By Jonathan Jones, CFP^®

As a financial advisor, my clients often ask me about how their accounts are taxed. The reason for writing this article is to take a quick dive into the common account types and how each of them are taxed.

Traditional IRA

If within certain income limits and the individual qualifies as having earned income, money contributed into a Traditional IRA is tax deductible in the year that the contribution is made. For those under age 50, they can contribute up to $6,000 per year. For those over age 50, they can contribute an additional $1,000 per year, which is called a catch-up contribution. When money is taken out of this account in retirement, that distribution is taxable income. Unless certain exceptions are met, any money withdrawn from a Traditional IRA prior to age 59½ is subject to a 10% early withdrawal tax penalty. It is important to mention that money in the IRA can be invested into different securities. As securities are bought and sold within the IRA, the money is not taxed until a distribution from the account has occurred.

Roth IRA

Although a Roth IRA has some similarities to a Traditional IRA, there are some key differences. Just as a Traditional IRA requires that the individual qualifies as having earned income, a Roth IRA has the same requirement. The same contributions limits and 10% early withdrawal tax penalty also apply. To be eligible to contribute to a Roth IRA, certain income limits are applicable. For a Roth IRA, any contributions made to the account are not tax deductible. However, when money is pulled out of the account in retirement after age 59½, it is not taxable. Therefore, if the assets were invested in securities and had grown, that growth is also not taxable.

Investment or Brokerage Account

This type of account can be owned by one or multiple owners. The IRS considers this type of account as non-qualified. Therefore, contributions into this account are not tax deductible. Distributions from the account are not taxable either. The taxability of this account depends on the interest, dividends, and realized capital gains on any securities that are bought and then later sold. Interest earned is always taxable as ordinary income in the year that it is accrued. Dividends are not as straight forward. Dividends are taxed as ordinary income in the year they are paid to the investor. Qualified dividends are taxed at the individual’s long-term capital gains tax bracket. The final item is capital gains. Capital gains are realized for tax purposes when a security is bought and then later sold. Capital gains are calculated by taking the difference in the security’s cost basis and the sale price. In general, the cost basis is the original purchase price, plus any additional reinvestments into the security. There are two types of capital gains. Short-term capital gains occur when a security is bought and then sold within a one-year period. These gains are taxed at the individual’s ordinary income tax rate. Long-term capital gains occur when a security is bought and held for over a year, then sold. Long-term capital gains receive favorable tax treatment and are taxed at a lower rate of either 0%, 15%, or 20%, depending on the individual’s income levels. It is important to mention that capital gains and losses are allowed to offset each other. If capital losses still remain after offsetting capital gains, up to $3,000 of losses may offset your ordinary income. Any other remaining losses may be carried forward to future tax years.

This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we do not provide advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.