This will be the first in a series of posts related to your investments and taxes. As I talk to people about investing, I find there is a pretty solid understanding of the importance of saving and investing. While many people may say they don’t fully know what they are doing with investing, the vast majority understand they need to diversify and spread their investment dollars around. In addition, people are aware that investing can come with tax benefits. What most people don’t understand is how they are taxed and how that will impact their retirement. Understanding how this works and how to use different investment tax rates in retirement can have a dramatic impact on your retirement projections. In this installment, I will go over the basics of how your investments are taxed and the following posts will expand on this.
Let’s start with the primary accounts at a high level and how they are taxed. Note that there are certain exceptions to these rules listed below and limited situations that may be taxed differently but this will likely cover at least 80% of account activity. This also only covers Federal taxes on investments. Your individual state will have its own tax rules as well.
401k/IRA
These are referred to as tax deferred accounts. This is the primary savings vehicle for a majority of people. While there are different rules on contributions, these two accounts are taxed the same. The tax benefit to you with these accounts is that when you make a contribution, that amount is excluded from your income for tax purposes so you receive a tangible tax benefit in the year of contribution. For example, if you make $100,000 per year and contribute $15,000 to a 401k, you will only be taxed on the remaining $85,000.
This is referred to as a pre-tax contribution. The tax deferral concept comes in because as you buy and sell your holdings within the account or they appreciate in value, there is no tax impact. There are no taxable events with this account until you take money out. All tax impact is deferred until you withdraw the money from the account.
What activity is taxed? Every withdrawal is taxable and every penny of the withdrawal is taxed assuming there are no after tax contributions in the account.
What about dividends and interest? As long as those dividends and interest stay invested in the account there is no tax as these are earned. But, at the time of withdrawal, every penny is taxed as ordinary income.
What about if an individual holding is sold for a gain? Again, as long as the money stays in the account, this does not result in any taxes. It also does not matter how long you have owned that specific holding.
What tax rate is used for withdrawals? Withdrawals are treated as ordinary income, so they are taxed at your marginal tax rate. As an example, let’s say a married couple is sitting at $75,000 of taxable income on the year which would put them in the 12% bracket. They make a $30,000 withdrawal from an IRA. The 12% bracket goes to $94,300 so the first $19,300 of the withdrawal is taxed at 12% and the rest is taxed at the next bracket which is 22%. This holds for every penny that is withdrawn. It doesn’t matter if the funds withdrawn were a result of capital gains, dividends or interest. They are all treated the same on a withdrawal.
When do I have to start taking withdrawals? Remember that money invested in these accounts was not taxed by the government so eventually they want to make sure they get their share. As a result, there is a rule called Required Minimum Distributions (RMD) where the IRS mandates you start taking money out of this type of account whether you need it or not. For a long time, withdrawals were required at age 70 ½. With the Secure Act that changed to age 72. Now with Secure 2.0, that has been pushed to age 73 as of 2023 and will change to age 75 in 2033.
How much will I have to withdraw? Once you are age 59 ½ you are free to take out as much as you like without penalty. Starting at age 73 the RMD kicks in even if you have been making withdrawals. The IRS has a calculation for this. There is a table with a life expectancy value and you divide your account balance from the end of the prior year by this number. So if on December 31st, 2023 you had $400,000 and your IRS table value was 20 you would be required to take out $20,000 as an RMD. These RMDs are taxed just like all other withdrawals from this type of account as regular income. The RMD is the minimum amount the IRS mandates you withdraw from the account. You are always able to withdraw in excess of the RMD.
Roth 401k/Roth IRA
Roth accounts are referred to as tax-free accounts. Taxation of these accounts is the exact opposite of the 401k/IRA. In the case of a Roth account the contributions you put into the account have already been taxed. There is no tax break in the year of contribution. These are called after-tax contributions.
What activity is taxed? In short, nothing, assuming you meet the criteria for a qualified withdrawal. Remember the government got their share before you ever made your contribution.
What are the rules? To be a qualified withdrawal you must be age 59 ½ and have had the Roth account for at least 5 years. You can take out your contributions tax free at any time. The rules apply to the gains on your investments.
