There are three types of investment accounts. This article gives examples of each type and how it is taxed.
Types of Investment Accounts
The three types of investment accounts are:
Pre-Tax and Tax-Free
Pre-tax and tax-free accounts are also referred to as “retirement accounts.” The IRS gives these accounts tax-favored status, to help people build wealth for retirement.
Retirement accounts can be opened through work, or outside of work. Retirement accounts have contribution limits. The limits vary by account type and sometimes by your income level. Also, the limits adjust upward with inflation over time.
Taxable accounts are not retirement accounts, and don’t have contribution limits. Anyone can open a taxable account.
Taxable accounts are sometimes referred to as brokerage accounts.
This table shows examples of each account type.
401(k), 403(b), 457
Cash Balance Plan
This table shows the tax treatment of each account type at three key points:
- When money goes in (contributions).
- While money is in (income).
- When money comes out (withdrawals).
Some discussion follows the table.
Pre-tax accounts are called pre-tax because you save tax on the front end. This is because you get a tax deduction for your contributions. If you contribute $20K to your pre-tax 401(k), you save $8K on your tax return, assuming a 40% tax rate.
With tax-free and taxable accounts, you don’t get a tax deduction for your contributions. So, you don’t save tax on the front end. The payoff comes later, on the back end.
While money is in an account, it can generate three types of income:
- Dividends from stocks (or mutual funds that hold stocks).
- Interest from bonds (or mutual funds that hold bonds).
- Capital gains (from selling stocks, bonds, or mutual funds at a gain).
With pre-tax and tax-free accounts, you pay no tax while money is in the account. Dividends, interest, and capital gains don’t affect your tax return at all.
With taxable accounts, you pay tax on the income each year.
With pre-tax accounts, you pay ordinary income tax on withdrawals. Every dollar withdrawn is taxed: your original contributions, plus all the growth.
With tax-free accounts, you pay no tax on withdrawals. Not on your original contributions, not on the growth. This is the payoff for not getting a deduction for your contributions: all that growth is-tax free.
With taxable accounts, you pay no tax on withdrawals either:
- If you sell investments in a taxable account to get cash, you may owe tax if you have a capital gain.
- But you’d pay that tax whether you leave the cash in the account, or take it out. The sale, not the withdrawal, causes the tax.
If you’d like to evaluate if you have the right mix of accounts for your goals, schedule a FREE Financial Pulse Assessment™. This is a 3-step process to get clarity on your finances and “test drive” our services.
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