How Are You Paying Taxes On Your Investments
As you see in the chart to the right, an individual that has saved $819,000 for retirement. You will also notice in the pie chart that 73% is in tax deferred accounts (this individual has not paid taxes on it yet).
Why is this important?
Because with tax laws always changing it is important to have balance with how your accounts are taxed. By creating diversification with regards to how an account is taxed it will give you greater control in the future!
Before you can start to create tax diversification, you need to know how accounts are taxed. There are 3 ways an account can be taxed
- Tax Deferred
- Tax Free
A tax deferred account is a “tax later” account, meaning you will make your contributions with pre-taxed money and then you will pay tax on withdrawals in retirement. You will not pay taxes on the gains in the accounts until you take the money out. Common accounts that fall under the tax deferred label are 401(k)s, 403(b)s, 457s, Traditional IRAs and Pensions.
A second feature of tax deferred accounts is that you are deferring income (and your taxes). If you are making $100,000 at you job and you chose to max out your 401(k) contributions (which is $19,500 in 2021) your income would now be $80,500 because you are deferring the rest into the 401(k).
Tax deferred accounts are very useful for lowering your current income.
A taxable account is a “tax now” account. With a taxable account you will pay taxes on the gains or receive a tax credit on losses (I’ll explain this concept in another blog). You will only be liable for taxes if there is a taxable event. A taxable event could be selling a stock, a dividend, or when a mutual fund passes a gain to you. Taxable accounts are usually Brokerage Accounts.
Unlike a retirement account, with a taxable account the funds can be withdrawn at any time, just be careful with short term vs. long term capital gains. A short-term gain is where you buy and sell a security within a year. A long-term gain is where the security is held for over a year. *
*Even if you hold a mutual fund for over a year you can have short term capital gains because the mutual fund company passes its trading gains/losses to you. This makes the majority of them less tax efficient than exchange trade funds, stocks and bonds.
The last way an account can be taxed is with no tax. Let me rephrase that; there is no tax on the distribution of the account, you will pay taxes initially because the contributions will be made with ‘after tax dollars’ (similar to the taxable accounts). Common accounts that are tax free are Roth IRAs and Roth 401(k)s.
Tax free accounts are useful for lowering future tax liabilities.
Which do should you contribute to?
You should be contributing to all 3 types of accounts.
- If taxes go up in your retirement you will be able to withdraw more tax-free money out of your Roth IRA.
- If taxes go down in your retirement you will be able to withdraw more money from your tax deferred.
By having accounts that are taxed differently you will create the diversification you need to be prepared for any changes in tax code.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax, legal, or investment advice and may not be relied on for purposes of avoiding any federal tax penalties. Individuals are encouraged to seek advice from their accountant, financial planner, and counsel. Neither the information presented, nor any opinion expressed constitutes a representation by WM Wealth Planning as a specific recommendation to the purchase or sale of any securities/investment. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by WM Wealth Planning for educational purposes.*