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IRA Tax Benefits: Taxes on Retirement vs. Non-Retirement Accounts

Updated for Tax Year 2021 / November 2, 2021 11:17 AM


OVERVIEW

Compare the benefits and tax implications of retirement and non-retirement accounts so you can choose the best option for your financial planning.


For information on the third coronavirus relief package, please visit our “American Rescue Plan: What Does it Mean for You and a Third Stimulus Check” blog post.


 

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When you invest, you have many types of accounts you can choose from to put your money in. One of the first decisions to make is whether to invest in a retirement or non-retirement account.

Your goal should be to find the best account type for your savings and investing goals. Deciding this is much easier if you understand the basic facts and benefits of each type of account.

What are retirement accounts and how do they work?

The key distinctions that define a qualified retirement account compared to a regular brokerage account are:

  1. Offering a tax benefit
  2. Having withdrawal penalties before you reach a predetermined age

These accounts have limits to the amount you can contribute each year. Your contributions could also be limited further if you earn about a certain annual income.

Typically, you can withdraw money from most retirement accounts after age 59 1/2 without penalties, but you may have to pay taxes on some or all of the withdrawal depending on the type of retirement account. You can make withdrawals before age 59 1/2, but they may be subject to specific requirements, be taxed and have penalties. A regular brokerage account does not have these restrictions.

Taxation of Roth vs. traditional retirement accounts

Retirement accounts come in many types. Overall, there are two major classes of retirement accounts. These are tax-free (Roth) or tax-deferred (traditional) accounts.

Depending on your situation, you might not pay income taxes on the money you contribute to tax-deferred retirement accounts. When you withdraw the money in retirement, you typically include the amount taken out in your taxable income.

Tax-deferred accounts and Roth 401(k) accounts typically require you to start making required minimum distributions (RMDs) when you turn 72. This is generally required so the government can start collecting tax revenue on the tax-deferred amounts within the account.

Roth retirement accounts do not give you any tax breaks when you make contributions. However, the money you withdraw during retirement, including any gains from your investments, is not taxed.

With both types of accounts, any earnings, capital gains, or dividends are not taxed as long as they remain in the account. For traditional retirement accounts, you defer paying taxes until you withdraw the money from the account during retirement. For Roth retirement accounts, taxes are never paid on these amounts.

Money withdrawn from a retirement account before the set age for that account, normally age 59 1/2, typically requires paying a 10% early withdrawal penalty for federal taxes and can be subject to state tax penalties as well. Additionally, you generally have to pay ordinary income tax on any money withdrawn early, although certain exceptions exist. For instance, you can typically withdraw contributions you made to a Roth IRA at any time without paying taxes or an early withdrawal penalty.

Your heirs may inherit your retirement account when you pass away. Taxation on inherited retirement accounts depends on several factors including whether you inherited the retirement account from a spouse or someone else as well as the type of account.

Workplace retirement accounts

Your workplace may offer one of several common retirement accounts. For-profit companies usually offer 401(k) plans, while non-profits, churches, and public schools may offer 403(b) plans. 457 plans may be offered by state or local governments as well as certain non-profit employers. Thrift savings plans (TSPs) are offered by the federal government and armed services.

Each of these retirement account types comes with a $19,500 annual contribution limit in 2021. If you’re age 50 or older, you may contribute an up to additional $6,500 as a catch-up contribution. Some plan types may allow other contributions in particular circumstances.

Your workplace may offer matching contributions depending on the details of your plan. Matching contributions are put into your account by your employer based on the plan’s requirements. For example, a plan may match the first 3% of your salary you contribute to your retirement account each year.

You get to keep your matching contribution money when you leave your firm if you’ve vested in the plan. Some plans allow you to vest, or own, the matching contributions immediately. Others may require you to earn the matching contributions over a number of years.

For instance, a plan may allow you to vest 20% of the employer contribution each year for your first five years of service. If you leave before the five years of service, you only get to keep the percentage of matching funds you are vested in.

When you leave a job, you may have an option to leave your account with the plan’s investment manager. Or, you could opt to move the money out of the workplace retirement account to a retirement plan at a new job or to an IRA while keeping the tax benefits of the original plan. Moving your account is called a rollover. Ask your new employer or IRA custodian to help with this transition to avoid any unintended tax consequences.

Retirement accounts outside of a job

You may also choose to open a retirement account on your own. You may be able to open several types of IRAs depending on your situation. The most common IRAs are traditional IRAs and Roth IRAs.

For 2021, these have a $6,000 annual contribution limit with an additional $1,000 catch-up contribution option for those age 50 and older. The contribution limit applies across all of your traditional and Roth IRAs, so you can’t double up. Contribution limits and deductibility depend on whether you have access to a workplace retirement plan and your adjusted gross income.

If you’re self-employed or run a small business, you may be able to set up other types of retirement accounts. Some examples include solo 401(k) plans and SEP IRAs.

