Maximize Retirement Income and Minimize Taxes: Understanding the 3 Types of Investment Accounts
***Transcript***
(Edited for clarity and grammar.)
Do You Want TO maximize savings, reduce income taxes, and increase your retirement income? Understanding the various investment accounts is key.
In this video, we'll explore taxable brokerage accounts, tax-deferred retirement accounts, and tax-free Roth accounts. We'll learn how they are funded, taxed, passed on to beneficiaries, and integrated into your retirement plan for optimal results.
Hi! My name is JP Geisbauer, founder of Centerpoint Financial Management. I'm a certified financial planner professional, a certified public accountant, and this channel is dedicated to helping diligent savers maximize their lives and minimize taxes as they transition into retirement.
Before we dive into the three accounts, let's discuss how investments create income. There are essentially two ways. The first is the income you earn while holding the investment. This can typically be in the form of dividends or interests. The second is the capital gain or loss when you sell your investment.
Let's take a look at a typical investment cycle. For example, you purchased shares of XYZ Corporation for a hundred dollars a few years back. Since you've owned that stock, XYZ Corporation has been paying you four dollars a year as a dividend. At this time, you no longer wish to hold the share of XYZ corporation, so you decide to sell it for its price of $110. Once sold, you realize the cash and can start that investment cycle all over again with a new investment.
So, what is the tax treatment of this particular investment cycle?
You had a $100, and you purchased one share of stock. That one $100 is now considered its cost basis. When you owned the shares, you were paid four dollars per year as a dividend. As the stock appreciated to $110, you had a $10 unrealized gain within the account. When you ultimately sell the share of XYZ Corporation, you have $110 in cash and a $10 capital gain. Now that you have realized $110 in cash, you can reinvest that in another company.
That's essentially the life cycle of an investment. Now, this is admittedly oversimplified for the purpose of this video, but this is generally how the investment income life cycle works.
Now that we understand this, let's examine how this activity is taxed within the three different investment accounts.
Brokerage Accounts
The first type of account we'll discuss today is a brokerage account. This account can be known by several names: brokerage account, taxable account, or investments account.
Funding. Brokerage accounts are typically funded with after-tax dollars, and there are no restrictions on how much you can contribute to a brokerage account.
Tax treatment. The investment income in a brokerage account is taxed annually. Any interest or dividends earned within that year are considered taxable income.
So, let's go back to our example of XYZ Corporation. Every year, you would have a taxable dividend income of $4. In the year that the stock appreciated to $10, there was no gain or loss at that time as it was unrealized. However, in the year the stock was sold, a $10 gain would be realized. Because ours was held over multiple years, it would be considered a long-term capital gain. This gain would then be reported on your individual income tax return.
Now, the taxation of brokerage accounts can get pretty complicated depending on the type of investments that you have in that account. But the takeaway is that your tax on the activity within the account every year. You'll begin to see the difference when we compare this to the other accounts.
Beneficiaries. A significant benefit from this account is from an inheritance perspective…When your beneficiaries inherit this account, they will get something called a step-up in basis. This basically means that if they sold the assets on the day you died, they would recognize no gain or loss on that transaction. This particular aspect of a brokerage account can provide an excellent financial planning opportunity.
So, to clarify this concept, let's go back to XYZ Corporation. If you were to pass why the shares were $110, your beneficiaries would inherit the stock, and their cost basis would be $110. Recall that you purchased the shares at $100. But because of the step-up in basis, your beneficiary's cost basis in that stock is now $110. The $10 gain disappears forever and is never subjected to taxes. This is quite a deal for your beneficiaries and taxpayers in general.
Pre-Tax Retirement Accounts
The second type of account I will talk about today are pre-tax or traditional retirement accounts. This type of account can come in many different configurations, such as an IRA, 401k, SEPS, SIMPLES, 403b, etc. All of these are considered pre-tax.
Funding. "Pre-tax" simply means that if done correctly, you received a tax deduction or a tax benefit in the year in which you funded these accounts. However, there are restrictions on how much you can contribute to any account in any given tax year. These restrictions typically involve wage income, earned income, and the type of retirement plan you have. So, unlike the brokerage account, you can't contribute unlimited amounts of money to these types of retirement plans.
These funding limits can be incredibly complex, so make sure you discuss them with your financial advisor or tax professional before contributing to any of these plans.
So, let's take an example of perhaps the most common type of retirement plan: the 401k. If you fund your 401k plan with pre-tax dollars, your taxable salary will be reduced by the amount of the contribution. For example, if you earn $100,000 and you contribute $20,000 to the 401k plan, your taxable salary for federal and state income tax purchases would be reduced to $80,000.
But again, each retirement plan has its own restrictions, so double-check with your advisor before contributing.
