What is the Tax Treatment of My Different Investment Accounts?

As clients have recently completed their tax returns for 2021, we are receiving many questions about the taxability of their different investment accounts. It is important to know the different tax treatments and potential penalties associated with any trades or withdrawals pertaining to your accounts. Below, we explain the tax treatment of different account types.

Taxable Accounts

Taxable accounts include individual brokerage accounts, joint brokerage accounts, custodial accounts (UTMA/UGMA) and trust accounts. Taxable accounts are funded with after-tax money. The taxation of these accounts is determined by the transactions occurring within the account during the year.

If an investment in a taxable account is held longer than one year before being sold, earnings will be taxed at long-term capital gains rates. If the investment sold within the taxable account was held for less than one year, any gain will be treated as additional ordinary income and taxed at ordinary income rates. Dividends are taxed at capital gains rates if they are considered qualified and at ordinary income rates if they are ordinary. Interest will be taxed at your ordinary income rate.

Withdrawals from taxable accounts are not taxed. If investments were sold to make cash available for the withdrawal, then those transactions would be taxed at the previously stated rates depending upon their holding period.

Traditional IRAs

Traditional IRAs are funded with pre-tax dollars. You can claim a tax deduction on the full amount of your contribution if you are not covered under an employee sponsored plan and your income is below a certain threshold. The maximum contribution to a Traditional IRA in 2022 is $6,000 for individuals under age 50, and $7,000 for individual over the age of 50.

Investments in a Traditional IRA will grow tax deferred meaning no taxes are assessed when trades are placed in a Traditional IRA account. Once an individual is older than 59 ½, funds may be withdrawn from a Traditional IRA penalty free, but the entire amount of the withdrawal will be taxed at ordinary income rates in the year the withdrawal is made. In the year an individual turns 72, annual withdrawals are required to be made called Required Minimum Distributions (RMD). The required amount is calculated by taking the value of an IRA on December 31 of the prior year and dividing that amount by an age denominator determined by the IRS. If the RMD is not withdrawn, you are penalized 50% on any amount not withdrawn from your Traditional IRA.

For withdrawals made from a Traditional IRA before age 59 ½ that are not a qualified withdrawal, a 10% penalty is applied on top of the ordinary income assessed on withdrawals. There are instances where withdrawals may be made prior to 59 ½ without penalty that include:

$10,000 for a first-time home purchase
qualified education expenses
medical expenses that equal more than 7.5% of Adjusted Gross Income (AGI)
$5,000 for expenses associated with the birth of a child or adoption fees
Periodic Systematic withdrawals

Roth IRAs

Roth IRAs are funded with after-tax dollars if AGI is below a certain threshold. If AGI is above a certain amount, contributions to a Roth IRA are not allowed. The maximum contribution to a Roth IRA in 2022 is $6,000 for individuals under age 50 and $7,000 for individual over the age of 50. Roth IRA investments grow tax-free and withdrawals are tax-free after age 59 ½. Roth IRAs do not have RMD requirements like Traditional IRAs. However, an individual must wait at least five years from the initial contribution year before withdrawals can be made tax-free.

For Roth IRA withdrawals made before the five-year requirement or age 59 ½, the earnings will be taxed at ordinary income rates, and a 10% penalty is applied. There are instances where withdrawals may be made prior to age 59 ½ or five years without penalty including:

$10,000 for a first-time home purchase
qualified education expenses
medical expenses that equal more than 7.5% of Adjusted Gross Income (AGI)
$5,000 for expenses associated with the birth of a child or adoption fees
Income following a disability
Periodic Systematic withdrawals

Employer Sponsored Retirement Plans

The most common types of employer sponsored retirement plans include 401(k)s, 403(b)s, and 401(a)s. There can be three different types of contributions available in these types of plans: pre-tax, Roth and after-tax. Contribution limits for pre-tax and Roth contributions in 2022 are $20,500 for individuals under age 50 and $27,000 for individuals over age 50.

Pre-tax contributions allow an individual a dollar-for-dollar deduction on your annual income. Oftentimes, employers will also provide an “employer match” to your contributions. These matching contributions are always pre-tax and deductible by the employer. Investments under these types of contributions will grow tax-deferred until withdrawal. When withdrawals are made, the entire withdrawal amount will be taxed at your ordinary income rate.

Roth contributions are made with after-tax money. Income is not reduced with Roth contributions, but contributions will grow tax-free and withdrawals will be made tax-free.

The final contribution type is after-tax contributions. Not all plans offer after-tax contributions and the difference between after-tax contributions and Roth contributions is that they are made after the maximum deferral limits referenced above are met. After-tax contributions then grow tax-free, and withdrawals of the contributions only are tax-free. Any earnings on after-tax contributions will grow tax-deferred but will count as ordinary income when withdrawn.

Education Savings Plans

The most common types of education savings plans are 529 plans and Coverdell Education Savings plans. Both are used for the purpose of funding higher education costs but have slightly different rules for each described below.

529 Plans

529 Plan funds can be used for up to $10,000 annually for K-12 private school tuition as well as qualified education expenses for undergraduate and graduate school expenses. Contributions to 529 plans grow tax-free and withdrawals for qualified education expenses are also tax-free. Many states offer tax deductions for your contributions on your state tax returns. However, it is state dependent, so it is important to check with your states plan to see what tax deduction is offered.

If you overcontribute to a 529 plan and do not need all the funds for education expenses, you can easily change the beneficiary of the plan to another related person. If you still will not need the funds after all potential beneficiaries have completed their education, you may withdraw any remaining assets. You will not pay any tax or penalty on the withdrawal that constitutes a return of basis but any earnings will be taxed at your ordinary income rate and a 10% penalty.

Coverdell Education Savings Accounts (ESA)

Coverdell Education Savings accounts can be used for qualified education expenses K-12 private education, undergraduate and graduate schooling. Your contributions are limited to $2,000 annually per beneficiary, and your income must be below certain thresholds to contribute to these accounts. You are also not allowed to contribute to ESAs once the beneficiary reaches age 18, and the entire account must be completely withdrawn by the time the beneficiary reaches age 30.

Contributions to ESAs grow tax-deferred and withdrawals are tax-free if the withdrawals are used for qualified education expenses. If the entire account is not withdrawn by the time the beneficiary is age 30, the account will be disbursed and you will pay ordinary income tax and a 10% penalty on the earnings.

If you have any questions about how your investment accounts are taxed or tax strategies, please do not hesitate to reach out to the SGK team.

Disclaimer

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