The taxation of financial transactions is an often-misunderstood topic. The root cause of this lack of understanding is in large part due to the complexity of the tax code, the different types of transactions that occur in investment accounts, and the different types of investment accounts that exist. Even as financial planners, we often need to go back to text books or the IRS website to refresh our memory on different aspects of tax law.

When thinking about the taxation of investments, it’s helpful to break down the laws by the type of investment account. There are four main categories of accounts:

Taxable Accounts– this category includes individual, joint tenant, and tenants in common accounts, to name a few. Even your checking and savings accounts fall into the taxable category.

Traditional (Pre-Tax) Retirement Accounts– this category includes most 401(k)s, 403(b)s, traditional IRAs, SEPs and several others.

Roth (After-Tax) Retirement Accounts– this category includes Roth IRAs and any contributions made to the Roth side of a retirement plan.

Trusts

There are several types of transactions or events that can trigger taxation:

Capital Gains and Losses– A capital gain occurs when any asset is sold for a price above its cost basis. Generally, the cost basis of an asset is equal to the price paid to acquire it, but this is not always the case. The tax on a capital gain depends on the holding period of the asset. When an asset is owned for longer than one year, gains or losses are considered “Long-Term” and when the holding period is less than one year, they are considered “Short-Term.” Long-term capital gains are taxed at capital gains rates, and short-term gains are taxed at ordinary income rates. Capital gains rates are lower than ordinary income rates.

Dividends and Interest– When you receive dividend and interest income from an asset held in a taxable or trust account, tax is owed on that income. Interest income is taxed at ordinary income rates, as is non-qualified (ordinary) dividend income. Qualified dividend income is taxed at capital gains rates. The rules specifying when dividends are qualified versus ordinary are complex, but most generally, the regular dividend income received on long-term stock holdings is qualified.

Withdrawal– Withdrawing funds from traditional (pre-tax) retirement accounts triggers taxes. The amount of the withdrawal is added to the account owner’s taxable income and tax is calculated at ordinary income rates. An additional penalty may be owed if the account owner is under age 59 ½ at the time of the withdrawal.

Conversion– Transferring assets from a pre-tax (traditional retirement) account to a Roth type account, also known as a “Roth Conversion” will trigger taxes at ordinary income rates.

Here is a breakdown of the taxation for each type of account:

Taxable Accounts

Taxable accounts offer no tax benefit when deposits are made. Capital gains taxes are due on realized capital gains and tax is due on dividend and interest income on an ongoing basis. There is no tax due when funds are withdrawn from taxable accounts. Capital losses can be used to offset capital gains, and unused capital losses in one year can be rolled forward indefinitely until exhausted. Furthermore, $3000 in capital losses can be used to offset ordinary income each year, if a capital loss is available.

Traditional (Pre-Tax) Retirement Accounts

Traditional retirement accounts are very common and well loved among participants due to the tax advantages they offer. These accounts allow participants to defer recognition of their salary and thereby reduce their income taxes in years they make contributions. Assets held inside these accounts are subject to neither capital gains taxation nor tax on dividends or interest. The only transactions taxed are withdrawals from the account. Traditional retirement accounts also have required minimum distributions (RMDs) that must be taken once the owner reaches age 70 ½. Taxes at ordinary income rates must be paid on withdrawals, even if the withdrawal was made to satisfy the RMD. Furthermore, the IRS assesses a penalty of 50% of the under-withdrawal if the distribution taken did not satisfy the RMD requirement. Pre-tax retirement accounts can also be used as a valuable estate planning tool. More information on some of these strategies is available here.

Roth (After-Tax) Retirement Accounts

Roth type retirement accounts are taxed similarly to traditional retirement accounts with two main differences: 1) Contributions are not deductible from income when they are made and 2) taxes are not due when withdrawals are made, as long as the account owner is over age 59 ½. Just like traditional retirement accounts, Roth type accounts are not subject to taxation on capital gains, interest, or dividends. Roth accounts are also not subject to minimum distribution requirements, except in the case of inherited Roth IRAs. We have written extensively on Roth accounts. More information is available here and in various other articles on our blog.

Trusts

Trusts are taxed very similarly to taxable accounts; however, the structure of the trust determines who pays the tax. In general, beneficiaries of trusts must pay the tax on the amount of income that is distributed to them, and the trust must pay the tax on the income that is accumulated in the trust. In addition, certain trusts have the requirement that all income must be distributed. If this is the case, beneficiaries must pay the tax on that income regardless of whether or not they actually received the income in a given year.

In certain instances, the grantor of the trust (the person who funded the trust) retains too much control over the trust causing the grantor to be taxed on the income produced by the trust. These types of trusts are known as “Grantor Trusts,” “Defective Trusts,” “Tainted Trusts,” or “Intentionally Defective Grantor Trusts.” These types of trusts are still valid trusts legally, but they are “defective” for tax purposes.

Finally, certain irrevocable trusts are considered to be separate tax entities. These are most commonly known as “Complex Trusts.” In general, a trust will be considered a separate tax entity when 1) it is irrevocable and the grantor has ceded all control over the trust and 2) the trust document allows the trustee to accumulate income (the trustee has discretion) or the trust is required to accumulate income. If these conditions are met, the taxation depends on the distribution of the income. In general, income accumulated is taxable to the trust and income distributed is taxable to the beneficiary.

The rules and laws surrounding trust setup, accounting and administration are very complex. We recommend seeking the advice of an estate attorney, a CPA and/or tax attorney, and a CERTIFIED FINANCIAL PLANNER™ prior to making decisions regarding trusts.

A Word on HSAs

Health Savings Accounts (HSAs) are the most tax advantaged accounts available to US taxpayers. They feature a triple tax benefit: 1) Contributions are deductible in the year they are made, 2) dividends, interest and capital gains accumulate tax free inside the account, and 3) Withdrawals made for qualified medical expenses are tax free. Furthermore, withdrawals can be made penalty-free after age 65 for non-medical expenses, though income tax would be due just like an IRA distribution. HSAs are only available to individuals participating in a High Deductible Health Plan. More information on HSAs is available here.

Tax planning is one of our most requested services and it is a topic we look at in all financial plans. If you would like assistance with tax planning, don’t hesitate to reach out to us!