Tax Treatment. These accounts are considered tax-deferred, meaning any activity that occurs within them is not taxed. As such, the power of compounding within these accounts is significant over time.
Let's go back to our example of XYZ Corporation. The dividends paid in the years in which they were paid are not considered taxable income to the account holder, nor is the $10 capital gain. Rather than being taxed on the income in the account as it occurs, these accounts are taxed as you take distributions from them. These distributions are taxed at ordinary income tax rates, which are usually the highest tax rates available to a taxpayer.
You get the tax benefit when you fund the account. The activity within the account grows tax-free, but you are forced to pay ordinary income tax rates when you take distributions from the account.
At a certain age, the account holder is forced to take required minimum distributions, or RMDs, from the account. Again, these are tax-deferred accounts, meaning that you will have to pay the tax at some point in time. The required minimum distributions are a way to force you to take distributions and pay the related income taxes.
I have another video on strategies for reducing required minimum distributions. You will find a link to that video in the description below or as a pop-up at the end of this video.
Beneficiaries. When your beneficiaries inherit these types of accounts, their distributions will also be considered ordinary income. Unlike the brokerage account, there is no step-up in basis in these particular accounts.
Now, there are different rules regarding how long your beneficiaries have to zero out these accounts once they've inherited them. So make sure you check on those rules depending on who your beneficiary is.
Roths
Number three, Roths. Like the pre-tax retirement accounts previously mentioned, Roths are also a type of retirement account. You've likely heard of them called Roth IRA, Roth 401k, or the recently created Roth SEP.
Funding. Like pre-tax retirement accounts, funding a Roth is restricted based on earned income and the type of Roth retirement account you have. You'll want to do some research on the type of account you have and how much you can contribute to it in any given year.
Tax Treatment. You do not receive a tax benefit for funding a Roth. Instead, once the funds are in the account, that account is allowed to grow tax-free for as long as you own it. This is very similar to the pre-retirement accounts. However, unlike those accounts, even distributions from a Roth are considered tax-free.
Now, given your age and the amount of time you've held that account, there are some restrictions around tax-free distributions. Make sure you double-check those rules before taking a distribution from a Roth.
Beneficiaries. Not only are Roths tax-free to the initial account holder, they're also tax-free to the initial account holder's beneficiaries. So, after the beneficiaries have inherited the account, they can take distributions from that account tax-free.
Suffice it to say, Roth accounts are outstanding, especially if you can get them sufficiently funded.
If you are looking for ways to supersize your Roth account, check out my video on Roth conversions. You will find a link to that video in the description below or wait till the end of this video where a link will pop up.
Summary
So, let's summarize the benefits of each of these accounts:
The brokerage account. There are no limits to funding a brokerage account. The appreciation of the investments isn't taxed until the investment is actually sold, and when it is sold, it's subject to the usually lower capital gains tax rates. Investments in the brokerage account are allowed to be passed on to beneficiaries with a step-up basis, essentially eliminating the gain for the beneficiaries. Unfortunately, you are taxed on the activity within the account as the activity occurs.
When it comes to the pre-tax accounts, you get a tax deduction or tax benefit in the year that you contribute to the account. The investment growth and income within the account are allowed to grow tax-free. However, there is a limit to how much you contribute to any one of these plans. You will also be forced to take distributions from these accounts, and these distributions will be taxed at the usually higher ordinary income tax rates. Also, when your beneficiaries inherit these accounts, they'll be forced to take required minimum distributions, and they'll be taxed at their ordinary income tax rates.
The Roths are tax-free forever to both you and your beneficiaries. However, it can be a bit tricky to get a substantial amount of funds into a Roth account.
As you can see, there are both pros and cons to all three of these accounts. Try to use these accounts in such a way that you can maximize their benefits. As you pull back the lens, you'll begin to see that the choices you make not only affect the current tax year but they'll also affect the amount of taxes you'll pay for the rest of your life. So make sure that your financial plan considers your lifetime and even the lifetime of your beneficiaries so you can ultimately reduce the income tax you pay over your life and create tax-efficient income in retirement.
Well, if you have made it this far, thank you for watching. If you enjoyed this content, please hit like or subscribe below. Thanks again for watching, and I'll see you next time.
About the author:
JP Geisbauer is a Certified Public Accountant, a Certified Financial Planner ®, and the founder of Centerpoint Financial Management, LLC, a financial planning, investment management, and income tax planning firm located in Irvine, CA. JP Geisbauer is dedicated to helping California-based business owners and executives transition into retirement. He has been quoted in many news outlets including Forbes, Newsweek, US News & World Report, MarketWatch, YahooFinance, CNN and NerdWallet.
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Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes individual financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, consult with your own financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.