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FinEdFriday: The 3 Areas of Investment Taxation Thumbnail

FinEdFriday: The 3 Areas of Investment Taxation

I remember the first time I earned a paycheck and the realization quickly set in...I didn’t get to keep everything I earned...

I was young, and just learning about the world of money, and while most adults understand how taxation works on earned income from our jobs, many do not understand how money invested is taxed.

There are several reasons someone may choose to invest their money, and not just save it inside a cash account. However, most of our attention falls upon our chance at returns, or our Return on Investment (ROI). Whether you have been investing for decades or you are fairly new to the idea of taking on some risk to possibly gain some reward, the annual returns on your investment can veil a VERY important detail of investing.

Investment Taxation

Here, we take a look at 5 different types of investment accounts that you may currently, or one day, own. These 5 types of accounts are HSAs, Roth Retirement, Traditional Retirement, 529 Plans, and Taxable Investment Accounts (with a quick note about property and business taxation). 

Allow this simple table, courtesy of Vanguard’s research department, to serve as a guide as we cover each in depth:

First, a quick guide to terminology on the 3 areas of investment taxation:

Contributions – When you put money into an account, whether it is the first time, or subsequent times, you are adding money that may or may not have already been taxed.

Investment Growth – Over time, your original investment may grow. The question becomes: Will you have to pay tax on those earnings?

Withdrawals – We love to think about contributing to an investment account, and definitely love the idea that it could grow without us lifting a finger, but rarely do we think through what happens when we go to withdraw, or use, that money for its original intention or goal. The * means that the money must be withdrawn for specific expenses to be tax-free.

Health Savings Account

An HSA is an investment account for medical expenses. It is one of the most overlooked, yet incredible, investment vehicles. Here’s why.

When you go to contribute to an HSA, it is either through your company paycheck before taxes are taken out, or if you do it manually, deductible from your taxable income. Either way, contributing to an HSA can actually reduce your taxes. As it is invested, and hopefully grows, you do not have to pay taxes on those earnings every year. And then, to cap it all off, if you withdraw the money for qualified medical expenses (whenever you want), you never have to pay taxes on the earnings.   

Do you realize what just happened? You just invested, possibly grew, and then used money without ever having to pay taxes.

What’s the catch? Your medical plan. You have to be signed up for a High Deductible Health Plan that allows HSA contributions. HDHPs only really pay off when something catastrophic happens to you. Otherwise, most medical expenses come out of pocket until your (high) deductible is met. 

Who this is for? Young people who do not have significant medical concerns, have no dependents, and rarely visit the doctor. 

One last catch. You can only contribute a certain amount to an HSA every year. The amount is determined by your tax-filing status. 

But imagine putting money into an HSA when you are young, allowing it to potentially grow by not touching it until you are older and medical expenses become rampant, and then having a bucket of tax-free money to use! The trifecta. In fact, many view an HSA as a "medical retirement account" for this very scenario.  

Roth Retirement Money

Our world has created a way for us to invest money now, allow it to potentially grow, enjoy its use later when we may or may not be working anymore, and reap certain benefits along the way. There are two ways to contribute to an account like this: pre-tax (see Traditional Retirement Money below) and post-tax. 

Whenever you see the word Roth, think post-tax. When we contribute to a Roth IRA or a Roth 401k, our money has already been taxed before it is invested. Why would I ever want to pay tax on that money before it is even invested?

There are certain years of our lives when we are in lower tax brackets (think when we are young and not making much, lose a job, our just make less that year). These are great times to contribute to a Roth retirement account because you pay taxes now, when your tax bracket is lower, assuming that when you go to use the money later in life, your tax bracket will probably be higher. 

There are such things as Roth accounts inside some employer plans. The withdrawal rules are slightly different than Roth IRA withdrawal rules, and will not be covered here.  

So, we contribute already taxed money to a Roth retirement account. The account then potentially grows tax-free. And since we have already paid our dues in the beginning, when we go to withdraw the money, it comes out completely tax-free!  Incredible. You can even change Traditional retirement money into Roth retirement money along the way through what is called a Roth Conversion.

The catch. You can convert as much Traditional (pre-tax) retirement money as you want, but you can only contribute so much to a Roth account each year. This is determined by your tax filing status and level of "earned" income. Also, you must meet certain conditions to use the money inside a Roth retirement account income tax free:

Original Contributions – you can take these out tax-free whenever you want for whatever you want

Converted Amounts – you must be 59.5 years old OR hold a Roth account for at least 5 years before you can pull out converted amounts penalty-free.

Earnings/Growth in the account – You must be 59.5 years old AND have held the account for at least 5 years before you can pull out earnings tax-free and penalty-free. 

However, both Converted Amount and Earnings/Growth Amount withdrawals have special circumstances where you can pull out a certain amount and not be penalized.

