Commanding a basic understanding of how taxes work is incredibly important for every adult. This is especially true as taxes relate to various types of retirement and investment accounts, as the difference between a little knowledge and none at all can come out to thousands of dollars in retirement.
Furthermore, by knowing how taxes work with different investment accounts, you’ll be in a much better position to select an investment account suited to your needs.
Retirement accounts have unique rules relating to taxation. This article will cover the rules as they apply to different retirement accounts so you can fully understand the implications of investing in and making withdrawals from these accounts.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. Tax situations can be very complex and laws vary by region. It may be wise to consider the help of an industry professional when it comes to tax-related decisions.
If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.
“Retirement accounts” in the United States include:
While all of these accounts have different nuances, they have one thing in common: they are tax-deferred.
What does tax-deferred mean? It means that any time an investment sale results in a gain, no taxes are due (yet). The same applies to earned income within these accounts. Some examples of portfolio income include dividends, bond interest, and capital gains distributions.
Under current tax law, taxes are not due until you actually withdraw the funds from the account (if they are due at all). However, it’s important to note that retirement accounts may also be subject to the 10% early withdrawal penalty. The IRS leverages this fee when a taxpayer withdraws funds from a retirement account before they have turned 59.5 years of age. (Some exceptions apply).
Notice how this differs from a standard brokerage account. If a taxpayer has net capital gains realized in the tax year in a brokerage account, they will owe capital gains tax. If they receive interest from bonds in a brokerage account, that income is typically taxable as ordinary income. These taxes apply in a brokerage account even if the investor reinvests the funds originating from dividends or bond interest.
Retirement accounts are often referred to as tax-advantaged accounts. This is because investors can continue to grow their investable net worth within them without feeling the effects of “tax drag.”
Before getting into the taxation of withdrawals from these accounts, it’s important to discuss the subject of “pre-tax” funds versus Roth funds. Each type of retirement account has unique rules as it relates to the funding of the account as well as withdrawals.
As the description suggests, pre-tax funds have not yet been taxed.
Here are some examples of pre-tax retirement accounts:
Traditional contributions made into an employer-sponsored plan, like a 401(k), are not taxable as ordinary income. This is what makes traditional contributions pre-tax. If a taxpayer earns $80,000 pre-tax and contributes $10,000 pre-tax, only $70,000 of their salary would be subject to ordinary income taxation.
This is due to the fact that the IRS leverages taxes on withdrawals from pre-tax accounts as ordinary income in the tax year the taxpayer makes the withdrawal.
Let’s discuss an over-simplified example to make this clear.
Assume a taxpayer earns a salary of $50,000, before taxes. If they withdraw $10,000 from a pre-tax retirement account, the IRS effectively assumes that the taxpayer “earned” $60,000 pre-tax in that tax year. That amount would be subject to ordinary income taxation.
If the taxpayer was under age 59.5 when they made the withdrawal, and they don’t meet one of the exceptions to the early withdrawal penalty, they will owe a $1,000 (10%) penalty when they file their return for the tax year.
This is because any time the IRS gives taxpayers an advantage, there is usually an accompanying provision. As it relates to retirement accounts, that’s where the early withdrawal penalty applies.
Roth retirement accounts are unique because they allow for withdrawals that are completely tax-free under certain requirements. This is a “qualified” withdrawal.
The primary types of Roth accounts are:
In order for a withdrawal to be considered “qualified”, there are two essential requirements that must be met:
If both requirements are met, then the entire withdrawal is completely tax exempt.
This is what makes Roth accounts so attractive. There are not many loopholes in the tax hole that allow for both tax-deferred growth and tax-free withdrawals.
Another unique factor of Roth accounts is that you can withdraw contributions at any time, tax-free. Unlike traditional contributions, you make Roth contributions on an “after-tax” basis. This means that contributions are counted as income in the applicable tax year.
Furthermore, you cannot deduct Roth contributions. When you make a withdrawal from a Roth IRA, the IRS assumes that the Roth contributions come out first.
For example, assume an investor contributes $3,000 to a Roth IRA and the balance grows to $4,000. If the taxpayer withdraws $3,000, the funds are not subject to taxation, because they represent a return of funds that have already been taxed.
What if the taxpayer withdrew the full balance? If the withdrawal is “qualified,” then no taxes apply.
If the withdrawal was not qualified, the $1,000 of earnings would be subject to ordinary income taxation and a potential 10% early withdrawal penalty.
The pro-rata rule applies to withdrawals made from Traditional IRAs, which contain after-tax dollars.
If you deduct the contributions made into a Traditional IRA, the entire account value is considered pre-tax. In order to be able to deduct the contribution, your income needs to fall under a certain threshold, depending on your filing status.
If you cannot deduct the contributions made into the Traditional IRA, the contributions are after-tax and the earnings on those contributions are pre-tax.
Withdrawals made from a Traditional IRA, which has been funded with after-tax dollars, are taxable on a pro-rata basis. This means that a portion of the withdrawal is not taxable, while the other portion is. The calculation depends on the percentage of the account that is attributable to after-tax contributions versus pre-tax earnings.
For instance, if a Traditional IRA balance consists of 50% after-tax and 50% pre-tax earnings, 50% of any withdrawal would be non-taxable. The other 50% would be subject to ordinary income taxation – as well as the 10% penalty, if applicable.
The tax-advantaged nature of retirement accounts makes them unique vehicles to build a base of investable assets. However, like any financial investment, there are pros and cons to each type of account. Carefully consider both your current and future tax picture when funding one account over the other.
Generally speaking, pre-tax accounts make sense if you either want to minimize your current tax liability or believe you will be in a lower tax bracket come retirement.
On the other hand, Roth accounts tend to make more sense if you currently reside in a lower tax bracket or if you believe you will be in a higher tax bracket come retirement. Roth accounts can also make sense for investors who want to maximize their tax-free withdrawals before or at retirement age.
If you have general questions about other types of retirement accounts, check out our article on 401k vs Roth IRA.
If you have questions related to your specific tax picture, it may be best to consult a tax professional.
Have questions on withdrawals from retirement accounts? Let us know!