One of the most common types of questions I receive revolves around how different types of accounts are taxed. With a patchwork of legislation over the years, our tax code is complex.
You receive a tax deduction when you contribute to certain accounts. You don’t receive it in others, and future distributions are tax-free. Meanwhile, other accounts are taxed along the way, but still have more preferential rates than earnings from a job.
Let’s make sense of it. I’ll clearly differentiate how capital gains tax rates are different from ordinary income tax rates, explain how different types of accounts are taxed, and help you decide to which account you should save.
Understanding Capital Gains vs. Ordinary Income
The first aspect you need to understand is that capital gains and ordinary income are taxed differently. Although they are connected, they are taxed separately.
Ordinary income is income from a job, pension, royalties, rent, and interest from savings accounts. For example, if you earn $50,000 from your employer, you have $50,000 of ordinary income. If your bank account pays you $8 in interest, that is $8 of ordinary income.
Capital gains are gains from selling assets for more than you paid for them. For example, if you bought a stock in a brokerage account for $5 and sold it for $10, you have a $5 capital gain.
Capital gains can be short-term or long-term, depending on how long the asset is owned. Long-term capital gains are recognized when an asset is sold after more than a year of owning it. Short-term capital gains are recognized when an asset is sold before owning it for a year. For example, if you bought a stock for $15 and sold it for $25 364 days later, you would have a short-term capital gain of $10.
Ordinary income rates tend to be higher than capital gains rates. Do you ever read articles about how billionaires pay a low effective tax rate of 10%? That is because most of their wealth produces capital gains, which are taxed at lower rates than earning income from a job.
The next aspect you need to understand is that capital gains taxes are stacked on top of ordinary income. For example, if you earn $100,000 from a job and have $25,000 of capital gains, the $100,000 fills up the ordinary income tax brackets, and the $25,000 of capital gains is taxed at their own separate capital gains tax bracket; however, the amount of ordinary income earned can affect in which capital gains bracket you find yourself.
Below are the 2021 capital gains tax brackets.
|Single||Up to $40,000||$40,000 – $441,450||Over $441,450|
|Married Filing Jointly||Up to $80,000||$80,000 – $496,600||Above $496,600|
Capital gains brackets are 0%, 15%, and 20%. In 2021, a single person can have a taxable income of $40,000 or less and pay 0% in capital gains taxes. Between $40,000 and $441,450, the capital gains rate is 15%. Above $441,450, the capital gains rate is 20%.
What this means in practice is that if someone were single, had no other ordinary income from a job, but recognized long-term capital gains of $52,550, you would pay $0 in capital gains taxes. This is because in 2021, a person filing single receives a $12,550 standard deduction. If you had $52,550 in capital gains, that would bring your taxable income to $40,000 after the $12,550 standard deduction, meaning you would be in the 0% capital gains bracket.
Let’s take it a step further and say you recognized $60,000 of capital gains. Part of your capital gains is still taxed at the 0% tax rate, but $7,450 would be taxed at 15%.
Let’s change the assumption of ordinary income. Instead of $0, let’s say you earned $30,000 from your job and recognized $60,000 of capital gains. In this scenario, remember your capital gains get stacked on top of your ordinary income, which means the first $30,000 is taxed at ordinary income rates, $22,550 would be taxed at the 0% capital gains bracket, and $37,450 would be taxed at the 15% capital gains bracket.
Always remember that ordinary income fills up the tax brackets first and then capital gains get stacked on top and taxed at their own separate tax bracket.
Now that you know what counts as ordinary income, capital gains, and how they are taxed differently, let’s explore how different types of accounts are taxed.
Taxes for Bank Account
Many people have a bank account and earn interest each year, making this a familiar account to many. Interest earned from a bank account is taxed as ordinary income.
If you receive a 1099-INT at tax time each year, that income is being taxed at ordinary income rates. For example, if you receive $10 of interest from your bank account, you will pay ordinary income taxes on that $10.
There is little tax planning to be done when it comes to bank accounts. Generally, I like having 6-12 months of living expenses in the bank to cover emergencies, such as losing a job.
