April marks the official celebration of National Financial Literacy Month. With a month dedicated to increasing awareness and education, this is the perfect time to explore perhaps one of the most often confusing areas of personal finance: tax qualifications. Understanding the different types of tax implications for the financial accounts that you own can help you identify tax-saving opportunities for your investments. While there is an entire alphabet soup of IRS intricacies, all financial accounts can essentially be categorized into four tax buckets—taxable, tax-deferred, income tax-free and income and estate tax-free.
Taxable Accounts: Taxable accounts can also be known as after-tax (meaning you have paid the income tax owed) or nonqualified (do not meet the requirement for ERISA tax-advantage retirement status). These may include savings, money markets, CDs and brokerage accounts. You will receive a Form 1099 or 1040 each year to show your interest, capital gains and losses to report on your annual tax filing. This category of financial account is the least tax-advantaged bucket; however, it often provides liquidity, or penalty-free access to your funds, which can play an important role within a financial plan.
Tax-Deferred Accounts: Stepping up to the first level of becoming more tax-advantaged, we have tax-deferred accounts. This may include traditional retirement accounts (IRAs, 401(k)s, 403(b)s, etc.) that are qualified, pre-tax accounts, meaning that you have not yet paid income taxes on these dollars, perhaps by way of a tax-deductible contribution. This bucket may also include any kind of annuity, whether qualified or nonqualified, this vehicle adds tax-deferred status to the account. Unlike our first taxable bucket, you will not receive annual tax statements for these accounts. Taxes are deferred until funds are withdrawn from the account, at which time they will be subject to income tax rates.
Without the interruptions of taxes, this tax-deferred status allows the growth to compound over time. For example, if you have a $100,000 investment earning 5% return, it will take approximately 19 years to double your money. By moving it into a tax-deferred account, earning the same 5% return, your money will double in approximately 14 years.
Tax-Free Accounts: The next step up in tax-advantaged accounts gets us to tax-free in which no income taxes are due on growth or income from the account. This may include municipal bonds, which are federal tax-free, and potentially also state tax-free depending on when and where it was purchased. This also includes qualified distributions from Roth IRAs, which may require certain limitations, such as the account holder is at least age 59.5 and that they have owned a Roth account for a minimum of five years. Lastly, this category includes life insurance, either through the payout of a death benefit or, in some instances, accessing cash value of a policy. For instance, as the insurance industry continues to evolve, more carriers are providing hybrid coverage for medical emergency or long-term care expenses. This means that rather than use-it-or-lose-it approach, a life insurance policy may provide either tax-free benefits for qualifying medical needs or pass on as a death benefit to loved ones if it is not needed during your lifetime.
Income & Estate Tax-Free: The last and final category of tax-advantaged planning is both income and estate tax-free. As of 2016, the federal estate tax exemption is $5.45 million per individual or $10.9 million per married couple. If you are concerned about these limits being reduced in the future or your estate exceeding these limits at the time of your passing, various trust work including legacy or charitable remainder trusts may be worth considering to help shelter assets from taxation.
With an understanding of these tax qualifications, you can begin to identify opportunities to maximize tax efficiencies within your financial plan. Through a comprehensive approach with the appropriately licensed tax and legal professionals, you can be on your way to minimizing your taxes and maximizing your retirement income and legacy goals. To discuss ways to make your investments more tax-advantaged for your unique situation, please give us a call at (803) 547-7853 for our Charlotte office or (843) 757-9400 for our Hilton Head office.