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How Each Type Of Investment Account Is Taxed

The prior week we introduced some basic tax concepts that everyone should know. This week, we are going to continue to build on that foundation by discussing the different types of retirement accounts and investment accounts, and how they are impacted by taxes. This week’s video will delve into all of this in detail.

Understanding how these accounts work can help guide what assets you contribute to them. 

So let’s jump right in. 

Let’s begin with the main retirement accounts we want to cover here:

  • Traditional IRA
  • Traditional 401(k)
  • Roth IRA
  • Roth 401(k)
  • HSA

There are more accounts out there, but these are the options that most people have. Also, the accounts that aren’t mentioned here, work very similarly to the ones listed. 

Additionally, we’ll cover a taxable brokerage account, too. 

Traditional IRAs and Traditional 401(k)s work very similarly. They take in pre-tax dollars and defer taxes until they are redeemed at retirement age. If you withdraw them earlier than the age of 59 ½, you’ll be subject to a 10% early withdrawal penalty on top of the taxes you’ll owe.

The traditional IRA has contribution limits on how much can be contributed to the account in the year. For 2023, that amount is $6,500. Traditional IRAs also have limits on their tax deductibility depending on the filing status of the taxpayer. For a married filing jointly taxpayer:

  • A full deduction is available if your modified AGI is $218,000 for 2023.
  • A partial deduction is available for incomes between $218,000 and $228,000 for 2023.
  • No deduction is available for incomes greater than $228,000 for 2023.

For a single filer:

  • A full deduction is available if your modified AGI is $73,000 for 2023.
  • A partial deduction is available for incomes between $73,000 and $83,000 for 2023.
  • No deduction is available for incomes greater than $83,000 for 2023.

The Traditional 401(k) does not have this deductible limit. So, for 2023, you can contribute up to $22,500. 

In practice, let’s say you have a salary of $200,000 and you contribute the maximum amount to your 401(k) ($22,500), you’re left with a taxable income of $177,500. You won’t pay any tax on that $22,500 until it’s withdrawn in retirement. It grows tax deferred, meaning any dividends, interest, capital gains (if you sell and reallocate) etc. are all tax free while the money is in the retirement account.

In that example your marginal income tax rate as a single filer is 32%, you’re benefiting significantly from by deferring that income. When you withdraw that money, it’s likely that your marginal tax rate will be lower because you won’t have nearly as much income in retirement. 

So, let’s move on to the opposite side of the coin – the Roth retirement account.

The Roth IRA and Roth 401(k) work opposite of their traditional counterparts. The taxpayer contributes post-tax dollars. This means they’ve already paid tax on the income that they’re adding to these accounts. The income grows tax free, just like in the traditional accounts, but they won’t ever pay tax on that money, again. All the growth, dividends, interest, capital gains, etc. is tax-free. That is the main benefit of the Roth. Withdrawals are always tax free, because you’ve already been taxed on the contributions.

Moving on to the final tax deferred account, the HSA (health savings account), probably the most advantaged account offered, works a lot like a mixture of both a Roth and traditional account. You can contribute up to $7,750 in 2023 to your HSA. 

The account takes in pre-tax dollars and reduces your taxable income, just like a traditional 401(k), and then it grows tax free until the funds are used. So what does it mean to ‘use’ HSA funds? Any qualified medical expense that you withdraw HSA money for comes as a tax-free distribution. That’s how use is defined. What qualifies can be found here. You’ll notice that the list is long and comprehensive, so it’s likely you’ll qualify for close to anything you may need. 

It’s common advice to try and pay as much of your medical bills out of pocket, if you can, and contribute as much toward your HSA every year. If you can accumulate funds for your old age, when medical expenses are naturally higher, it can make a huge difference in the quality of your retirement from a financial perspective. Take advantage of the tax-free growth!

Finally, let’s talk about the investment account that has no tax deference – the taxable brokerage account. This account has no limits on contributions, nor does it have any type of early withdrawal fees. This offers a great deal of flexibility as to what you can do with the funds in it. The tradeoff, of course, is that all the dividends, interest, capital gains, etc. that come with the investments in the account are taxable in the year they are incurred. 

You can do what you want with that money, when you want, how you want. 

That covers the basics of retirement investment accounts. I hope you enjoyed the video and this blog. As always, thank you for reading!