Imagine two builders, both tasked with building identical, structurally sound, and physically comfortable homes in the same general location. The only difference is that one builder is working in the year 2021, with all the technological advancements and knowledge available, while the other house builder is working in the year 1821. The tasks are the same, but the builder in 2021 is likely to be more efficient in their efforts with effective tools that allow them to work smarter, not harder. When it comes to our investments, it’s important to appreciate the tools at your disposal so that smart money strategies can be implemented for your long term investment plan. Cultivating the right financial behaviors builds your financial rocket ship, and being smart about how you invest are the turbo boosters that speed up that enhance financial outcomes.
Let’s consider the basic fundamentals of investment accounts, especially the important role that taxes play on your investment outcomes.
Any investment follows a life cycle that includes the amount of money contributed, the growth of that account over time, and the eventual distribution of money.
Pre-tax vs Post-tax Contributions: Typically, money added to an investment account will be referred to as “post-tax money.” This means that the money being used to invest has already been subject to income tax. For example, I receive a paycheck from work that already has money withheld for taxes, and after paying my necessary expenses for the month, I add $100 to an investment account. This is a post-tax contribution since the money I used to add to the account has already been taxed. US tax policy seeks to avoid “double taxation” and therefore post tax contributions are not subject to tax again when distributed. Pre-tax contributions are different in that they are added to an investment account before taxes have been withheld on them. For example, if I make $50,000 per year and elect to contribute $5,000 to either a 401(k) plan through work or an IRA account on my own, the amount of income that I will be subject to tax on is $45,000 ($50,000 less the pre-tax contribution of $5,000). Pre-tax contributions provide an immediate tax benefit as illustrated above, but the amounts contributed pre-tax will be subject to tax when distributed in the future. The government has created pre-tax contributions to encourage people to save for things like retirement. Depending on the type of account, there might even be penalties if you withdraw pre-tax contributions too early, but the immediate tax benefit and long term tax deferral of growth from that contribution can be quite powerful.
Growth: Investment accounts grow in two ways: income and capital appreciation. Income can take the form of interest earned on securities, such as bonds and dividends, which are a distribution of a company’s profits to shareholders. Capital appreciation is the idea that the tradable value of a security (stock or bond) can go up in value over time. Think about stock in a company like Microsoft. Microsoft generates profit every year. A portion of the profits will be paid to shareholders as a dividend, and a portion will be reinvested in the company in order to develop new products and services that should increase profits in the future. This reinvestment supports the growth of the company in the future and will increase the value of the company’s share price today – that is capital appreciation! Anytime a security is sold at a price more than its original cost to the investor, a capital gain is created (capital loss if sold for less than the original cost). Interest, dividends, and capital gains are known as realized income, and would be taxable to investors in certain accounts. For example, if I held Microsoft stock in both my taxable brokerage account and my tax-deferred IRA, the dividend I receive in my taxable brokerage would be taxable to me in the year I receive it, whereas the dividend paid to the IRA would be “tax-deferred” until I take a distribution from the account. To further complicate matters, not all gains are taxed the same, investment related income might be taxed similar to your salary, but other types of income such as qualified dividends, municipal bond interest, and long term capital gains can be taxed at lower rates.
Distributions: When money is withdrawn from an investment account, it is referred to as a distribution. Hopefully, the growth over time has increased the balance from the original amounts contributed and you are now ready to reap the fruits of your investment labor! The tax treatment for distributions will depend on the type of account you open – you will either pay taxes on the difference between the value of what was taken out and your “cost basis” (i.e. the amount funded with post-tax contributions), or you might pay tax on the entire distribution, or possibly not pay any tax at all.
There are important nuances across the spectrum of taxable, tax-deferred, and tax-free accounts but here is a summary (not all inclusive) to help summarize:
Arranging your cash flow in a way that allows you to save and invest for long term goals, such as retirement, is Personal Finance 101. Realizing that not all long term investment accounts are treated the same will give you a leg up when deciding where to invest your retirement savings. Taxes are a real expense, so the ability to grow long term money in tax deferred/tax-free ways should be prioritized when organizing your investment account strategy.
*HSA accounts are funded with pre-tax dollars. This makes what is often viewed a shorter term healthcare only account, one of the most powerful retirement planning options available!
The decision to start saving and investing is yours, the “how” can be hard. We suggest speaking with a “fee only” financial planner operating as a fiduciary – having a CPA or tax background is a huge plus. Email firstname.lastname@example.org to schedule a free financial planning consultation with our team.
Elliot Pepper, CPA, CFP®, MST is Co-Founder of Northbrook Financial, a Financial Planning, Tax, and Investment Management Firm. He has developed and continues to teach a popular Financial Literacy course for high school students.