The same investment can be a winner in one type of account, not so good in another. So Andrew Westlin, a planner at robo-advisor Betterment, recommends thinking carefully about what to own in a taxable account versus a 401(k), IRA or Roth IRA or Roth 401(k).
In a taxable account, interest and dividends are taxed the year they are received, and profits on investments that are sold are taxed the year of the transaction. Different rates apply to each type of income or gain. In a traditional IRA and traditional 401(k), taxes on interest, dividends and sales profits are postponed until money is withdrawn, and then all are taxed as income. In a Roth IRA or Roth 401(k), nothing is taxed, though many investors do not qualify for a Roth IRA account.
This means the same investment can be taxed more in one type of account than in another. A stock that provides most of its returns through gains in share price, for instance, could have profits taxed at the 15 percent long-term capital gains rate if held in a taxable account, but the same profits might be subject to an income-tax rate of 22 percent to 37 percent in a traditional IRA or 401(k), or no tax in either type of Roth.
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Similar considerations surround dividend earnings, especially for the retiree who plans to spend them rather than reinvest. For most investors, dividends are taxed at 15 percent in taxable accounts, but at rates as high as 37 percent in traditional IRAs and traditional 401(k) plans.
The investor's income-tax bracket is a factor as well. The lower the investor's income, the smaller the difference between the capital gains rate in a taxable account and the income-tax rates in the retirement accounts. That can reduce the benefit of using one type of account over another. Also, the investor should think about how the income-tax rate may go up or down over the years as income rises and falls. While most people expect income to fall as retirement progresses, experts say that's not necessarily the case if investments do well or a big inheritance arrives.
No one knows how the tax laws may change, so most planners assume current rules will continue. Generally, it is better to pay tax in years your bracket is lower, when you are young and poor or old and thrifty, rather than in your big earning years in middle age. Obviously, tax on investments is a tricky matter, which is why advisors recommend giving it plenty of attention as early as possible.
"Understanding your current and future tax bracket can help you save money on taxes and open up more planning opportunities in the future," Westlin said.