One of the largest lifetime expenses that many Americans face is taxes. Since we all have to pay taxes on our income and we (ideally) earn an income or profit from our investments, we have to pay taxes on our investments as well. This is why it is important to consider the types of investment accounts you hold.
If you are interested in minimizing your lifetime tax bill then you will want to carefully examine which type of accounts your investments are in. Listen in to hear the tax structure of each type of investment account so that you can make an informed decision about where to invest your money.
You will want to hear this episode if you are interested in…
- Three ways investments can be taxed [1:22]
- The third type of investment account [4:20]
- Which account is right for you [6:30]
- Your homework [8:46]
The 3 types of investment accounts
Since the goal of investing is to increase the value of your investments you’ll generate income or increase the value of your investments. My job as a financial planner is to help my clients minimize their lifetime tax bills. I help my clients do this by using three types of investment accounts: after-tax, tax-deferred, or pre-tax.
After-tax investments are created by using money that you have already paid income taxes on. This means you pay taxes annually on realized gains and income from the portfolio, but do not trigger a tax when you take money out of this account.
Tax-deferred investments are commonly held in employer-sponsored accounts
The second type of account is created with money that has not yet been taxed. We call these accounts tax-deferred. The most common type of account with this structure is an employer-sponsored retirement account like the 401K or 403B. There can be many stipulations to investing in these types of accounts, but the most common one is that they aren’t accessible without penalty until age 59 ½.
Often times we look at our balances of these accounts with pride and think that we have so much money, but it is important to recognize that you have a silent partner invested in your account: the IRS. The IRS ensures that you don’t leave the money there forever by imposing the Required Minimum Distribution rule.
That is why it is important to not put all your eggs in this basket. Doing so will ensure that you have a hefty tax bill when it is time to withdraw your money.
After-tax accounts grow tax-free
The third type of account is one that you have paid taxes on already and the money grows tax-free as long as you follow the rules. The most common types of after-tax accounts are Roth IRAs and 529 plans. Roth IRAs can be accessed without penalty after age 59 ½ and 529s can be used for qualified education expenses.
Which account is right for you? Usually, a mix of different account types is the best way to invest. However, every person is different and so their tax situations are different too. A financial planner can help you decide the best way to split your investments so that you can reduce your lifetime tax bill. If you would like help understanding the best fit for your situation shoot me an email.
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