The Three Types of Account Taxability
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We have many choices when investing. Today, we are going to look at the different ways an account may be taxed: now, in the future, and never again.
Given these choices, we might think the “never taxed again” structure is best and the “taxed now” is worst, but there’s much more to the story.
Your typical savings and brokerage accounts are the “taxed now” accounts. This means all the earnings including realized gains and losses go straight to your income tax filings each year. Most typically, these are your savings, checking and regular brokerage accounts.
The good news is there is no tax penalty for moving these funds around (or spending them). These accounts are referred to as “Taxable Accounts,” though the bulk of the balance in them is already after-tax because you paid tax before putting the money into the account (like when you get your paycheck).
Taxed in the Future
Your retirement accounts like Traditional 401(k), Traditional IRA, and employer-offered “non-qualified” plans are taxed “in the future.” When you take money out of these accounts, the transfer is treated as income on your tax return. Additionally, if you take funds out of these accounts before reaching age 59 ½ you will likely owe an additional 10 percent tax penalty.
Never Taxed Again
Roth IRA and Roth 401(k) accounts are the elusive “never taxed again” variety. Why are they never taxed again? Because you pay income tax on the deposits you make into these accounts. Once you’ve paid tax on the way in, there is no future tax on either the balance or the earnings. The strings attached vary depending on how the account is funded, but generally, you cannot take earnings out for at least 5 years (or until age 59 ½) without paying a 10 percent penalty.
Roth accounts are very popular because they are one of the only ways you can earn money without ever paying any tax on those earnings.