Account types and taxes: the basics
Where you hold your investments can matter almost as much as what you buy.
Regular brokerage accounts
A taxable brokerage account is the most flexible: you can put in and take out money any time. The trade-off is taxes on dividends, interest and profits from selling.
Retirement accounts in the US
A 401(k) is a workplace retirement plan. Money usually goes in from your paycheck before income tax, grows without yearly tax and is taxed when you withdraw it in retirement. Many employers add a match, extra money when you contribute; if one is offered, it's worth understanding, because it's part of your pay.
An IRA (individual retirement account) is one you open yourself. With a traditional IRA, contributions may be tax-deductible now, and withdrawals are taxed later. With a Roth IRA, you contribute money you've already paid tax on, and qualified withdrawals in retirement are tax-free. Roth contributions have income limits. Many 401(k)s also offer a Roth version.
These accounts have yearly contribution limits that change, so check the current limits. Withdrawing before age 59 and a half usually means taxes plus a penalty, with some exceptions. Other countries have their own versions, such as ISAs and pensions in the UK, or TFSAs and RRSPs in Canada.
Capital gains in one paragraph
When you sell an investment for more than you paid, the profit is a capital gain. In the US, gains on investments held one year or less are short-term and taxed like ordinary income; gains on investments held more than a year are long-term and usually taxed at lower rates. You only owe tax when you sell (the gain is 'realised'), losses can offset gains, and none of this applies inside retirement accounts while money stays in. Rules vary by country and change over time, so check current rules or ask a tax professional.
You have $1,000 of earnings to invest and pay a 20% tax rate both now and in retirement.
Traditional: the full $1,000 goes in. Say it triples to $3,000. You pay 20% on withdrawal and keep $2,400.
Roth: you pay $200 tax first and invest $800. It triples to $2,400, withdrawn tax-free. You keep $2,400.
Same result when tax rates are equal. The choice depends mainly on whether you expect your tax rate to be higher or lower later.
Key terms
- 401(k)
- A US workplace retirement account, often funded from your paycheck before tax.
- Roth IRA
- A US retirement account funded with after-tax money; qualified withdrawals are tax-free.
- Capital gain
- The profit from selling an investment for more than you paid.
- Employer match
- Money an employer adds to your retirement account when you contribute.
Account type decides when you pay tax, so know the rules before choosing where to invest.