What Should I Know About Taxes on My Investment Accounts?
An informed and educated investor can make better decisions if they know the unique tax attributes of each type of investment account.
In the US, 33% of households have a taxable investment account—often referred to as a brokerage account—and 89% of those households also have at least one retirement account, like an IRA or an employer-sponsored retirement account. We know that the medley of account types can make it challenging for the average investor to decide which account to contribute to or withdraw from at any given time. Further, the factors that might inform this decision don’t necessarily align with a straightforward, black-and-white rubric.
Taxable investment accounts are typically the easiest to set up and have the least amount of restrictions. Although you can easily contribute and withdraw at any time from the account, there are trade-offs. A taxable account is funded with after-tax dollars and any capital gains your incur by selling assets, as well as any dividends you receive, are taxable on an annual basis. While there is no deferral of income like a retirement plan, there are special tax benefits only available in taxable accounts.
Any gains avoid taxation until they are realized, or in other words, sold. Investments held for over one year qualify for long-term capital gains treatment, so those gains are taxed at a lower rate than investments that have been sold before being held for a year. There is an additional exception for an investor who holds investment assets until death: their cost basis is “stepped-up” (reset) to the market value on the date of their death. This means that the original cost of the assets is now considered to be the current value, and gains on any growth during their lifetime are avoided. Note too that inherited assets, when sold, are always taxed at the lower capital gains tax rate for long-term gains.
The term dividend is frequently used in a broad sense but can ultimately be referring to distributions from a variety of investment activities.
- Qualified dividends paid from the the earnings and profits of corporations are taxable at the reduced long-term capital gains rates.
- Foreign taxes paid on dividends from non-US investments may be eligible for a foreign tax credit—to partially or fully offset taxation in the US so you aren’t paying double taxes.
- Dividends paid from taxable bond investments are taxed at ordinary income tax rates.
- Dividends paid from municipal bond investments are generally tax-free.
Main Considerations for Choosing a Taxable Retirement Account
- You would like the option to withdraw at any time with no penalties.
- You have already contributed the maximum amount to all tax-advantaged retirement accounts.
Includes Traditional IRAs, Traditional 401(k)s, Traditional 403(b)s, Traditional 457 Governmental Plans, and Traditional Thrift Savings Plans (TSPs)
Traditional type investment accounts for retirement are generally funded with pre-tax dollars. The investment income received is deferred until the time of distribution from the plan. Assuming all the contributions are funded with pre-tax dollars, the distributions are fully taxable as ordinary income. For investors under age 59.5, there may be an additional 10% early withdrawal penalty unless an exemption applies. There are a number of possible 10% penalty exemptions, such as death, disability, or taking distributions as an annuity stream—refer to IRS.gov for more information. Unlike a taxable account, retirement plans do not receive a step-up in cost basis upon death. Foreign taxes paid on retirement account investments are not eligible to be claimed as a tax credit.
Main Considerations for Choosing a Traditional Retirement Account
- You expect your tax rate to be lower in retirement than it is now.
- You recognize and accept the possibility of an early withdrawal penalty.
Includes Roth IRAs, Roth 401(k)s, Roth 403(b)s, Roth 457 Governmental Plans, and Roth Thrift Saving Plans (TSPs)
Roth type investment accounts for retirement are always funded with after-tax dollars. Qualified distributions are tax-free. For investors under age 59.5, there may be ordinary income taxes on earnings and an additional 10% early withdrawal penalty on the earnings unless an exemption applies. While there is no step-up in cost basis upon death, distributions made to beneficiaries after the account has been open for five years are automatically tax-free. Foreign taxes paid on retirement account investments are not eligible to be claimed as a tax credit.
Main Considerations for Choosing a Roth Retirement Account
- You expect your tax rate to be higher in retirement than it is right now.
- You desire the option to withdraw contributions without being taxed.
- You recognize the possibility of penalty on earnings withdrawn early.
Summary of Key Considerations
- Are the retirement account contributions pre-tax or post-tax?
- Are the retirement account distributions expected to be tax-free?
- Is there a 10% early withdrawal penalty from a retirement distribution?
- Is there potential for long-term capital gain tax rates and qualified dividend rates?
Going the Extra Mile With Additional Tax Efficiencies
Betterment can help you be a smarter investor, because we offer additional features — at no extra cost — to help you minimize taxes so that you can maximize your money. Tax Coordination can help increase your overall returns if you are investing in multiple types of investment accounts, because it allocates your assets within each account type as tax-efficiently as possible. Tax Loss Harvesting+ can be used to capture losses during market declines so that you can use them to help offset future gains or even lower your tax bracket. Learn more about how Betterment helps you maximize your after-tax returns. Betterment is a financial advisor, not a tax advisor—consult a tax advisor or IRS resources for additional guidance.
Within a Betterment account, we can provide additional advice regarding which accounts you should be funding and in what order. You can even sync up your 401(k)s and other accounts to see an overall picture your finances. Get started or log in to complete your retirement plan and see personalized savings advice.