How do I start investing? It is a simple question and an understandable one at that. With the seemingly endless strength of the stock market and the rise of easy-to-use investment apps like Robinhood[i], everyone wants to try their hand at investing. What many fail to realize however, is that the type of investment account you choose, matters. The reason that this is so important is because Uncle Sam treats each type of account very differently. At their most basic level, investment accounts can be broken down into three different categories: Taxable, Pre-tax, and After-Tax accounts.
Part of being a citizen of the United States, or really any country for that matter, is paying your taxes. When you earn money from employment and receive a paycheck, part of that paycheck goes to the state and federal government. Investment income and returns are not excluded from this. Taxable, or brokerage accounts, are the simplest type of investment account to understand and therefore one of the most common among individual traders on the apps and services mentioned above.
In an individual brokerage account, you have the ability to invest in any asset class. The world is truly your oyster! You could purchase stocks, bonds, mutual funds, ETFs, or even options or commodities. If you decide to sell one of your holdings, you will pay capital gains taxes if you sell the holding for more than you bought it for. If you sell multiple holdings for both gains and losses, you can report a net gain/loss on your taxes. For example, let us say that you sold ABC for a gain of $6,000 and XYZ for a loss of $4,000. You would be liable for capital gains tax on $2,000 worth of gains. In this way, taxable accounts are fairly straightforward and act just like any other asset.
A pre-tax, or tax deferred, investment account is exactly what it sounds like: investments made pre or before taking out taxes. Another name for a pre-tax account is a ‘qualified account’ as opposed to a taxable account which would be referred to as a ‘non-qualified’ account. Examples of qualified accounts are individual retirement accounts (IRA) and company 401(k) or 403(b) plans. In the example of a company retirement plan, your contributions are pulled directly from your paycheck and deposited into your account without being assessed federal or state income tax. An IRA, or Traditional IRA, differs in that contributions can either be made as a rollover from a previous employer plan or as an after-tax contribution with the ability to take a federal income tax deduction in the amount of your contribution.
It is important to note here that there are a few ways in which taxes are handled differently in a qualified account. First, the only time that an investor pays taxes in a qualified account is when they take a withdrawal from that account. The investor can buy and sell holdings within the account without tax consequences. Those taxes are deferred until an actual withdrawal is made from the account. Secondly, the type of taxes owed on a qualified account differ from a non-qualified account. You will remember that in non-qualified account you pay capital gains tax on any gains that result from the sale of an investment. In a qualified account, you pay ordinary income tax on any and all withdrawals that you make from the account. This includes both your contributions as well as any gains that have accrued in the account. In addition, if you take an early withdrawal (any withdrawal prior to age 59 ½) you will also be charged a 10% by the IRS. Suffice it to say that it is in your best interests to use a qualified account as a long-term investment saved only for retirement.
The best example of an after-tax investment account is the Roth IRA. Contributions made to a Roth IRA are made directly from your bank account or by check which means that you have already paid taxes on those dollars. Contributions made to a Roth IRA are tax free upon withdrawal regardless of when you make the withdrawal (i.e., there is no 10% penalty to withdraw contributions prior to age 59 ½). Like a Traditional IRA, contributions in a Roth IRA also accrue tax deferred and gains are not taxed until withdrawal. However, unlike a Traditional IRA, gains are only taxed in a Roth IRA if they are withdrawn prior to age 59 ½. If the investor waits to take a withdrawal of their gains until after retirement age then the entire withdrawal, both gains and contributions, will be tax free. It is also worth noting that if the investor elects to take a withdrawal including investment gains prior to retirement age that the gains will not only be taxed but also assessed the 10% penalty. There are caveats and exceptions to these rules which can be found here[ii].
This blog post is not meant to be an exhaustive list of all the rules and guidelines for each type of account nor is it meant to be an endorsement of one type of account over another. Rather, I want to give you a basic understanding of the different types of accounts and how they might fit into your plan. For more information on opening an investment account you can reply to this email with questions (email@example.com), give me a call at 616-914-2758, or schedule a Zoom call here.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.