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Keeping track of tax deferment differences can help save a bundle

by Susan Wright | Contributor
April 15, 2020


Knowing how and when different types of financial accounts are taxed can make a big difference regarding how much net spendable income you end up with – and ultimately, in determining your overall retirement lifestyle.

Taxes will typically play a key role throughout our entire lives. We generally pay tax on the income that we earn (both active and passive), as well as on many of the goods and services we purchase. Tax will also be collected on the growth that takes place in savings and investment accounts – and in some cases, tax will be due on the gain every year, even if the funds are not actually withdrawn.

How is the gain taxed in different types of financial accounts?

There are three primary types of financial or investment accounts when it comes to taxation. These include:

  • Taxable accounts
  • Tax-deferred accounts
  • Tax-free accounts

Taxable accounts

With a taxable account, as your funds grow, you will owe tax each year on the gain. This is the case, regardless of whether the money is withdrawn or remains inside of the account. One such example is a brokerage account. These accounts allow you to invest in a wide range of financial vehicles, such as stocks, bonds and mutual funds.

So, for instance, if you own shares of a mutual fund in a taxable investment account, you will be required to pay tax on the distributions – regardless of whether these fund distributions are paid out to you in cash or they are reinvested in additional shares. However, you have no control over the type distribution or whether it is a short-term or long-term capital gain.

Most taxable accounts allow you a lot of flexibility, such as being able to take withdrawals at any time without a penalty. In most cases, if you hold investments in a taxable account for at least one full year, you will be subject to the more favorable long-term capital gains rates (except for mutual funds) upon withdrawal, versus paying ordinary income tax on withdrawals that take place in a shorter time period.

Long-term capital gains tax rates (in 2021)

Tax Rate Single Head of Household Married Filing Jointly Married Filing Separately
Tax Rate0% Single$0 - $40,000 Head of Household$0 - $54,100 Married Filing Jointly$0 - $80,000 Married Filing Separately$0 - $40,000
Tax Rate15% Single$40,001 - $445,850 Head of Household$54,101 - $473,750 Married Filing Jointly$80,001 - $501,600 Married Filing Separately$40,001 - $250,800
Tax Rate20% Single$445,851 or more Head of Household$473,751 or more Married Filing Jointly$501,601 or more Married Filing Separately$250,801 or more

But, while taxable accounts impose fewer restrictions than tax-advantaged accounts (such as IRAs and 401ks), the regular taxation on the gain can end up slowing down, and essentially diminishing, your overall returns – especially over a long period of time. That’s because, even if the account has a positive return for a given time period, the tax that you incur can end up reducing what you actually earn.

Tax-deferred accounts

With an account that is tax-deferred, the gain that takes place on the underlying investments will not be taxed until the time it is withdrawn. So, the taxes are being “deferred” (or postponed) until a time in the future.

Because of that, the returns with tax-deferred accounts can compound exponentially, as the account is generating a return on the contributions, as well as on previous growth, and on the funds that would otherwise have been taxed.

Many types of tax-deferred accounts – such as a traditional IRA and 401(k) plan – will also allow investors to contribute pre-tax dollars. This means that the amount of the contribution will not be taxed as income at the time of contribution, and in turn, can reduce an investor’s income taxes due. At the time of withdrawal, then, 100% of the funds that are accessed from tax-deferred accounts will typically be taxed as ordinary income.

Tax-free accounts

In addition to taxable and tax-deferred options, there are also tax-free accounts. Keep in mind here, however, that even though the terms tax-deferred and tax-free may sound similar to one another, they are actually very different.

There are couple of reasons for these differences. First, the contributions that go into a tax-free account are usually after-tax dollars (meaning that they have already been subject to income taxation).

Tax Treatment of Different Financial Accounts

Taxable Tax-Deferred Tax-Free
TaxableSavings account Tax-DeferredTraditional IRA Tax-FreeRoth IRA
TaxableBrokerage account Tax-DeferredTraditional SEP IRA Tax-FreeRoth 401(k)
TaxableMutual funds Tax-DeferredTraditional SIMPLE IRA Tax-FreeRoth 403(b)
TaxableMoney market account Tax-DeferredTraditional 401(k) Tax-FreeRoth 457 plan
TaxableCDs (Certificates of Deposit) Tax-DeferredTraditional 403(b) Tax-Free529 plan
Tax-DeferredTraditional 457 plan Tax-FreeCoverdell education savings account
Tax-DeferredQualified annuity Tax-FreeHealth savings account (HSA)
Tax-DeferredNon-qualified annuity

The growth that takes place in a tax-free account, as well as the withdrawals that are accessed, will be free of income taxes. So, regardless of how much the account has grown, and no matter how high the income tax rates are the time of withdrawal, the investor will still net 100% of these funds as spendable income.

It is important to note that with tax-advantaged accounts, such as IRAs, annuities and employer-sponsored retirement plans, you can typically incur a 10% early withdrawal penalty from the IRS if you access your funds before turning age 59½. So, in most cases, these accounts should be considered long-term components of your overall portfolio.

Are withdrawals based on FIFO, LIFO or an exclusion ratio?

One of the other ways to determine how – and how much – you could owe in tax on your withdrawals is based on whether the withdrawals are considered FIFO (“first in, first out”) or LIFO (“last in, first out”), or alternatively computed via an exclusion ratio.

For instance, LIFO means that money taken out of the account is either the gain, or if there isn’t any gain, the most recent contribution that was put into the account. Alternatively, FIFO means that what went into the account first (i.e., the basis) will come out first – leaving the (possibly taxable) gain to be accessed last.

On the other hand, the exclusion ratio is defined as the percentage of the return that is not subject to taxes. For instance, with non-qualified annuities (i.e., annuities that are purchased with after-tax dollars), a portion of the income received will typically consist of taxable gain, and another portion will consist of non-taxable return of the contribution if you annuity contract is annuitized. Knowing which is which can help you in determining that taxes that are due on these withdrawals.

How can you minimize the impact of taxation on your retirement income and funds?

Before moving forward on any type of retirement income plan, it is recommended that you discuss all of your potential options with a financial specialist who is well-versed in this type of planning and who can help you to anticipate – and possibly even to reduce – the impact of taxes on your withdrawals.

If you’re ready to discover how to lock in a guaranteed income for life – regardless of how long you may need it – then contact Alliance America and set up a time to chat with a retirement expert today.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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