Understanding How Investments are Taxed Differently

When planning your investments, particularly as you approach retirement, one consideration is how the investments are taxed differently. The type of account you hold your investment in, as well as the type of investment could have an impact on what you can expect when it is time to pay taxes.

Tax Efficient Investing Takes Planning

Calculating how investments are taxed differently
Calculating how investments are taxed differently

Nearly everyone wants to make sure they are paying as little in taxes as possible. Chances are, your total investment portfolio has a combination of taxable, tax deferred, and tax-free accounts. Here is a brief explanation of what type of accounts fall into each category, and how investments are taxed differently:

  • Taxable Accounts — nearly everyone has at least one account which will result in all earnings being taxable. These types of accounts include jointly held accounts at brokerage firms, money market accounts, and other non-retirement accounts.
  • Tax Deferred Accounts — investments which are sheltered from taxes until a later date include 401(k)s and traditional IRA accounts. In most cases, investors will not pay taxes on these funds until such time as they withdraw them. Since these accounts are typically used in retirement, annual Required Minimum Distributions become necessary but, your income is generally lower meaning you are paying less in taxes.
  • Tax Exempt Accounts — examples include Roth IRA or Roth 401(k). Funds are deposited into these accounts as after-tax dollars and therefore you pay before you make deposits. Providing you follow the required rules pertaining to withdrawals, your earnings may also be tax free.

Ways that Investments are Taxed Differently

Different Investments get taxed differently
Different Investments get taxed differently

It is important to be aware that the type of investment you invest in may also impact the taxability of the investment.

Example: Municipal Bonds

For example, municipal bonds are generally not subject to federal taxes. However, they may be subject to both state and local level taxes which could negate any benefit you gain from holding these types of securities in a taxable account.

In many cases, an investor may opt for a mutual fund investing in bonds believing this type of fund will protect them from some taxes.

Make sure you fully understand the investments in the fund before counting on them to be tax deferred or tax free

Unless the bond fund is fully invested in tax-free bonds, you could get a big surprise at tax time.

Advantages and Disadvantages of Account Selections

It is important to understand that each type of investment account has upsides and downsides. First, jointly held investment accounts make sense for numerous reasons, particularly if you are holding cash in a money market account. These funds provide you with nearly immediate access to cash should you need it in an emergency. Additionally, since these funds are jointly held, your spouse or partner has equal access to the funds should you be incapacitated. This could be as important as minimizing your tax burden, particularly as you get older and are facing, or in retirement.

Your retirement accounts are more complicated. Your 401(k) may be sponsored by your employer. This means when you retire, you must make sure the funds are rolled over properly to maintain their tax deferred status. You may also have one, or more, IRA accounts that are also tax deferred. Since these accounts are subject to taxes when you withdraw funds, most investors prefer to avoid withdrawing funds until such time as the Internal Revenue Service mandates this be done through Required Minimum Distributions (RMDs). Beginning at age 70 1/2 , owners of IRA, SEP IRA, and Simple IRA plans must take a minimum distribution which is then included in your taxable income for the year.

Roth Accounts in a Separate Class

Roth IRA plans do not require you to take RMDs but a Roth 401(k) plan does have the same requirement as other retirement accounts. It is worth noting failure to take these distributions could mean the required amounts are subject to taxation of up to 50 percent.

It is worth noting for most people, Roth accounts will be out of reach as they earn more money. In general, if you are approaching retirement, you may be ineligible to make deposits to a Roth account. However, if you started investing early, you may have balances in your Roth accounts as you approach retirement. The funds not in a Roth 401(k) can remain untouched without penalty.

Tax Status Projections Play a Role

Most of us cannot easily determine how much income we will have in retirement. However, we must project that amount to ensure we have set up our investment portfolio in a manner that will provide us with the most tax relief, knowing that investments are taxed differently. The closer we are to retirement, the more important this step will be since our income will decline once we stop working.

To estimate your post-retirement tax bracket, there are several steps that must be taken which include determining how much social security you will receive, calculating pension benefits where applicable, and estimating income from your investments. Once you have an estimate of your Adjusted Gross Income (AGI) you may be able to determine how much of your investment portfolio should remain in tax free or deferred accounts. Remember, once you retire, you will be unable to add funds to your retirement accounts but there may be other options available to you.

Taxes in Retirement Can Have a Serious Impact

Retirees should be aware their taxable income could have an impact on more than their investment portfolio. For example, you could see an increase in Medicare taxes of up to 3.8 percent of your modified adjusted gross income exceeds $200,000 if you are single, or $250,000 if you are married and plan to file a joint return. This means you have to pay attention to possible capital gains and dividends from your investments, particularly as you approach retirement.

Accumulating Wealth Versus Preserving Wealth

Retirement for most of us means we are more concerned about maintaining our lifestyle by wise use of our investments versus accumulating additional wealth. This means you must take a realistic approach to manage your current investment portfolio. We are less risk-tolerant as we approach retirement, or during retirement, because our focus is more on stability than on the growth of our portfolio. This means we tend to be more conservative in our investment approach since we now need the income generated from our investments to maintain our lifestyle.

No Single Investment Answer for Everyone

There is no investment strategy that will work for everyone. There are numerous factors that must be considered to find a plan that helps you meet your financial goals. The age of your spouse is also a consideration when you are making these decisions. For example, if you and your spouse are both 60 years old, the decisions you make will be significantly different than if you are 60 and your spouse is 65.

Current Performance, Past Performance, and Future Performance

Investors also need to be aware of the fluctuations which can impact their investment portfolios. Just because a stock position has outperformed market expectations for a decade or more does not mean it will continue to do so.

Investment decisions need to be made free of emotion, based on the current market, and with your financial goals in mind.

This is the best way to approach your portfolio.

Focusing on Account Investment Strategies

We previously discussed the three types of accounts, taxable, tax-deferred, and tax-exempt accounts. Each of these accounts will require you to make specific decisions as you approach retirement and once you do retire. You still need to maintain a diversified portfolio, though chances are your investment choices will be less aggressive based on your current needs and the tax implications of your decisions.

There will always be investment basics that must be followed to ensure you get the most out of your investment portfolio. First, you cannot let market volatility force you into making bad decisions, you need to control the tax burden your investments could create, and your plan must take into consideration your specific goals and your risk tolerance.

How your Investment Decisions Impact your Taxes

You should always talk to your investment advisor about how your investment decisions could impact your taxes, regardless of what stage of your life you are preparing for. For those who are approaching retirement, or who have already retired, this is even more important because you do not want to face any major surprises at tax time.

Proper investment management is important to ensure you are getting the most out of the years you spent working towards a secure retirement.

That is one of the reasons why our focus is on helping you understand the right processes, the right tools, and the right mindset to ensure a successful investment experience.

Finley Wealth Management offers a rounded approach to managing your wealth. Thanks to our designation as a Certified Financial Planner™, you can get unbiased information from a fee-only specialist. We believe the best investment decisions are reached when you have the information you need to make the best decisions for you to reach your financial goals. Contact Finley Wealth Management today and schedule a conversation with us to tip the odds of successful planning in your favor.

About the Author Doug Finley

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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