For a tax-conscious investor, finding tax-efficient investments is the key to successfully saving for retirement.
Not everyone thinks about the tax consequences on their investments and trusts that their financial advisers will be knowledgeable before making a recommendation. Often, it is a challenge for advisers to educate themselves on all of the tax laws that affect investments, which can cost you a hefty amount.
Tax laws are complicated and vary based on the different types of investments and retirement accounts. Here are the tax rules on 10 different retirement accounts and investments:
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1. Traditional IRA, 401(k) or similar accounts
Traditional IRA, 401(k) or similar accounts allow your retirement dollars to grow tax-deferred. Dividends, gains or profits from the accounts aren’t taxed until you withdraw the money.
Taxes are applied on the full amount of any withdrawal you make, unless you made a post-tax contribution. And the tax rate would be your ordinary income tax rate, which is typically higher than the more advantageous long-term capital gains tax rate.
Savers typically make pre-tax contributions to their 401(k)s, therefore anything they withdraw will be taxed. On the other hand, high-income earners who choose to contribute to a non-deductible IRA only owe taxes on tax-deferred earnings on the principal.
If for some reason you have company stock — perhaps in their 401(k) — make sure to transfer it to a taxable brokerage account to receive a Net Unrealized Appreciation (NUA) tax break. Company stock is taxed at a long-term capital gains rate if held for over a year.
2. Roth IRA, Roth 401(k) or similar accounts
Roth IRA, Roth 401(k) or similar accounts are funded with after-tax contributions. They allow your retirement dollars to grow tax-deferred, and withdrawals are tax-free as long as you’re age 59½ or older and the account is at least five years old. In addition, you can withdraw the contributions you’ve made (but not the earnings themselves) tax-free and penalty-free at any time.
3. Annuities
The interest earned from an annuity account is taxed at an ordinary income rate minus the principal. For instance, if you purchased an annuity with $100,000 and in 10 years it is worth $190,000, you would only pay tax on the $90,000 of interest earned. Different rules apply if you bought the annuity with funds from a traditional or Roth IRA or 401(k).
It is more advantageous to purchase an annuity through a traditional or Roth IRA or 401(k) rollover, because those accounts aren’t taxed at a more favorable rate (in comparison to stocks, bonds and mutual funds).
4. Stocks, bonds, mutual funds, real estate
Sales of stocks, bonds and mutual funds that have been held for over a year are taxed at a long-term capital gains rate. These rates will work out in your favor as long as current tax laws don’t change in the future. If you’re single and earn up to $38,600, married filing jointly and earn up to $77,200, or head of household and earn up to $51,700, gains are entirely tax-free up to a certain amount.
Short-term capital gains from sales of investments held for under a year are taxed at your ordinary income tax rate.
5. Dividends
Dividends are the profits gained from stocks. There are two types of dividends, taxed at different rates. Qualified dividends are taxed at long-term capital gains rates, and non-qualified dividends are taxed at an ordinary income tax rate.
To be considered as “qualified,” dividends must be held for a minimum of 60 days during a 120-day period which begins 60 days previous to the ex-dividend date. The ex-dividend date is the day after a company distributes dividend payments to its shareholders.
6. Municipal bond interest
The interest on a municipal bond is not taxed at the federal level, but capital gains from the sale of these bonds can be taxed at the federal level. Interest from bonds issued in an investor's home state is usually exempt from state income taxes, too.
Keep in mind that although municipal bonds are tax-free, interest earned will be factored into calculating Social Security taxation.
7. Pensions
Pensions are taxed at an ordinary income rate, as long as no contributions are made to the plan after tax. If you transfer a pension to an IRA and purchase an annuity, there is no tax advantage besides having the ability to choose when payments begin.
8. Cash value life insurance
Life insurance policies should be structured to maximize the cash value accumulation. Under IRS rules, the cash value withdrawn from a life insurance policy is tax-free as long as it is structured properly and doesn’t become a Modified Endowment Contract (MEC).
9. CDs, savings accounts and money markets
Interest payments on CDs, savings and money market accounts are taxed at an ordinary income tax rate.
10. Social Security benefits
Many people don’t realize that income from Social Security might be taxed. Taxes owed on Social Security income depend on your provisional income, which is calculated as follows:
- Your adjusted gross income — including salary, wages, dividends, alimony and withdrawals from an IRA or 401(k), but excluding Social Security
- plus any tax-exempt interest (i.e., municipal bond interest)
- plus 50% of your Social Security benefits
The worksheet in Publication 915 will determine if any of your Social Security benefits are taxable or not.
If you are in a low or 0% tax bracket, then you will not pay taxes on your Social Security. If your provisional income is between $25,000 and $34,000 as a single individual, or $32,000 and $44,000 as a married couple, up to 50% of your benefits will be taxed. Above those levels, up to 85% of your benefits could be taxed.
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