For tax-deferred accounts, such as 401(k)s and 403(b)s, you contribute money from your paycheck before it is taxed, or with “pre-tax dollars.” In other words, you do not pay taxes on the portion of your salary that goes directly into your 401(k) or 403(b). Moreover, each year, you do not pay taxes on the income or capital gains earned. You pay taxes when you withdraw money from the account in retirement at the ordinary income rate. Ordinary income is the tax rate that you pay on your salary, interest, and other sources of income.
Roth IRAs are tax-advantaged accounts. You fund Roth IRAs with after-tax dollars, so you do not get a tax break upfront. After you fund a Roth IRA, however, the income, appreciation, and withdrawals are all tax-free. The long-term tax advantages of Roth IRAs are powerful.
For taxable accounts, you can access the money whenever you like. You have complete flexibility. At the same time, you owe taxes on income and gains earned each year. Tax efficiency means that you are managing a taxable account in a way that minimizes the taxes owed each year. The tax treatment for income and gains depends on several factors.
- A capital gain or capital loss is the difference between the cost basis of an investment and what is received when you sell it. Remember that the cost basis is the original amount paid for an investment plus or minus any adjustments to the initial cost that occur while you hold the investment. If you invest in mutual fund and reinvest dividends or capital gains, it will affect your cost basis. For assets that have appreciated relative to the cost basis, you pay taxes on capital gains when you sell the asset.
- Short-term capital gains occur when an appreciated investment is held for one year or less. Tax rates for short-term gains are taxed as ordinary income. Long-term gains occur when an appreciated investment is held for at least one year plus one day. Long-term gains are taxed at a lower rate.
- When you take a loss on an investment, you can use that loss to offset some or all the capital gains on other investments. It is also possible to carry losses forward to offset gains in the future. You cannot realize a capital loss in the event of a wash sale, which occurs when an investor sells an investment to realize a loss and buys it back within thirty days.
- For taxable accounts, the treatment of dividends depends on whether they are qualified or nonqualified. Most US company dividends are qualified and are taxed at the same rate as long-term capital gains. Dividends from foreign companies and REITs (real estate investment trusts) are nonqualified. Investment income from nonqualified sources is taxed at the ordinary income rate.
If you do not rely on income from your investments to help you live day-to-day, you should focus on investments that appreciate, rather than those that generate interest and dividends. For investments that earn interest and dividends, also called current income, you will pay taxes each year. With appreciated securities, you decide when you want to sell and pay capital gains.
