With every transaction having some sort of tax consequence, understanding those implications is fundamental to building long-term wealth. In addition, when placing money in an investment account, you should understand the tax rules. You may have opened several different types of investment accounts over the years and need to understand the tax implications of each. Or you may have accounts available to you through your employer, but you do not fully understand their tax features. The following are the tax basics of some commonly used investment accounts:
Traditional IRAs and Traditional 401(k)s
These accounts are taxed very similarly – you contribute money to them with pre-tax dollars, the funds in the account grow tax-deferred, and withdrawals are taxed at your ordinary income tax rate after you reach age 59 1/2. Therefore, with these accounts:
You receive a tax deduction when you make a contribution,
You do not pay taxes on this money while it grows in the account, and
Once you make withdrawals, the withdrawals are taxed as ordinary income.
If you withdraw funds from these accounts before age 59 1/2, you may be subject to a 10% early withdrawal penalty in addition to paying ordinary income taxes on the amount.
NOTE: there are exceptions to the early withdrawal penalty if you take out money from a Traditional IRA or 401(k) before age 59 1/2. Consult your financial advisor or tax preparer to see if these apply to you.
Traditional IRAs and 401(k)s have annual contribution limits that are set annually by the IRS. Additionally, the IRS may limit the amount of your IRA contribution that you can deduct if you (or your spouse) are an active participant in a work retirement plan. In other words, if you and/or your spouse are receiving income but neither of you are participating in your work's retirement plan, you can contribute to an IRA and deduct the total amount – up to $7,000 if you are under age 50, and $8,000 if you are 50 or older for 2024. If you and/or your spouse are receiving income and participate in a work retirement plan, you may receive a partial or no deduction for contributions depending on your filing status and your modified adjusted gross income (MAGI).
NOTE: IRA contribution deductibility is based on your modified adjusted gross income (MAGI), not your base salary. If you are unsure about how to determine your Modified Adjusted Gross Income (MAGI), talk to your financial advisor or tax preparer.
Traditional 401(k)s do not have the same deductibility restrictions as IRAs. For 2024, you can contribute up to $23,000 as an employee to a Traditional 401(k) if you are under age 50 and $30,500 if you are 50 or older. If you are self-employed and a sole practitioner, you may want to consider the benefits of a Solo 401(k), which has the added tax benefit of allowing you to make both employee and employer contributions.
The benefits of these accounts are particularly useful for working individuals who expect to be in a lower tax bracket when they retire. Therefore, they get the tax deduction now and defer paying the taxes until later on when they will not be working, not receiving a salary, and will be in a lower tax bracket.
For example, let's say you file your taxes as a Single individual and have an annual salary of $115,000. If you contribute the maximum amount to your 401(k) – $23,000, assuming you are under 50 years old. That means your taxable income will be brought down to $92,000, and your contribution will not be taxed until it is withdrawn in retirement. Everything else being equal, without this deduction, you would have found yourself in the 24% federal income tax bracket. With the deduction, you drop to the 22% tax bracket and benefit significantly by deferring that income. All dividends, interest, and capital gains earned on your contribution are not taxed in the account. Then, when you withdraw that money, you will likely be in a lower tax bracket because you will not have nearly as much income in retirement.
Roth IRAs and Roth 401(k)s
Roth IRAs and Roth 401(k)s effectively work in the opposite way as their pre-tax counterparts listed above. With Roth accounts, you make contributions with after-tax dollars. This means that you do not receive a tax deduction for Roth funds, and you make contributions with income on which you have already paid taxes. Just like in traditional (pre-tax) accounts, you do not pay taxes on the growth of the funds in the account. The difference is that when you take distributions in retirement, the withdrawals are tax-free. In other words, since you already paid your taxes upfront by making the contributions with after-tax dollars, you will not be taxed on withdrawals. Therefore, withdrawals from a Roth account will be tax-free.
As with Traditional IRAs, Roth IRAs have the same contribution limits – for 2024, up to $7,000 if you are under age 50 and $8,000 if you are 50 or older. It is worth noting that if you have both Traditional and Roth IRAs, you cannot contribute the maximum contribution limit to both. Therefore, you can spread your yearly contribution between your Roth and Traditional IRAs, but the total amount you contribute across all of your IRAs cannot exceed the annual limit.