A solo 401(k) allows business owners to contribute up to $19,500 of their compensation in 2021. You can contribute an additional $6,500 if you’re age 50 or older. Additionally, you can contribute an employer contribution to this account type but the amount varies depending on your situation. Total contributions for both the employee and employer side cannot exceed $58,000 in 2021.

SEP IRAs are another option a self-employed business owner may want to consider. These allow you to contribute up to 25% of the employee’s compensation not to exceed $58,000 in 2021. This plan type only allows employer contributions.

Pros of retirement accounts

  • Tax benefits
  • Less temptation to withdraw money before retirement due to penalties
  • Your employer may match your contributions
  • Earnings on investments are tax deferred

Cons of retirement accounts

  • Annual contribution limits
  • High income may limit your contributions further
  • Employer plans often have limited investment choices
  • Early withdrawal penalties
  • Required minimum distributions in most retirement accounts

What are non-retirement accounts and how do they work?

Non-retirement accounts can come in many forms, but the most common is a taxable brokerage account.

Taxable brokerage accounts

You can typically open these accounts with most brokerage firms, though they do not have any unique tax benefits.

You can generally deposit and withdraw money from these accounts without any limitations or penalties unless they are imposed by your brokerage firm or a specific investment. You don't have to roll over these accounts because they have no special tax benefits.

Taxation of taxable brokerage accounts

Brokerage accounts are taxed depending on the type of transaction within the account. Whenever you receive taxable distributions from an investment, you pay a tax on them during that tax year. Qualified dividends and capital gains distributions are taxed at more favorable long-term capital gains tax rates.

You also pay taxes when you sell an investment at a gain. Gains on investments held for more than one year typically qualify for more favorable long-term capital gains tax rates. Gains on investments held less than a year are typically taxed at your ordinary income tax rate. Losses on investments can offset investment gains, which may lessen your tax burden.

Pros of taxable brokerage accounts

  • Flexible access to funds
  • No income limits
  • No contribution limits
  • No required minimum distributions
  • No early withdrawal penalty
  • Can qualify for long-term capital gains tax treatment

Cons of taxable brokerage accounts

  • No tax breaks
  • Taxed when you realize gains by selling an investment
  • Taxed on dividends and distributions as they occur

Other non-retirement account types

Besides brokerage accounts, other non-retirement account types exist. Two popular options include health savings accounts (HSAs) and education accounts, such as 529 plans.

Health savings accounts

You may qualify to open a health savings account if you have an eligible high deductible health plan. A high deductible is considered $1,400 or higher for individual health insurance plans and $2,800 or higher for family health insurance plans.

These plans allow you to contribute money pre-tax or claim a tax deduction for contributions to the account. In 2021, you can contribute up to $3,600 to this account type if you have an individual health insurance plan. The limit increases to $7,200 if you have a family health insurance plan.

Some HSAs allow you to invest the money within the account. All earnings on HSAs grow tax-deferred. You can withdraw money tax-free at any time to pay or reimburse yourself for qualifying medical expenses. Withdrawals made for non-medical expense reasons may be subject to ordinary income taxes and an additional 20% tax. After you reach age 65, you may withdraw the money for any purpose without paying the additional 20% tax. Regular income taxes still apply, though.

529 plans

529 plans are a tax-advantaged way to save for education costs. 529 plans are run by each state. Almost every state has at least one 529 plan to choose from, but you don’t necessarily have to use your state’s plan.

On the federal income tax level, you don’t get a deduction for contributions you make to this account type. That said, your state may offer tax deductions, credits, or other benefits for using their plan. Earnings kept within the 529 plan account do not incur income taxes on the federal level.

Withdrawals from the account do not incur any federal income taxes as long as they’re used for qualified education expenses. This can include qualifying college or K-12 education expenses. Money withdrawn for non-qualifying purposes requires you to pay taxes on the earnings plus a 10% penalty. State or local income taxes and penalties may also apply.

529 plans do not have annual contribution limits as tax-advantaged retirement plans do. But, your state’s 529 plan may have a cap for the total dollar amount you can have in an account.

How to pick the best account type for your situation

Picking the best account type for your investments comes down to answering a single question: Which account type will most effectively help you reach your financial goals? Consider which account type provides the best way to achieve those goals based on your current situation.

If your goal is to fund your retirement and never touch the money before you retire, the tax benefits of a retirement account may help you achieve your goal faster. Examine your financial situation to determine if a Roth or traditional account type is more advantageous based on your tax situation.

If you want to set aside money for other goals and intend to withdraw before the age retirement accounts typically allow, you will likely want to choose a regular taxable investment account. These accounts don't come with early withdrawal penalties.

Most comprehensive financial planning includes a mixture of different investments including various tax-deferred, tax-free, and brokerage accounts.

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