What about dividends and interest? Not taxed
What if a holding is sold for a gain? Not taxed
How are withdrawals taxed? You guessed it, not taxed as long as it is a qualified withdrawal. This is the case regardless if the funds came from contributions, gains, interest or dividends.
When do I have to start making withdrawals? You don’t. Because the government got their share up front, they aren’t concerned about you withdrawing the funds during your lifetime.
Taxable/Brokerage account
These accounts, unlike the previous two, are not intended specifically for retirement so have a different tax treatment. There are no tax breaks on the front end for making a contribution.
What activity is taxed? This is the big difference with this type of account. Here, the activity within the account is what gets taxed, not withdrawals. This activity may come in the form of capital gains, interest and dividends. As this activity occurs within the account the gains are realized and become taxable.
How are capital gains taxed? Capital gains are a result of selling a holding for more than you paid for it. If you bought $10,000 worth of Apple stock in 2017 and sell it in 2024 for $40,000, you would have $30,000 in capital gains. If you held the investment you sold for more than a year then you will get taxed at long term capital gain rates. If you held it for less than a year, then it will be considered a short term gain.
There is a second type of capital gain that can occur within a taxable account if you own a mutual fund. As mutual funds buy and sell individual holdings throughout the year, the fund may accumulate gains. These gains must be distributed and taxes will be owed even if you don’t sell the fund.
Short term gains are taxed at ordinary income rates. Long term gains have different rates depending upon your income. In 2024 for a married couple, it is 0% for income up to $94,050, at 15% up to $583,750 and then 20% above that. Note that the taxable event here is the sale of the investment itself even if the funds are reinvested or stay in the account. The full list of tax rates can be found here.
This is taxes and the IRS so it isn’t quite as straightforward as if you have capital gains of $50,000 you will owe no taxes. Your capital gains tax rate is determined by adding your gains to your taxable income. That doesn’t mean you add your regular income and capital gains together. Instead, it is treated as though you do a full tax return to determine your taxable income and determine the taxes you pay on that and then add the capital gains on top of that to determine your cap gains rate and tax amount.
A couple of examples here will help.
Example 1. You have $80,000 in taxable income and $10,000 of capital gains. We add the two together to get $90,000. The $90,000 total places you under the 0% cap gains threshold of $94,050 so you will pay 0% on your capital gains.
Example 2. You have $80,000 in taxable income and $20,000 of capital gains. The 0% bracket tops out at $94,050 so you would pay 0% on the first $14,050 of capital gains and 15% on the next $5,950.
Example 3. You have $300,000 of taxable income and $150,000 of capital gains. The total of $450,000 falls within the 15% capital gains rate which goes all the way to $583,750 so all of your capital gains would be taxed at 15%.
Example 4. You have $600,000 in taxable income and $5,000 in capital gains. The total of $605,000 is fully above the 20% bracket so your capital gains would be taxed at 20%.
Likewise, if you sell an individual investment for a loss, you create a capital loss. You can use this to offset other gains over the course of the year. If you have a net capital loss on the year, you can use $3,000 to reduce your taxable income and carry the rest over to future years.
How are dividends taxed? Qualified dividends, those from a holding you have owned for over a year, are taxed at 0% on income up to $94,050, 15% up to $551,350, and 20% above that. Non-qualified dividends are taxed at ordinary income rates. This occurs as the dividends are received.
How is interest taxed? Interest is taxed at ordinary income rates unless the individual investment is a tax-free vehicle like a municipal bond. Again, this occurs as the interest is received.
How are withdrawals taxed? They are not. The taxable activity is the selling of individual investments or the earning of capital gains, interest and dividends.
When do I have to start making withdrawals? You don’t. Like a Roth, this type of account is funded by after-tax contributions so the government has received their cut.
Clear as mud? As you can see there is a big difference in how your various investment accounts are taxed. Having a strategy on when to utilize the different accounts depending upon your income level is key to maximizing the amount of your investment money you get
to keep.
These rules apply to the account owner. In the next piece, we will cover how your investments are taxed if inherited.
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