The prior week we introduced some basic tax concepts that everyone should know. This week, we are going to continue to build on that foundation by discussing the different types of retirement accounts and investment accounts, and how they are impacted by taxes. This week’s video will delve into all of this in detail. 

Understanding how these accounts work can help guide what assets you contribute to them. 

So let’s jump right in. 

Let’s begin with the main retirement accounts we want to cover here:

• Traditional IRA
• Traditional 401(k)
• Roth IRA
• Roth 401(k)
• HSA

There are more accounts out there, but these are the options that most people have. Also, the accounts that aren’t mentioned here, work very similarly to the ones listed. 

Additionally, we’ll cover a taxable brokerage account, too. 

Traditional IRAs and Traditional 401(k)s work very similarly. They take in pre-tax dollars and defer taxes until they are redeemed at retirement age. If you withdraw them earlier than the age of 59 ½, you’ll be subject to a 10% early withdrawal penalty on top of the taxes you’ll owe.

The traditional IRA has contribution limits on how much can be contributed to the account in the year. For 2023, that amount is $6,500. Traditional IRAs also have limits on their tax deductibility depending on the filing status of the taxpayer. For a married filing jointly taxpayer:

• A full deduction is available if your modified AGI is $218,000 for 2023.
• A partial deduction is available for incomes between $218,000 and $228,000 for 2023.
• No deduction is available for incomes greater than $228,000 for 2023.

For a single filer:

• A full deduction is available if your modified AGI is $73,000 for 2023.
• A partial deduction is available for incomes between $73,000 and $83,000 for 2023.
• No deduction is available for incomes greater than $83,000 for 2023.

The Traditional 401(k) does not have this deductible limit. So, for 2023, you can contribute up to $22,500. 

In practice, let’s say you have a salary of $200,000 and you contribute the maximum amount to your 401(k) ($22,500), you’re left with a taxable income of $177,500. You won’t pay any tax on that $22,500 until it’s withdrawn in retirement. It grows tax deferred, meaning any dividends, interest, capital gains (if you sell and reallocate) etc. are all tax free while the money is in the retirement account.

In that example your marginal income tax rate as a single filer is 32%, you’re benefiting significantly from by deferring that income. When you withdraw that money, it’s likely that your marginal tax rate will be lower because you won’t have nearly as much income in retirement. 

So, let’s move on to the opposite side of the coin - the Roth retirement account.

The Roth IRA and Roth 401(k) work opposite of their traditional counterparts. The taxpayer contributes post-tax dollars. This means they’ve already paid tax on the income that they’re adding to these accounts. The income grows tax free, just like in the traditional accounts, but they won’t ever pay tax on that money, again. All the growth, dividends, interest, capital gains, etc. is tax-free. That is the main benefit of the Roth. Withdrawals are always tax free, because you’ve already been taxed on the contributions.

Moving on to the final tax deferred account, the HSA (health savings account), probably the most advantaged account offered, works a lot like a mixture of both a Roth and traditional account. You can contribute up to $7,750 in 2023 to your HSA. 

The account takes in pre-tax dollars and reduces your taxable income, just like a traditional 401(k), and then it grows tax free until the funds are used. So what does it mean to ‘use’ HSA funds? Any qualified medical expense that you withdraw HSA money for comes as a tax-free distribution. That’s how use is defined. What qualifies can be found here. You’ll notice that the list is long and comprehensive, so it’s likely you’ll qualify for close to anything you may need. 

It’s common advice to try and pay as much of your medical bills out of pocket, if you can, and contribute as much toward your HSA every year. If you can accumulate funds for your old age, when medical expenses are naturally higher, it can make a huge difference in the quality of your retirement from a financial perspective. Take advantage of the tax-free growth!

Finally, let’s talk about the investment account that has no tax deference - the taxable brokerage account. This account has no limits on contributions, nor does it have any type of early withdrawal fees. This offers a great deal of flexibility as to what you can do with the funds in it. The tradeoff, of course, is that all the dividends, interest, capital gains, etc. that come with the investments in the account are taxable in the year they are incurred. 

You can do what you want with that money, when you want, how you want. 

That covers the basics of retirement investment accounts.

Now, we’ll discuss:

• The difference between marginal and effective tax rates
• What the marginal tax bracket is
• Tax credits vs. tax deductions
• Capital gains tax
• The difference between long-term and short-term capital gains
• How dividends are taxed
• The difference between ordinary and qualified dividends

So let’s jump into tax rates.

In this week’s video, I use the example of a taxpayer that has $100,000 of taxable income. That means after all deductions are applied, they had $100,000 of income subject to income tax.

