CWG Insight Series: Investment Account Taxation

During a recent review with one of our Crown clients, I started discussing the balance sheet, specifically which assets would be used to fund their retirement goals. With a variety of different accounts inside client portfolios, often there will be an intricate tax strategy when it comes to drawing down the portfolio as we navigate the tax brackets to ensure the smallest tax bill as possible.  

Given the timing of the year with tax filings being due in a little less than 2 months, I figured it’d be a good time to breakdown the different types of investments accounts; specifically, their tax impact on the portfolio.    

Taxation of Different Investment Accounts:  

Traditional IRA:

• Contributions to a traditional IRA are often tax-deductible in the year they are made, which means you can deduct the amount you contribute from your taxable income, reducing your tax liability for that year.
• The earnings in a traditional IRA grow tax-deferred, meaning you won't pay taxes on them until you withdraw the money in retirement. Withdrawals from a traditional IRA are taxed as ordinary income at your applicable income tax rate.

Roth IRA: 

• Contributions to a Roth IRA are made with after-tax dollars, meaning you don't get a tax deduction for them in the year you contribute.
• However, the earnings in a Roth IRA grow tax-free, and qualified withdrawals (usually after age 59½ and held for at least five years) are tax-free.

Brokerage Accounts: 

• Brokerage accounts are taxable investment accounts where you can buy and sell various securities like stocks, bonds, mutual funds, and ETFs. They are not specifically designed for retirement savings like IRAs.
• In a brokerage account, you are subject to taxes on any investment gains. There are two main types of taxes: 
  • Capital Gains Tax: When you sell an investment for a profit (capital gain), you may owe capital gains tax on the profit. The rate depends on how long you held the investment (short-term vs. long-term). 
    • Short-term capital gains apply to assets held for one year or less, taxed at ordinary income tax rates, while long-term capital gains apply to assets held for more than one year, taxed at lower rates to incentivize long-term investment.
    • Dividend Tax: If the investments in your brokerage account pay dividends, you may owe taxes on those dividends. The tax rate depends on whether the dividends are qualified or non-qualified and your income tax bracket.
  • Qualified Dividends: 
    • To be considered qualified, dividends must meet the following criteria:
    • The dividends must be paid by a U.S. corporation or a qualified foreign corporation.
    • The stock must have been held for a certain period. Generally, this period is more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. This is known as the holding period requirement.
    • Qualified dividends are taxed at the same preferential rates as long-term capital gains. For most taxpayers, this means a lower tax rate than their ordinary income tax rate. As of 2022, the tax rates on qualified dividends range from 0% to 20%, depending on the individual's taxable income and filing status.
  • Non-Qualified Dividends: 
    • Non-qualified dividends do not meet the criteria to be considered qualified.
    • They include dividends from sources such as real estate investment trusts (REITs), master limited partnerships (MLPs), dividends paid on employee stock options, dividends on savings and cooperative bank deposits, and dividends on tax-exempt organizations.
    • Non-qualified dividends are taxed at the individual's ordinary income tax rates, which can be higher than the tax rates for qualified dividends and long-term capital gains.

Annuities: 

• Immediate Annuity: With an immediate annuity, you start receiving payments right away after making your initial investment.
• Deferred Annuity: With a deferred annuity, you make payments over time, and the payments start at a later date, typically during retirement.
• Taxation of Annuities: 
  • Annuities are taxed differently depending on whether they are funded with pre-tax or after-tax dollars and the timing of the payments. 
    • Pre-Tax Contributions (Traditional Annuities): 
      • If you fund your annuity with pre-tax dollars (e.g., through a retirement account like an IRA), the earnings in the annuity grow tax-deferred until you start receiving payments. When you begin receiving payments from a traditional annuity, the payments are taxed as ordinary income at your applicable income tax rate.
    • After-Tax Contributions (Non-Qualified Annuities): 
      • If you fund your annuity with after-tax dollars (e.g., using funds from a regular savings account), a portion of each payment you receive is considered a return of your principal (the after-tax amount you invested), and the remainder is considered earnings. The portion of each payment that represents a return of your principal is not taxed since you already paid taxes on that money. Only the earnings portion is subject to taxation as ordinary income.
    • Other Tax Considerations: 
      • Early Withdrawal Penalties: With some annuities, if you withdraw funds before reaching a certain age (usually 59½), you may incur early withdrawal penalties, similar to penalties for early withdrawals from retirement accounts.
      • Death Benefits: Annuities often offer death benefits that may affect the tax treatment of the annuity upon the annuitant's death. These can vary depending on the type of annuity and specific terms of the contract.

 As your personal CFO, it’ll be our job to navigate the tax component of funding your retirement lifestyle, figuring out which accounts to draw from and when. In the meantime, please work on gathering your tax documents so you can get your taxes filed on time, or into the hands of your CPA in a timely manner; April 15 will be here soon!

 
 As always, if there’s any questions or concerns regarding taxes or anything else financially related, reach out to your family’s personal CFO and our team here at Crown.