Like most subjects, investing requires a thorough understanding of the basics. Whether you’re creating a portfolio for the first time, going through a life event (marriage, birth of a child, divorce, etc.) or just want to take a closer look at your finances, you’ll need to first understand the core concepts and types of accounts available to you.
One of those concepts is the difference between tax-deferred (e.g. IRAs, Roth IRAs, 401(k)s) and taxable accounts (e.g. Joint, individual, trusts accounts). Here’s a quick overview of the differences to get you started. Then, check out these pieces to learn how to strategize your financial plan based on your life stage:
- Student Loan Repayment, Simplified
- Good vs. Bad Debt
- How to Set Up Your Emergency Fund
- Why Everyone 18 and Older Needs an Estate Plan
- Say “I Do” to Your Spending Plan
- Estate Planning: Not Just for the Old and Rich
- Collecting Social Security on a Former Spouse
- Is Life Insurance for You? 3 Questions to Ask Yourself
- 3 Considerations for Dividing Assets in a Divorce
Tax Deferred Accounts (IRAs, 401(k)s, Roth IRAs)
Tax deferred accounts include employer retirement plans (or qualified plans) and retirement accounts. In essence, they are called "tax deferred" because you don't pay taxes on investment income while it's growing in your account. You often pay taxes on the dollars when you withdraw from the account. Typically, contributions to tax deferred accounts are pre-tax meaning you have not paid taxes on the dollars yet. (There are a couple of exceptions, like a Roth IRA.)
Distributions from IRAs and qualified plans are taxed at the account owner’s ordinary income rate. For example, if you are in the 22% tax bracket, you will pay 22% on all distributions from the account(s) – except Qualified Charitable Distributions. The major exceptions to this rule – because there is always one – are Roth IRAs and Roth 401(k)s.
Roth accounts not only grow tax deferred, but distributions are tax-free if made after the account owner is age 59 ½ or under special circumstances.
Time can work in your favor in tax-deferred accounts. Typically, in retirement, you are in a lower tax bracket than what you are while you are working. Therefore, by deferring the taxes to your retirement years, you pay lower tax rates overall on the investment growth and the interest and dividends that have been accumulating in the account over time. The longer the account grows tax-deferred, the more the investments can grow tax-deferred and then be taxed at the lower tax rate during retirement.
Most of the time, the investments in a tax deferred account are relatively liquid, meaning they can be sold and converted to cash relatively quickly. However, to withdraw the cash, there will likely be tax consequences and/or penalties. Tax Deferred accounts should be looked at as funds for retirement and only used in a true emergency once a professional has been consulted.
Taxable Accounts (Joint, Individual, Trust, etc.)
Brokerage or investment accounts that are not governed by ERISA or other IRS rulings. We refer to them as “taxable,” because you pay taxes on income generated as it’s earned.
Interest and dividends are taxed in the year they are paid; whether or not the dollars are taken from the account. The account owner pays taxes on realized capital gains, but that tax rate is often equal to or lower than the tax rate than ordinary income tax brackets unless you held the share for less than a year.
So, for instance: Let’s say you pay $10 for a share of ABC stock two years ago. Today, you sell it for $15. The difference is $5, so that’s what you would pay taxes on.
Because you pay taxes as income is earned or gains are realized, when you take cash withdrawals or transfer securities from the account, you pay no taxes and there are no penalties for withdrawing dollars prior to retirement age.
The timeline is defined by your personal financial goals for the dollars. For instance, retirement would be a much longer-term timeline than a home purchase (mid-term) or cash reserve (short-term). You can adjust the risk profile within the account to adjust for the when you plan to use the funds. If you are using the funds to plan for your two-year-old’s college tuition, you can take additional risk in the investments. Whereas, if you're sending your seventeen-year-old to college with the funds, you will likely take significantly less risk.. There is no restriction that defines that the funds be used in retirement or after a certain age.
Nothing in finance is ever one-size-fits-all. But by understanding the general differences between tax-deferred and taxable accounts, you’ll be better equipped to create and reach your financial life goals.
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
This post was written by a member of the Plancorp Women’s Initiative, which strives to advocate for clients and women in the community by addressing topics specific to their financial lives. For more information about the Women’s Initiative and how you can get involved, email email@example.com or visit the Plancorp Women’s Initiative page.