A reasonable person could take a look at the United States’ tax brackets and see that in 2023, a person making $100,000 falls into the 24% tax bracket. They may rationally assume that means they will owe $24,000 in tax. Makes complete sense, right? However, this is a very common misconception. The US operates under a marginal tax system (sometimes called a progressive system). This means that different portions of your income are taxed at different rates. 

Let’s continue with the example. We’re going to reference the 2024 tax tables from here on out. Taxpayer’s $100,000 is taxed in the following way:

• The first $11,600 is taxed at 10%. 
• The next range is $11,600 — $47,150 at 12%
• The remaining $52,850 is 22%

If we want to look at a tally of taxes incurred at those rates it would look like this:

• 10% of $11,600 = $1,160
• 12% of $35,550 = $4,266
• 22% of $52,850 = $11,627

That’s a total of $17,053 in taxes. Significantly less than the $24,000 that someone may have assumed they owed. 

So, now they know how much they are expected to pay in taxes, but we need another figure for our own analysis - the effective tax rate.

Effective tax rate is the percentage of taxes you pay in relation to your income. ETR = Total tax / total taxable income.

In this example it would look like this: $17,053 / $100,000 = 17.05%

For every dollar earned, they paid about $0.17 in taxes.

Now that you know the marginal tax rate and the effective tax rate - let’s move on to another often confused topic: the difference between tax credits and tax deductions.

The difference is very simple. A tax credit reduces your tax liability dollar for dollar. A tax deduction reduces your taxable income, only.

For example, if the taxpayer has $100,000 taxable income, so they currently have a tax bill of $17,053, and they claim tax credits worth $10,000, they would reduce their tax bill by $10,000 - down to $7,053.

With a tax deduction of $10,000 they would reduce their taxable income by that amount. $100,000 becomes $90,000. That would reduce their taxes by $2,200, as the reduction only happens in one marginal tax bracket, the calculation becomes $10,000 x 22%. 

Tax credits are typically preferred albeit they are more rare and apply to less people. 

With all that we have discussed so far, we are only concerned with ordinary income taxes. Let’s move on to a different topic: capital gains.

Capital gains come in two forms: short-term and long-term. 

The terms are measured by the time you held the asset. If you sell the asset within one year of purchasing it, the gain will be considered short-term. 

The opposite scenario would result in a long-term capital gain - holding the asset for longer than one year. 

Short-term capital gains are subject to ordinary income tax rates like we discussed in the first portion of this post. For the purposes of this discussion there really isn’t a difference between how short-term gains are taxed compared to your traditional income. One thing to keep in mind is that if you accumulate enough capital gains (short or long-term) you can trigger an additional 3.8% tax called net investment tax. We won’t get into that here, but it’s something to be aware of.

In contrast, long-term capital gains are subject to preferable tax treatment. Depending on your income, you’ll be taxed at 0%, 15% or 20% on those long-term gains. 

To drive home the point, let’s take the example of Apple stock that was acquired for $100. 

In the first scenario, that Apple stock was held for 3 months and sold for $200. We’ll also borrow from the first example given of a taxpayer with income of $100,000 of taxable income. Following the sale of that stock, that taxpayer would pay an additional $44 in tax because that income would fall into the highest marginal tax bracket that they are currently in (22%).

Let’s take the same example, but the Apple stock was held for 1 year and 3 months. That taxpayer is now looking at the 15% long term capital gains rate on that sale. So, they would only have an additional $30 in tax to pay. 

In 2024, for single filers, incomes below $47,025 pay 0% on long term capital gains. The 15% bracket is for income in excess of that amount up to $518,900. Incomes in excess of that amount will be taxed at 20%. 

That’s the basics of capital gains taxes. 

For this introduction on basic US taxes, the final topic we’re going to cover is how dividends are taxed. 

Taxes on dividends are going to be simple, but there’s a few things to note. The first is that there are two kinds of dividends: ordinary and qualified.

Let’s start with ordinary dividends - similar to the capital gains determination it’s based on the length of time you’ve held an underlying asset. The durations are a bit different for dividends. 

To be considered an ordinary dividend, you need to have purchased the asset less than 60 days before the dividend was declared by the company issuing it. That declaration date is also referred to as the record date. If you have an ordinary dividend, it will be taxed as ordinary income. 

To be considered a qualified dividend, you need to have purchased the asset 60 days before that record date and held it for at least 61 days in the next 121 days before the next dividend. I know that ends up being a little confusing. If you need assistance, your broker should be able to assist you, as all of this will be reported on your 1099-B that they will issue to both you and the IRS. If you end up having a qualified dividend, you’ll pay the long-term capital gains rate on your qualified dividend income, which is preferential once again. 

That’s all we’re going to cover here and in this week’s video. It goes without saying that there is much, much more to discuss when it comes to taxes as this truly is the tip of the iceberg. 

Thanks for reading!