Whereas the deductibility of Traditional IRA contributions is subject to income limits, Roth IRAs have income limits regarding your ability and eligibility to contribute to them. Depending on your filing status and modified adjusted gross income, you may be able to make a full contribution up to the contribution limit, make a reduced contribution, or be ineligible for making a contribution.
Unlike Roth IRAs, Roth 401(k)s do not have income limits to make contributions. Therefore, regardless of your income, you can contribute up to the full annual allowable amount to a Roth 401(k) – the maximum allowed for 2024 is $23,000 if you are under age 50 and $30,500 if you are 50 or older.
Individual Brokerage Accounts (aka Cash Management Accounts) and Trusts
These are referred to as 'taxable brokerage accounts.' They do not have any contribution limits or income restrictions, and there are no early withdrawal penalties. Of the accounts mentioned above, taxable brokerage accounts offer a great deal of flexibility in how you can use the funds.
NOTE: Depending on the type of trust and how the trust document was drafted, there may be certain restrictions as to how the funds in the trust account can be invested, how assets are disseminated, and whether you can contribute more to them. If you are unsure about this, talk to a financial advisor or estate planning attorney.
The tradeoff to the flexibility that these accounts offer is that these accounts are not tax-advantaged. Therefore, any dividends, interest, and capital gains accrued from your investments in the account are taxable.
Health Savings Account and Flexible Spending Account
Taxation for Flexible Spending Accounts (FSA) is fairly straightforward – you can set aside money pre-tax, and when you spend the funds (so long as they are for qualified medical expenses), the withdrawals are tax-free. However, there is no accumulation benefit with FSAs. Money in an FSA is meant to be spent and not accrue. Consequently, FSAs have a 'use-it-or-lose-it' provision, which states that if you leave over a certain amount in your FSA at the end of the year, you could lose it. If you have an FSA with a large amount of unused funds in it, talk to your plan provider about how much of your FSA can be rolled over each year without losing it.
Health Savings Accounts (HSAs) are probably the most tax-advantaged account available. Think of the tax treatment for these accounts as a combination of a pre-tax (traditional) retirement account and a Roth retirement account. In other words, the money you put into an HSA is tax-deductible (just like a pre-tax retirement account), money in the HSA can then grow tax-deferred, and withdrawals can be made tax-free (just like a Roth retirement account) so long as they are for qualified medical expenses.
NOTE: FSAs are only provided through employer-sponsored health plans – self-employed and unemployed individuals cannot open an FSA. Meanwhile, HSAs are available to anyone who meets the eligibility requirements; they do not have to be offered through an employer.
Like retirement accounts, HSAs and FSAs have contribution limits. For 2024, the maximum contribution for individuals to contribute to an HSA is $4,150, and families can contribute up to $8,300. There is also a catch-up contribution for individuals 55 and older of $1,000. For FSAs, the contribution limit for 2024 is $3,200.
If you are interested in learning more about HSAs, check out Health Savings Accounts: Everything You Need to Know to Make the Most of Your HSA.
529 Savings Plans
529 Savings Plans (or simply '529s') are one of the most popular investment vehicles when paying for education expenses. Similar to Roth accounts, contributions are made with after-tax dollars, the money grows tax-deferred within the account, and distributions are tax-free so long as they are for qualified education expenses.
Note that while there are no federal tax deductions for contributing to a 529 account, there may be state tax deductions. Most states offer their own 529 plans, and depending on where you live, your state may give you a deduction for contributing to that plan.
Moreover, there are no annual contribution limits for 529s like there are with retirement accounts, but if your contribution exceeds your gift tax exclusion for the year, it may trigger a gift tax. There are, however, maximum contribution limits per beneficiary that each state sets. This limit applies to the total contributions to a beneficiary under a particular state's plan over the life of the account.
If you are looking for a financial advisor to help you better understand the tax impact of your investment accounts, check us out! You can schedule a complimentary, no-obligation call with us here.
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About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
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