The Taxable Brokerage Account
|The Taxman Cometh|
Anyone may open a standard taxable brokerage account with a brokerage firm such as Vanguard, Fidelity, Scottrade, Charles Schwab, T. Rowe Price, E*Trade, TD Ameritrade, etc. You fund this account just like you would a checking or savings account, by transferring money electronically or by writing a check. Once inside the account, you invest this money by using it to purchase securities, which are financial instruments representing financial value—most commonly debt (‘bonds’) or equity (‘stocks’). You may exchange the securities you own for cash at the going market rate, which you may then reinvest or withdraw.
Taxable brokerage accounts funded with regular income experience double taxation. The money that you use to fund the account is already ‘post-tax’ - you already paid income tax (and likely payroll tax) on that money when you earned it. When you exchange a security and that security has increased in value, the resulting ‘capital gains’ earnings are taxed at the current capital gains rate. If you’ve held the security for less than a year, your earnings are considered ‘short-term capital gains’ and they are taxed at the ordinary income tax rates - 10% to 39.6% in 2013, depending on your tax bracket. If you’ve held the security for over a year, your earnings are considered ‘long-term capital gains’ and they are taxed at the long-term capital gains rates - 0% to 20% in 2013, depending on your tax bracket. Additionally, your state will tax your capital gains at the ordinary state income tax rate. By taxing away some of your earnings, the overall rate of return on your investments is reduced.
Tax-Advantaged Retirement and Education Savings Plans
The government gives you an incentive to save for your own retirement by providing tax breaks for money placed in a qualified retirement plan account. Sections have been added to the IRS code to create tax-advantaged investment plans that facilitate saving for education and retirement, and these investment plans are often named after the section of the tax code that created them (e.g. 401(k), 403(b), 529 Plan). Essentially, you are accepting a stricter set of rules on contributions and distributions in exchange for a reduction in your taxes.
Contribution and Distribution Restrictions
Contributions are the transfers of money into the investment account. While your contributions to a regular taxable brokerage are unlimited, tax-advantaged plans impose annual contribution limits. These limits may be quite low ($5,500 per year for the Roth IRA) or quite high ($51,000 per year for a Solo 401k).
All tax-advantaged plans share the advantage of avoiding capital gains tax on the growth of the invested money, and many offer an additional choice: pay your income tax now, or pay it later. If you pay it now, the contributions are 'post-tax' and will not be taxed at all when you make a withdrawal later on; if you'd rather pay later on the withdrawals, contributions are 'pre-tax' and you can deduct them from this year's income taxes. This can be extremely useful for those who are currently making a lot of money and expect to be in a lower tax bracket when they're in retirement.
Distributions are the transfers of money out of the investment account. A distribution may consist of a mixture of principal—the money you originally placed into the account—and earnings—the money you've made in the account due to increases in the value of your investments.
A distribution that follows the rules and serves the intended purpose of the plan is called a ‘qualified distribution’; nonqualified distributions may trigger extra taxes and other penalties. A distribution might be qualified if you're over a certain age or if it's used to pay for education expenses; it all depends on the specific account type.
As already mentioned, there are several different types of tax-advantaged investment plans. These plans differ in terms of who is eligible to participate, whether contributions are pre-tax or post-tax, under what conditions a distribution is qualified, and how distributions are taxed. The type of plan that’s best for you depends on what you’re eligible for, the goals you have for your money, and your current and expected future tax situations.
Due to the extremely broad eligibility requirements, excellent tax advantages, and flexible distribution rules, the Roth IRA is an excellent choice for very many people. Get the details here here and open that account!