Taxes for 401(k), 403(b), SEP IRA, SIMPLE IRA, Solo 401(k), and Traditional IRA
Retirement accounts provide more opportunities for tax planning. These types of retirement accounts generally provide a tax deduction when you contribute to the account, earnings are tax-deferred, and future distributions are taxable as ordinary income.
SPECIAL NOTE: There are situations where contributing to a Traditional IRA does not provide a tax deduction.
For example, if you contribute $10,000 to a 401(k) in 2021, you are reducing your ordinary income by $10,000 this year. If you are in the 22% marginal tax bracket, you are saving $2,200 in taxes when you contribute $10,000 because you are reducing your ordinary income by $10,000 with the contribution. If you are instead in the 35% marginal tax bracket, you are saving $3,500 when you contribute $10,000.
The higher your marginal tax bracket, the more in taxes you save today.
Paying less in taxes is great; however, it’s not the only part of the equation that needs to be analyzed.
You also need to estimate how much you are paying in taxes when you take the money out of the 401(k). For example, if you save money at 22%, but need to pay 24% when you take it out, you are actually two percentage points worse off. You saved $2,200 when you contributed $10,000, but you pay $2,400 when you take $10,000 out. You are actually $200 worse off.
Now, you may be thinking, “How do I know what rate of tax I will pay when I take money out of the 401(k)?”
You don’t know, but you can make a best guess.
The key variables are tax rates and your earnings.
Although earnings are unknown, most people can create a fairly good trajectory of their earnings. For people early in their careers, they are often in a lower tax bracket than they will be in the future. This makes sense because most people early in their careers start at a lower income and gradually earn more over time. In most careers, it’s normal to assume a higher income in their 50s compared to their 20s. What this means in practice is that you might be in the 22% tax bracket today, but in the 32% tax bracket in the future.
Another factor many people do not consider is their income tax rate in retirement. If you do a great job saving in a 401(k), the government is going to force money out of it at age 72, and that amount gradually increases each year. For some retirees today, they are required to take out more than they earned in their jobs. That amount combined with Social Security push them into a higher bracket again.
In most cases, I am not a fan of tax deductions at 22% today. Even at 24%, I am on the fence.
The reason I am on the fence is that tax rates are very low compared to historical averages.
The tax rates we have today are scheduled to go back to higher tax rates in 2026. As an example, many people in the 22% tax bracket today will find themselves in the 25% tax bracket in 2026 if tax rates are not changed before then.
While it’s impossible to know what tax rates will look like decades from now when you start needing to take money from your 401(k) for retirement purposes, I’m speculating they will be higher. Personally, I am willing to forgo tax deductions today in the 22% and 24% tax brackets.
Please bear in mind not everybody should forgo tax deductions today. If tax rates decline in the future, you would be much better off saving into a 401(k) and receiving a tax deduction. If you anticipate your earnings to decline or take time off work that lowers your income tax bracket, there are other strategies, such as Roth conversions, you can do during that time to take advantage of your lower tax bracket.
There is no good blanket advice when it comes to deciding whether to contribute to a 401(k). It depends on the person and their comfort level around future taxation possibilities.
Generally, the rule of thumb is that if you expect to be in a lower tax bracket today than in the future, you want to forgo the tax deduction today if possible. I’ll talk in the next section about how to skip the tax deduction today.
Taxes for Roth 401(k) and Roth IRA
Another retirement account option is a Roth 401(k) or Roth IRA. Unlike the Traditional 401(k), you do not receive a tax deduction when you contribute money, but earnings grow tax-free and future distributions are tax-free. Plus, there are no required distributions after age 72 like with a 401(k) or Traditional IRA.
Although many employers offer a Traditional 401(k), not all employers offer a Roth 401(k) option. You’ll need to ask your employer if they do.
When you make a contribution to a Roth 401(k), it does not reduce your ordinary income. For example, if you contributed $10,000 to a Traditional 401(k) and earned $80,000, your ordinary income would be reduced to $70,000. At a 22% marginal tax bracket, you are saving $2,200.
When you contribute to a Roth 401(k), you are saying, I want to be taxed on the full $80,000, forgo the $2,200 in tax savings, and remove the IRS as a future partner in my retirement account. All the appreciation in the account grows tax-free and all distributions in the future are tax-free.
