There are 3 tax structures you can invest under:
- Already-Taxed or Roth
If you asked your local financial advisor for investment suggestions, chances are they’ll recommend that when planning out your long-term investment portfolio, you want to spread your cash among all three structures. Before understanding why this is a key part of your path to financial freedom, you should understand how each structure works.
A Taxable account is like a regular brokerage or revocable family trust account. The IRS doesn’t offer any special treatment for it, so if you sell stock at a gain, you will owe tax in the current tax year. The advantage of a Taxable account is that you’ll pay taxes now, so you won’t have to pay them in the future. When your RSUs vest, you’re automatically taxed and the only taxes would be gains that you realize in the future.
A Tax-Deferred account is one where you owe tax later, such as a traditional IRA or 401k. You deduct from your income any contributions made to the account, leaving those funds as non-taxable today. You can invest them, but when you take out money, the IRS will tax you on the entire balance as if it were income. There are no capital gains treatment for all the gains you build up in a tax deferred account.
3. Already-Taxed or Roth
This can be a Roth IRA or a Roth option inside your 401k. With the Roth, you don’t get a tax deduction for money that goes in. The money you put in comes from earnings that are taxed today. However, when you take money out of a Roth to use it for retirement, you don’t pay taxes. You can invest in your Roth, have it grow, and not pay any tax on the growth.
Not everyone can use a Roth IRA. You can contribute if your family income is lower than about $200,000. However, if your employer has a Roth 401k option, there is no income limit. You can funnel your 401k contributions into your Roth 401k up to the annual limit each year. Your employer contributions will always go to the Tax-Deferred or traditional 401k account because they want the tax deduction now.
The 3 structures come down to this:
- You can pay tax today on the performance of your account in a Taxable Account.
- You can defer today’s income tax to later years in a Tax-Deferred Account.
- You can never pay tax again in a Roth Account by paying tax today..
Which tax structure should you use?
Most people should use all 3 tax structures for their long-term portfolios for two key reasons.
- Your circumstances change over time. Your withdrawal and use of the funds will determine how and when you pay taxes. By staying flexible and retaining balances in all three accounts, you’ll get the most out of your portfolio.
- The tax laws will change. There have been major changes in the tax code over the last several administrations, and that won’t settle any time soon.