Tax Talk – How different Investments Are Taxed

In the latest market update blog, I used an analogy involving cars, I’m going to continue with that as we talk about how different investments are taxed.


We’re going to pretend the tax is kind of like a toll that we all go through.


We have three different categories of how things could be taxed. First, we have taxable account. In our tax tool, you have to stop at each tool and pay every time you go thru (each tax year).


There are also a couple of different ways that you could have to pay the tax. You will have a base rate, similar to a car going thru the toll, which in this case is income tax, which is based at your current rate.


But there is also another tax that can be due, and that is capital gains tax. This happens if we sell something that is appreciated and most people understand this, but it can also be the result of someone else selling something if you are invested in a pooled security such as a mutual fund or ETF. (we talk about this in more detail in Tax Efficient Investing Part 1) It’s like the tolls that trucks have to pay at the toll both based on the number of axles.


Next up is tax-deferred investment vehicles. If you have an Ipass then you end up paying the toll (tax) at a later time, but unlike an Ipass, the rate(tax) we pay is based on when we pay it.  Later, when we take money out, we have to pay tax. Not only are there investment vehicles in this category, but just like an Ipass can switch cars, the driver of these tax-deferred accounts can drive other investment vehicles, and then it is the driver that determines how the vehicle is taxed. (an example of this would be an IRA that is held in a CD at the bank or in mutual funds)


Traditional IRAs as well as any type of 401k or 403b or any type of retirement plan go into that tax-deferred column. Annuities are also tax-deferred vehicles.


So to recap, if it’s just non-qualified money that means you saved it outside of any government-sponsored program, then it’s taxed based on how the vehicle itself is taxed, however, if it s a government-sponsored program, that is the driver and determines how the account is taxed.


The last category is tax-free investment vehicles. This means you paid the tax up-front before you invested and now all gains are tax-free.


Rescue vehicles usually don’t have to pay tolls, the toll was paid for by using other tax dollars so it is necessary to pay more tolls.


Roth IRAs, Roth 401k’s, HSA plans 529 or other kinds of college plans, and most cash value life insurance falls into this category. (you can get more details by downloading our free report of the month Life Insurance as an Asset Class)


Hopefully, this analogy helps a little bit as well as the chart below. If you have any questions, be sure to schedule a call and we’ll kind of talk through how things how your different accounts are taxed, and maybe what you can do to reduce those taxes,


If you have money in category one, then now is the time to plan and reduces those hidden capital gains taxes. If you have money in an IRA or tax-deferred account, then we will also look at how to reduce the lifetime tax bill.

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