Since I started in this industry in 2021, I’ve noticed a trend. Advisors and regulators love to jam-pack as much financial jargon as possible into your financial statements and every ‘educational’ video. It seems that we (as an industry) chose this route rather than considering clarifying and elaborating on the points we’re trying to get across. It can be a fallible way to do business: “Just trust me, I’ll take care of you!”
So, I have a topic to chat about today to clarify some things for you readers who desire clarity – Retirement and Non-Retirement assets. Let me begin by saying that if you aren’t going to read this whole blog, but just want the gist, here’s what you need to know: Retirement money is taxed differently and is exclusively set aside for retirement (such as 401k’s, pensions, and IRA’s). Non-retirement money is the money that is more liquid to you but comes at the cost of capital gains tax (often listed as TOD, brokerage, individual, or joint accounts.)
I put together a few paragraphs below to explain taxation, the pros and cons of retirement vs non-retirement assets, and how they should fit into your financial plan.
Taxation:
The taxation of retirement assets and non-retirement assets are very different and very important to the financial planning process. Retirement assets are taxed as income in your personal income bracket (10-37% based on income earned) and those taxes will be reported at time of investment into a Roth, or when you take money out of a traditional IRA or 401(k) in the future. (Think of Roth as “taxing the seed” and traditional 401k/IRA as “taxing the harvest”.)
Non-Retirement assets are taxed when you close out a position and incur capital gains. There are 2 ways those gains are taxed:
- Short-term capital gain (taxed at your income bracket) if held for less than 365 days.
- Long-term capital gain (0, 15, or 20% based on your personal tax situation). If you’ve held the position longer than 365 days.
- Example: Sally buys a share of a stock “A” for $100.
- If she has a 100% gain and doubles her money in one day, then sells the position. She would incur $100 of short-term capital gains and pay income tax on the transaction.
- In the same scenario above, she holds the position for 1 full year, then sells. She would incur $100 of long-term capital gains and pay 15%. (See tax table for why she doesn’t pay 0 or 20%.)
If you do not have gains, there will be no taxable event that occurs.
Pros and Cons of Retirement Assets:
Pros:
- A lower tax bill during high earning years (Deferring a portion of your salary now then taking money out of your account in retirement means you’ll get tax savings now, then possibly pay less on taxes down the road when you aren’t earning an income).
- This does not apply to Roth IRAs as those contributions must be made with after-tax money.
- No tax to trade positions in your account as capital gains realized do not happen in retirement accounts.
- Ex: in my IRA, I sell an appreciated share of Apple and use the proceeds to buy a share of Microsoft – no taxes are incurred unless I actually take the money OUT of the IRA altogether.
Cons:
- Early withdrawal penalties of 10% if you take money out of your retirement assets before you turn 59 ½.
- Income tax brackets are subject to change and may be higher when you retire.
- Having all of your assets in 401k/IRA vehicles means that every dollar you will live off of in retirement could count against your income tax, meaning you can bump yourself into higher income brackets.
- This is why tax planning and talking with your Advisor about a Roth IRA is important.
- RMD’s (Required Minimum Distributions)
- In all Non-Roth retirement accounts, you’re required to take a certain amount of your IRA and pay taxes on it every year once you turn a certain age (72, 73, or 75 depending on when you were born). This can lead to unnecessary taxes.
- Inheritance Taxes
- Under new IRS rules, your heirs have 10 years to close out their inherited IRA. This can be detrimental if they are in their high-income earning years.
Pros and Cons of Non-Retirement Assets:
Pros:
- Liquidity – You can take money out of your account at any time without early withdrawal fees (as long as the investment doesn’t have separate surrender charges)
- Tax-Loss Harvesting – You can close out positions that haven’t grown to create “Small wins” in your account by lowering your annual capital gains that you must report to the IRS.
- Upon your passing, your heirs may be entitled to a “step-up” in cost basis, which means your heirs essentially “bought” the shares on the day that you passed away. This is incredibly tax-friendly for inheritance purposes.
Cons:
- Annual tax consequences: Index Funds, Mutual Funds, and individual stock positions may pay dividends and pass-through capital gains distributions to shareholders. This is great because it means more money in your pocket but is also reported as capital gains which are taxable.
- It can be easy to get stuck holding a highly appreciated position because of the large potential capital gains that can come along with it.
Wrapping Up:
Regardless of your financial planning needs and who you decide to do that with, it’s imperative to any investor that they have their financial needs planned for. Liquidity, tax-planning, and time horizon all play massive roles in your future, and to have all your eggs in the same tax basket can prove to be quite the handcuff! Make sure you talk with an advisor or use the information you’ve got to give yourself options with your investments.
*** Information and opinions are my own and do not necessarily reflect the beliefs of LPL financial or JBA Wealth Management. ***