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Tax Treatment of Investments and Your Retirement

Tax Treatment of Investments and Your Retirement

February 15, 2024

The phrase is that two things in life are sure, death and taxes. Here is how our pal Uncle Sam is dipping his hand into your different types of accounts….


Taxable Accounts (taxed always): Investments held in taxable accounts, such as brokerage accounts, are subject to capital gains tax when sold. The tax rate depends on how long the investment was held (long-term vs. short-term) and the investor's tax bracket.

401(k) and Traditional IRA Accounts (taxed later): Contributions to 401(k) and traditional IRA accounts are tax-deductible, which means that the investor does not pay taxes on the money they contribute. However, withdrawals from these accounts in retirement are subject to income tax at the investor's tax rate.

Roth IRA Accounts (taxed before): Contributions to Roth IRA accounts are not tax-deductible, but qualified withdrawals in retirement are tax-free. This means that investors can contribute after-tax dollars to their Roth IRA and enjoy tax-free growth and withdrawals in retirement.

BONUS:

Health Savings Accounts (HSAs) (taxed NEVER when used properly): Contributions to HSAs are tax-deductible, and qualified withdrawals for medical expenses are tax-free. Additionally, HSA funds can be invested, allowing for tax-free growth on investments.

529 College Savings Plans: Contributions to 529 college savings plans are not tax-deductible, but investment earnings grow tax-free, and withdrawals for qualified educational expenses are also tax-free.


Why does it matter where I grow money? The difference between a traditional IRA and a Roth IRA comes out to nothing mathematically if every factor stays the same while you are accumulating and distributing money. This means if your tax rate is the exact same, income level is the same, rate of return is the same, etc.  However, life doesn’t work out like that. In general, if you will be in a lower tax bracket in retirement, it might make sense to look more at a deductible traditional IRA contribution. If you will be in a higher tax bracket in retirement, you probably want to look at paying the taxes now and using a Roth IRA.

The last general principle to highlight is flexibility. Flexibility is key when retirement planning. Having dollars in multiple different tax buckets allows for flexibility during the distribution stage of life (retirement).

Understanding the tax treatments of different investment accounts can help investors make informed decisions about where to invest their money and how to manage their tax liabilities. It's important to consult with a financial advisor or tax professional to determine the best investment strategy based on an individual's unique financial situation and goals.