There are no required minimum distribution rules of Roth accounts (see traditional retirement money RMD rules below).

So, what happens if you don’t abide by these rules? You owe 10% in penalties, could pay income tax, and lose any future tax-free compounding growth on the amount. 

Traditional Retirement Money

This is similar to Roth retirement money, but your contributions are pre-tax (meaning they can reduce your overall taxes), grow tax-deferred, and then when you go to withdraw, you must pay income tax on the amount at your then current rate.

The catch. For a traditional IRA (individual retirement account), you can only contribute a certain amount each year, according to your tax-filing status and level of earned income. If it is an employer account, like a 401k, 457b, or 403b, there are other rules that allow you to possibly contribute more than an IRA. 

Also, since you do not pay your dues in the beginning, your original contribution, and all earnings, can only be withdrawn once you are 59.5 years old (there are certain specific exceptions to avoid penalties). If you don’t follow the rules? Same as a Roth, 10% penalty, income tax due on the amount, and you miss out on future tax-deferred growth. 

Another catch! When you turn 72 years old, you are required to withdraw, and thus pay taxes, on a certain amount every year. If not planned for, these withdrawals can be a surprise and push someone into a higher tax bracket. Less money in your pocket. And if you fail to withdraw the required amount, you lose 50% of the required amount to a penalty!

529 Plans

These are state-specific investment accounts for education expenses with some incredible features. When you contribute to a 529, and depending on your state, you get to deduct the amount from your state taxes (if your plan is from the state in which you reside). Note: The Vanguard table says contributions are "taxable" because it is not deductible on your federal taxes. This money can then grow tax-free over time. As long as you withdraw the money for qualified education expenses, the money can come out completely tax-free.  

There are MANY different rules around 529 plans that a qualified professional can help you navigate. But everyone wants to know, what if my kid doesn’t go to college? 

First, 529 funds can be used for more than just traditional college tuition. There is a long, and seemingly growing, list of qualified expenses you can use these funds for. 

Second, if the money is used for non-qualified expenses, you pay a 10% tax penalty, plus income tax. Usually income tax is paid at the owner's tax rate, however there are some plans that allow you to determine who is receiving the withdrawal, and if you can select the beneficiary as distributee, their tax bracket may be lower than yours.   

Third, you can change the beneficiary of a 529 plan to whomever you want, even yourself. Just because your child, or grandchild, doesn’t attend higher education doesn’t mean your successor owner’s (when/if you pass away while holding the account) child won’t attend, and so on. These accounts can be educational legacy builders, but a few plans have restrictions on how long an account can be passed down.

Taxable Investment Accounts

Yes, you can invest money without it being for retirement or education. When you contribute to these accounts, you contribute money that has already been taxed. This money can then grow, but you will owe capital gains tax on the earnings, possibly every year, depending on the types of investments used. Then, when you go to withdraw money for use, you will pay any capital gains tax on growth that has been “unrealized” during the time of holding. 

If you hold certain investments for more than 1 year, you will be taxed at your Long-Term Capital Gains rate (usually lower than your income rate). If you hold certain investments shorter than 1 year, you will pay tax at your Short-Term Capital Gains rate (usually your income tax rate). 

While the above sounds sub-optimal, depending on your situation, it can be wise to invest money that is not tied towards retirement or education, but instead can be used for goals along the way (like a home, a big trip, a shiny splurge, etc). This also gives you a way for your hard earned money to continue to work for you above and beyond the interest earned in a bank account. Remember, if prices are theoretically inflating 3%/year, and the cash in your bank account is only earning .5%/year, you are losing purchasing power.  

Also, if the asset is sold at a loss, those losses can be used to offset other gains, possibly reducing your tax liability. However, we usually never recommend investing money in a taxable account if you plan on withdrawing in less than 2 years. It is not worth the taxation, fees (if applicable), or shortened compounding time.

What about Property or Business Ownership?

As a simplification, the sale of directly held property and business ownership are also considered taxable investment assets that abide by the Long-Term vs. Short-Term taxation described above. Income from sources like real estate rentals is taxed at ordinary income rates, but is usually considered "passive," meaning it cannot be used to qualify you for IRA contributions, etc. 

Farms, Land, Rental Real Estate, Second Homes, Business Ownership, etc. all have significantly different (and complicated) features when it comes to their valuation and taxation, especially concerning available tax deductions. It is important to learn these details from a tax professional for your specific situation.

If you have made it this far without skimming and are still hungry for more, maybe you should become a tax professional! This stuff can be really dry, but can impact a family’s financial planning immensely. Investing can be very exciting, and is a great feature of how our economy, and its businesses, function. But your investment strategy should ALWAYS match the landscape of your family’s finances and the amount of risk you are willing to take on. There are many questions to be asked and discussions to be had before jumping into the deep end of any investment, specifically when it involves how the asset will be taxed when it is withdrawn.

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