Broker Check
What to Know Before You Open Your Next Investment Account

What to Know Before You Open Your Next Investment Account

August 23, 2023

Understanding the difference between taxable, tax-deferred, and tax-exempt accounts can improve portfolio diversification and make a difference in how much you earn over time. But investors may not fully understand how a strategy called asset location may help improve returns and lower their overall tax bill using these different types of accounts. Each account type has different tax rules and treatments, and understanding each may help you determine which accounts suit your situation. Here, we outline what you need to know about each account type:

Taxable accounts - A taxable account is an account for which the IRS default rules apply, meaning there are no tax benefits. However, taxable accounts often have fewer restrictions and more flexibility when investing and withdrawing from them. Examples of taxable accounts include:

  • Checking and savings accounts
  • Money market accounts
  • Brokerage accounts that hold securities (stocks, bonds, ETFs, mutual funds, private investments)

In a taxable account, earnings such as dividends or interest are taxed yearly (money market, checking, and savings accounts) or when you sell strategies that gain value. Long-term gains on investments sold from taxable accounts are taxed at the 15% capital gains rate, which may be lower than an investor's federal tax rate.

Also, taxable accounts have no contribution limits or age restrictions for withdrawing.

Tax-deferred accounts - Tax-deferred accounts allow the payments of taxes to be delayed until the money is withdrawn. Examples of tax-deferred accounts include retirement savings accounts such as:

  • 401 (k)s
  • IRAs
  • 403 (b)s
  • Tax-deferred annuities
  • Health Savings Accounts (HSAs)

Contributions into a tax-deferred account are made with money that has not been taxed, and contributions may help lower the investor's taxable income the year they were made. However, once the money is withdrawn from these various accounts, the contributions and earnings are taxed as ordinary income at the investor's current tax rate.

Tax-deferred accounts have contribution limits, age restrictions for withdrawing, or other conditions such as what the money can be used for, such as health care expenses. Tax-deferred accounts are often part of an employer-sponsored retirement savings plan or other employer benefits.

Tax-exempt accounts - Tax-exempt accounts require contributions to be made with after-tax dollars and do not provide a tax deduction on those dollars. However, tax-exempt accounts may not have additional taxation, providing the investor follows the applicable tax rules on these types of accounts:

  • Roth IRAs
  • Roth 401(k)s
  • Roth 403(b)s

Tax-exempt accounts provide future tax breaks since withdrawals at retirement are not subject to taxes; the accumulation is tax-free.

There may be income limits to invest in tax-exempt accounts and age restrictions on the withdrawal age or the tax-exempt status, or a penalty may apply. Your financial and tax professionals can help you understand the rules on tax-exempt status for your situation.

An asset location strategy using these three investment strategies, taxable, tax-deferred, and tax-exempt, may help your tax situation now or later in retirement. A financial professional can help you determine if diversifying your portfolio using all three investment strategies may be appropriate for you.



Important Disclosures:

Content in this material is for educational and general information only and is not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.

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.

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.

Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.?

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals 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. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by Fresh Finance.

LPL Tracking #1-05372941

Sources:

https://www.thebalancemoney.com/taxable-accounts-vs-iras-2466429

https://www.investopedia.com/terms/t/tax-deferred-savings-plan.asp

https://www.investopedia.com/articles/taxes/11/tax-deferred-tax-exempt.asp