The Roth option is great for people who think they are in a low tax bracket today compared to future tax rates. For example, people early in their careers may be in the 22% tax bracket today and anticipate being in the 32% tax bracket later. They may prefer to pay 22% today and switch to Traditional 401(k) contributions when they are earning enough to put them in the 32% tax bracket.
Sometimes people ask, “What if the government changes their mind and taxes Roth IRAs?” I suppose it’s possible, but I consider it unlikely. Besides, if they start taxing Roth IRAs, there is likely a good chance overall tax rates would be raised, meaning if you contributed to a Traditional 401(k), you would be paying a higher tax rate anyway.
I’m a big fan of the Roth 401(k) option or Roth IRA option for people who are in their lower-income earning years and even for some people who are mid-career earnings given the lower tax rates today.
Taxes for Brokerage Account
I don’t think the brokerage account gets enough love in personal finance writing. Retirement accounts have many restrictions and penalties if accessed before age 59 ½, making them less versatile.
A brokerage account is a fairly tax-efficient way to invest that provides far more flexibility.
A brokerage account is like a bank account that can be invested, and the taxes are a mix of ordinary income or capital gains depending on which investments you choose.
Unlike with a Traditional 401(k), you receive no tax deduction for contributions to a brokerage account. The earnings are not tax-deferred. When you sell something for more than you paid for it, you’ll pay capital gains taxes.
You may be thinking, “This doesn’t sound like a very good account. It has none of the great features of a Traditional 401(k) or a Roth 401(k).”
You are right. It has none of the great tax benefits, but it offers something better – flexibility.
The money can be used at any time.
Here is how the taxes work. If you invest $10,000 in a brokerage account, it grows to $15,000, and then you sell, you have a $5,000 capital gain. If you owned it for more than a year, it is a long-term capital gain and taxed at preferential long-term capital gains rates (0%, 15%, or 20%). If you sell it after owning it for less than a year, it is a short-term capital gain and taxed at ordinary income tax rates.
Assuming it is a long-term capital gain, best case, you pay $0 in taxes if you have very little income. Middle case, you pay $750 in taxes. Worst case, you pay $1,000 in taxes. That’s not a bad trade-off considering you made $5,000.
Your investments may produce interest, dividends, and capital gains throughout the years. Interest will be taxable as ordinary income. Interest is primarily produced by corporate bonds. Dividends are generally produced by stocks, ETFs, and mutual funds. There are qualified and nonqualified dividends. Qualified dividends are taxed at capital gains rates while non-qualified dividends are taxed at ordinary income rates. Capital gains primarily come from mutual funds and when you sell something for more than you paid for it.
In general, an all-stock portfolio may produce around 2% in dividends each year, depending on the investments selected. If you had $100,000 invested in a brokerage account, that is about $2,000 in dividends. Let’s assume all the dividends are qualified. This would mean about $300 in taxes annually. As the portfolio grows, the amount will increase, but my main point is that it is not very much in taxes.
While retirement accounts like a Traditional 401(k) are important for retirement savings, a brokerage account can also be used for retirement. More importantly, it can also be used before retirement without tax penalties. If you want to take a sabbatical, start a business, or simply want an account with a different tax structure that is more readily available, a brokerage account is an excellent tool.
Summary – Final Thoughts
Taxes are unnecessarily complicated. The key things to remember are the following:
- Capital gains tax rates are generally more favorable than ordinary income tax rates.
- Capital gains are stacked on top of ordinary income.
- Traditional 401(k)s provide a tax deduction today, but then the IRS becomes a partner in your retirement account. Future distributions are taxable as ordinary income at your ordinary income tax rate in the future. It may be higher or lower than your current tax rate.
- Roth 401(k)s provide no tax deduction today, but then the IRS is not a partner in your retirement account. Future growth and distributions are tax-free. The money is 100% yours.
- Deciding between a Traditional 401(k) and Roth 401(k) is not an easy decision. Current and future tax rates and your income are the key variables to consider.
- A brokerage account is often overlooked as a flexible account that can be used in tandem with retirement accounts.
Lastly, don’t forget to analyze this decision each year. Tax rates change. Incomes go up and down. Tax legislation occurs. You’ll need to stay up-to-date about what makes the most sense for you.