The 3 Ways Your Investments Are Taxed & How to Reduce Taxation
Believe it or not, taxes are typically one of, if not the largest expense we pay throughout our lifetime. While taxes are always constant, with proper planning and an understanding of how investments are taxed, you can be proactive in building effective, long-term tax planning strategies. In this article, we will be covering the basics of tax planning, touching on how accounts are taxed, the importance of tax diversification, and required minimum distributions.
How Investments Are Taxed
I cannot tell you how many times I have sat down with somebody for the first time, and they have been great savers, putting money aside, and following the traditional rules of thumb, but it has all gone to pre-tax because their earned income was higher during their working years. However, many may not realize some of the future impacts of all this tax deferral. One of the primary impacts is the potential tax trap where every single penny is taxable, and the IRS starts to require distributions that are fully taxable as well. That is a big drag on your accounts, but also your legacy. Taxes are an expense that we need to deal with, but these pitfalls can be easily avoided if we just back up and start to look at effective tax planning strategies as early on as possible.
There are generally three different ways that any investment can be taxed.
Taxable Accounts
The first is what we call taxable accounts. The way this type of investment works is that money goes into the account after tax. The money that goes into this investment has already been taxed—maybe from a paycheck. Since the contributions have already been taxed, you will only start to pay taxes as you realize growth in the investments. For example, if you bought a stock for $10 and five years later sold it for $40, you would realize a gain of $30 and pay taxes on that $30 gain.
The great thing about this type of account is that you can contribute as much or as little as you want. You can also withdraw as much as you want or leave as much as you want in the account. Essentially, this account offers complete flexibility when it comes to investments.
One downside of this type of account is that you are taxed as you go. If the investments are not handled properly, this can create a bit of a drag on your account over time. However, when these accounts are used properly, you may be able to pay capital gains taxes (typically around 15%) instead of ordinary income taxes, which might be significantly higher.
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Tax Deferred Accounts
The second way your accounts may be taxed is through tax deferment. Tax-deferred accounts work by allowing pre-tax money to be contributed. This means you get a deduction from your income on the contribution amount for that tax year. As those funds grow, all the taxes are deferred, they are pushed off to the future. When you eventually withdraw the funds, typically in retirement, every penny you take out is fully taxable as ordinary income.
You may already recognize this as the structure of the most common retirement accounts, we see, such as 401(k)s, pre-tax or traditional IRAs, and similar plans. Essentially, you get a tax break today in exchange for a tax bill in the future. The benefit of this setup can be significant, as a tax break today (especially for those in higher income brackets) can help defer some of your taxable income. The challenge, of course, is that eventually, you will pay that tax. Sometimes, this can be on a much larger amount if the account grows to a substantial balance over time.
Another important topic related to tax-deferred accounts are required minimum distributions (RMDs). RMDs are a forced distribution of funds in retirement that are fully taxable. The IRS requires these distributions at certain ages based on your year of birth. Once you reach that age, the IRS will mandate distributions from your retirement accounts every single year.
Tax-Free Accounts
The third type of account is what we call tax-free. Tax-free accounts are essentially the reverse of tax-deferred accounts. After-tax money is contributed to the account, and all the earnings and growth from that point forward are not taxed. In fact, when you withdraw the money—provided it is a qualified distribution, the entire balance is completely tax-free forever.
As you might imagine, these accounts do not offer tax benefits in the current year, but they provide significant tax freedom in the future. The most common examples of these accounts include Roth 401(k)s, Roth IRAs, and, in some cases, 529 plans for education funding.
The benefit of these accounts is the tax freedom they provide down the road, especially for those with time on their side. When contributing to retirement, you are essentially planting a seed with the hope that it will grow into a full-blown harvest. The question to consider is whether you want to pay taxes today on the seed or in the future on the harvest.
The longer you have for these assets to grow, the more you may reap in the harvest, which may help determine the correct approach. Many people assume this means you should use Roth accounts only while you are young. However, even if you are just entering retirement, you may still have 30 or more years of retirement ahead. You might even leave excess funds to children or loved ones, who may not withdraw the money for 50 years or more. For this reason, Roth accounts can be incredibly powerful for various purposes.
Health Savings Accounts (HSAs)
As a special bonus category, there is another type of account that can work completely tax-free. With this account, money is contributed on a tax-deductible basis, grows tax-free, and can be withdrawn tax-free for qualified medical expenses. What I am referring to is called a Health Savings Account (HSA). HSAs are becoming more popular, though they do come with specific qualifications to be eligible for contributions and to realize the tax benefits on distributions. When used properly, an HSA can be an account that is never taxed and can play a significant role in covering future healthcare or long-term care costs. You can learn more about how to utilize an HSA for retirement planning here.
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How to Diversify Your Accounts to Reduce Taxes
Where do you think most people find most of their assets for retirement? Generally speaking, a significant portion of retirement assets are held in tax-deferred accounts. This is typically the most common vehicle when investing, and while this growth can be beneficial, it often creates a bit of a ticking tax bomb. By utilizing some of the other types of accounts, you can handle taxation more effectively and develop a long-term tax strategy.
Another question you may ask is, "Which type of account is best?" We have three different types of accounts to consider, and the answer to this question often depends on individual circumstances. The truth is that the best option varies for every person.
It is safe to say that, in general, you might want to consider tax diversification. This doesn’t mean finding a single “right” answer but rather creating the right blend of solutions. Diversifying your taxes—just like you diversify the investments within your accounts—can provide flexibility for whatever the future holds. Whether it is new legislation or the need to withdraw a significant amount of money from one of your accounts, having multiple buckets to choose from allows you to adapt to the environment and make the most of the situation.
One of the biggest mistakes we see made when setting up a plan is focusing on a single path, putting everything into one type of account. This approach leaves little room for the “what ifs” in life. Things rarely go exactly according to plan, so it is crucial to have different paths available. This way, you can course correct along the way based on the realities of your situation and changes to the tax landscape, which you can never fully predict.
Many Americans pay taxes throughout their working lives, only to set themselves up to continue paying income taxes in retirement. However, with proper tax planning and diversification, you can create financial “buckets” that provide true freedom in retirement. This strategy also gives you the flexibility needed to be as tax efficient as possible.
If you have any questions about how to create financial "buckets" with your own financial situation in retirement, please reach out to a member of our team below.
Advisory services offered through Mainsail Financial Group, LLC, a Registered Investment Adviser. For informational purposes only, not intended as tax advice. Please consult a tax professional when appropriate.