Summary/TL;DR
In general, income produced in investment accounts will be classified as ordinary income or capital gains. Growth in a pre-tax retirement account will always be taxed as ordinary income, while growth in Roth accounts will always be exempt from taxation as long as all of the rules are followed. Capital gains will be paid on growth in taxable accounts, which can also incur dividends and interest.
Introduction
There are numerous vehicles that investors may use to save their money, all of which possess unique characteristics that may make them more or less ideal than others in a given set of circumstances. Perhaps the most important differentiator between them all is taxation.
In today’s post, I discuss the tax treatment of some of the most popular types of investment accounts.
Taxation Taxonomy
When it comes to paying taxes on investments, income will typically be classified in one of two categories: ordinary income, or capital gains. How it is classified will influence the taxation rate.
Ordinary income is taxed according to the marginal income tax brackets (below). One common misunderstanding with these tax brackets is that all of your income is taxed at the same rate as your marginal rate. Fortunately, this isn’t how it works. Each dollar of income is only taxed at the rate it falls in. For example, a married couple with $200,000 in taxable income will have the first $23,850 of income taxed at 10%, the next $73,100 taxed at 12%, and the final $103,050 taxed at 22%. Ordinary income is always taxed at a higher rate than long-term capital gains, which are discussed next.
Capital gains are split into two categories: short-term, and long-term. Short-term capital gains are incurred on the sale of an investment held for less than 12 months, and long-term capital gains are incurred on the sale of an investment held for 12 months or longer. Short-term capital gains are taxed as ordinary income, and long-term capital gains are taxed according to the capital gains tax brackets (below).
As can be seen, $1 of ordinary income is vastly different from $1 in capital gains from a tax perspective. Now that we’ve discussed how different types of income will be taxed, we can discuss the types of income produced by the different investment accounts and their respective tax treatments.
The Different Types of Accounts and How They Are Taxed
Pre-tax (Traditional) IRAs/401(k)s
“Pre-tax” accounts include Traditional IRAs and almost any employer retirement account that doesn’t have the word “Roth” in front of it.
Pre-tax accounts get their name from the fact that funds saved into them are not taxed at the time they are saved. In other words, they are saved before (“pre”) taxation. These funds remain untaxed until they are distributed in retirement (no capital gains tax is paid, in other words), at which point the entire distribution is taxable as ordinary income. Distributions from these accounts become mandatory at age 73-75, depending on your birth year. These mandatory distributions are called Required Minimum Distributions, or RMDs. Distributions from IRAs made before age 59½ are considered “premature” and are subject to a 10% penalty tax.
Finally, pre-tax retirement accounts are very tax-inefficient to inherit. When they’re inherited by non-spousal beneficiaries, all funds must be distributed within 10 years of receipt and all will be taxable as ordinary income.
Roth IRAs/401(k)s
Roth accounts are just the reverse of “pre-tax” accounts. When funds are deposited into a Roth account, they will still be included in your taxable income. However, Roth accounts remain tax-free forever after your original contributions (growth and all) as long as you follow a few IRS rules. Like pre-tax retirement accounts, premature distributions from Roth accounts are subject to a 10% penalty in addition to ordinary taxation on growth.
Roth IRAs are subject to a 5-yr rule that states that it must have been opened for at least 5 years before distributions from it qualify for favored taxability. If distributions are made before the 5-yr time period is up, then taxes and penalties will apply. Contributions in a Roth IRA are always accessible tax and penalty free regardless of age and whether or not the 5-yr time limit has been met.
Unlike pre-tax retirement accounts, Roth accounts are very tax-efficient to inherit. They are also subject to a 10-yr distributions period, but no funds are taxable upon distribution.
Non-Qualified Accounts
These accounts get their name from the fact that they are, simply, not “qualified” accounts like the ones discussed above. A qualified account is generally any investment account that qualifies for a tax-advantage contingent on certain rules being followed. A non-qualified account is therefore an account that does not qualify for any tax breaks, but also has the advantage of having no strings attached. Non-qualified accounts are also referred to as “taxable” accounts, or sometimes “brokerage” accounts.
When funds are saved into a non-qualified account, they will still be included in your taxable income. When funds are sold (not necessarily distributed) only the growth, calculated as the difference between the cost basis (what the investments were purchased for) and the fair market value of the investments at the time of sale, is taxable. If funds are sold at a loss, this may reduce your taxes. Generally, if you’ve held the stock for less than a year, the gain is classified as a short-term capital gain and will be taxed at your ordinary income rate. If the stock is held for a year or longer, then the gain will either be completely tax-free or taxed at a flat rate of 15% or 20% depending on your overall taxable income.
Other income produced by investments held in non-qualified accounts (such as dividends and interest) will also be taxed. Interest is always taxed as ordinary income, while dividends can be taxed as ordinary income (in the case of non-qualified dividends) or as long-term capital gains (in the case of qualified dividends). Finally, all income (capital gains, dividends, and interest) realized in a non-qualified account are considered “Net Investment Income”, which might be subject to an additional 3.80% tax depending on your overall income.
Non-qualified accounts are also very tax-efficient to inherit. At the time of inheritance, the cost basis in the investments receives a “step-up” to their current fair market value, which then becomes their new cost basis. Therefore, only growth that occurs after inheritance will be taxable, and it will always be considered “long-term”.
