Taxes Affected by Investment Account Type

By Financial Advisor Peter Egolf

This article is not tax advice. Please consult with a tax accountant to make any tax calculations and decisions.

The type of account an investor uses for their investments will dictate how they will be taxed and may apply to specific investors in different ways. Retirement accounts, such as a Traditional IRA or a Traditional 401(k), allow investments to grow tax-deferred. Thus, an investor avoids short and long-term capital gains that would occur if the same investments are held in a brokerage account. Instead, the investor will be required to take a yearly Required Minimum Distribution (RMD) from their retirement account upon reaching age 73, as recently updated in the Secure Act 2.0. RMDs are considered ordinary income. Thus, traditional retirement accounts allow for investments to grow by deferring the influence of taxes. Alternatively, investors who would rather pay taxes at the time of investment have the option of using a Roth IRA or Roth 401(k) account. Roth retirement accounts can hedge against an increase in future marginal tax rates or a higher tax rate in retirement or provide account diversification for future income streams. Additionally, an investor can remove their contribution principal at any time, providing the optionality for liquidity in a retirement account.

On the other hand, a brokerage account is taxable and will force the investor to realize the gains within their investment funds each year, as described in the prior sections. An investor will only realize gains or losses on the investments at the time of sale. However, dividends and interests are taxed yearly as ordinary income even if the investor elects for reinvestment. Thus, ordinary and qualified dividends that otherwise would be sheltered in a retirement account are subject to taxation in a brokerage account. Note that an index fund investment with high capital gains and low dividends might perform better on an after-tax basis in a brokerage account than an IRA due to the potential difference between an investor's capital gain tax rate and their marginal income tax rate.

There are tax-advantaged accounts designed explicitly for healthcare and educational costs. A Health Savings Account (HSA) allows investors with eligible high-deductible healthcare plans to create a savings or investing account. The contributions to the HSA are tax-deductible and provide tax-free distributions for eligible healthcare expenses and tax-free investment returns. Additionally, the account balance is available in perpetuity, even if your healthcare plan changes and you cannot contribute to the account.

A similar account type exists for educational expenses. A 529 account allows families to contribute money for use towards educational expenses into an investment account and have the investment earnings grow tax-free. The 529's preferential tax treatment is an opportunity for families to save for their children and grandchildren's education, or even themselves.

Finally, after an investor has identified the optimal investment accounts, the final step is to select which index investments will go into each account. The pairing of investments to accounts is a critical step in ensuring that you maximize your investment strategy's characteristics. For example, a high dividend index investment fund, such as Vanguard's Real Estate ETF (VNQ), has its dividends taxed as ordinary income. Thus, this type of index investment is best suited for a tax-deferred or tax-sheltered account, not a taxable brokerage account.

The key takeaway? Choose your investment account types wisely and match your investment fund characteristics to the appropriate accounts to minimize your taxes.