How Tax Free Accounts Work [Video]

Let’s look at how tax free accounts work. Who are they for and what rules do they have? Maybe this is an account that’s beneficial for you. We have already discussed taxable accounts and tax deferred accounts in our recent posts. When thinking of tax free accounts think of after-tax account types. For example Roth, Roth IRAs or Roth 401(k)s; these are after-tax accounts. 

Who are tax free accounts for? 

Anyone with earned income can open one. There is no age limit. You will need to have a job or be self-employed to be able to put money in.  These accounts are retirement focused and because of this there is a benefit to them. The accounts do grow tax free however the government has a limit of how much you can put in.  Annually you can put in $6,000 per person. Those individuals over 50 years old can add another thousand dollars equaling $7,000 total. 

When the money goes in that is considered after-tax.  This is money out of your checking or savings account.  It’s already been taxed in your paycheck so when you put the money in there is no tax benefit.  There is not a tax deduction. It doesn’t reduce your taxable income, but the account then grows. None of this is taxable, so interest, dividends, capital gains, it’s all inside this protection.  There is no tax impact.  

When you take it out it could be completely tax free.  When you take money out this is the way it works, first in-first out.  So you are looking at any contributions or any money that is deposited.  Those contributions come out first.  So if you put in $1,000 the next money that you take out is that contribution.  Then when you have exhausted and used up all your contributions then you go to the next level. You start to pull out returns or the growth on the contributions, and that is when it could be taxable.

What are the rules for making withdrawals?

Age-  If you are 59 ½ or older you may be able to withdraw funds penalty free. If you are not 59 ½ yet there is going to be a penalty on that growth distribution. There would be a 10% penalty.  

Age of account-  If the account has not been open for five years that’s another rule that you have to meet.  So if you are over 59 ½ and have met the five year rule then you can take all that distribution tax free and it doesn’t show up as a line item on your tax return. 

With these accounts there are no RMDs (Required Minimum Distributions) meaning you are not required to take that money out, which is a great thing.  You can let it grow and eventually pull it out in the future.  So while this is a retirement account it doesn’t only have to be used for retirement purposes it can be used for other needs.  As long as you are over age 59 ½ and the account has been there for five years.  

Like the other two accounts, the tax deferred and taxable, the tax free can definitely fit into your financial plan.  What are your goals and needs?  As always if you have any questions and wonder how this fits into your situation let us know. We would love to walk you through this and see how it fits into your specific situation.