Written By: Steve Smalenberger, EA
The last post in this series entitled “What’s In Your Toolbox,” we looked at the various types of accounts and grouped them into three general categories:
Today, let’s focus on the taxable accounts in order to better understand their characteristics and how they can be a great “tool” to have available. In the future, we will compare how this group differs from the other two.
In order to understand the differences, we need to look into the nature of the accounts and into how the movement of money within is treated.
- Investment Growth
Taxable accounts such as individual, joint, and trust accounts by nature are usually considered investment accounts. They are not primarily for retirement although they can be used for this reason. Their primary purpose is to create a place to invest and multiply assets, all the while, keeping the money accessible. Sometimes the money is needed for lifestyle expenses but it could also include emergencies, college, gifts and retirement.
A main difference from the tax-deferred or tax-free qualified accounts is that there is no limit on the amount of money that can be deposited. This is true whether you are employed, self-employed or retired.
There are also no age-based restrictions so an account can be opened for anyone.
The money within the account may be invested in the market into such things as stocks, bonds, mutual funds and ETFs. As the account and underlying investments grow, it will be taxed according to the nature of the growth.
Interest Income: For example, bonds pay the bondholder a periodic payment on the money loaned
Dividend Income: companies share a portion of their profits with shareholders through dividend payments
Capital Gain/Loss: a stock is purchased at a particular price which becomes your “basis” and depending upon whether it is later sold at a higher price or lower price determines whether it is the gain or loss.
When you own an investment and still have the potential for a gain or loss the difference is known as an “unrealized” gain or loss. Once you sell that holding the gain or loss becomes “realized”. The time span between the purchase and sale is considered short-term if you owned it less than a year or long-term when held greater than a year.
The fine details just explained matter, because a taxable account incurs tax on the growth in the year earned. This is not necessarily a good or bad thing. It just means that the tax is both realized and recognized for tax purposes now, and not deferred or pushed out into the future.
Taxable accounts are the most flexible of the three options for accessing funds. The money can be accessed as needed and used as wanted. Any money that is not sitting in cash or a money market but rather invested in a stock or fund is still accessible. The investment just needs to be sold to create cash available to withdraw, which can take generally between one to four days, depending on the investment. That money can then be sent to the account owner via instructions they choose.
Here’s a summary of what we have covered so far:
|Can anyone set up an account?||Yes|
|Deposit limits?||No Limit|
|When is the account taxed?||As Earned|
Stay tuned for the next few posts to flesh out the differences and finally why they matter in your overall plan.