is not taxed upon withdrawal.
The gain in the contract is taxed as ordinary income upon withdrawal. However, here is where cash value life insurance gets interesting. You don’t have to withdraw gains as taxable income. Instead, cash value life has a loan feature that allows you to withdraw gains through a loan on the policy. As it’s a loan, it is not taxed.
It is important to note that life insurance policies can lapse if not properly maintained. If a policy lapses, all gains taken out via a loan will be taxed as ordinary income but no cash will be paid out.
Finally, if you die, a life insurance policy pays out the death benefit minus loan as a tax-free death benefit.
Summary
While you don’t need to know the ins and outs of every account type, it is important to understand the high-level benefits and structures of each account. Saving to one and not another has long-term implications that impact future decisions and options. Where one account type may be great for one person, another might be the better option for a different set of circumstances and goals.