I love writing about taxes. I liken them to a massive puzzle or a strategy game. I love the complexity and trying to get to the most optimal end. In fact, in my younger years, I was quoted in Investment News as saying “taxes can be lots of fun.” Not one of my more intelligent quotes but I’ll stand by it. While I realize 99% of people do not enjoy reading or learning about taxes, I do believe that in personal finance simple education can go a long way in assisting people in using their funds to reach goals. Below is a quick definition of the three general tax types of invested assets.
Tax Deferred - You receive a tax deduction when making the contribution but both the earnings and growth are included in taxable income when withdrawn. For example, deductible contribution to a Traditional IRA.
Tax Free - You don’t typically receive a deduction when making the contribution but the contribution and earnings are tax free when withdrawn (if done correctly). For example, a Roth IRA contribution.
Taxable - You don’t receive a deduction when making the contribution. You are taxed on any realized gain or dividends. For example, investments purchased in a joint brokerage account.
There actually is kind of a fourth type that I won’t go into that is somewhat a combination of Tax Deferred and Tax Free. It is unfortunately way more complicated than the above and there are more exceptions than can be counted. For example, Health Savings Account contributions receive a tax deduction when contributed and come out tax free if used for qualified expenses. On a dollar-for-dollar basis, they are the most tax-efficient investment vehicles that I am aware of. Another quick note, it isn’t always as simple as looking at the account type to know what type of money is in the account. For example, a 401k can have both Tax Free and Tax Deferred money in the “same account.” Below are three takeaways:
Be aware of what type of money you are buying and selling before you make trades. Will this cause a taxable event?
Be aware of what type of money you are withdrawing before you withdraw from an account. Will this cause a taxable event?
Be aware of what type of money you have. For example, $100K Tax Deferred dollars is “worth” significantly less than $100K Tax Free dollars (unless you can utilize a strategy to get the Tax Deferred money out without paying tax).
Thank you for taking a quick few minutes to learn about taxes and investments this weekend. I hope you have a wonderful day!
Interesting Articles/Videos
A Wealth of Common Sense - We're Still in a Bear Market You Know
“In his book The Four Pillars of Investing, William Bernstein offers up one of my all-time favorite stock market analogies courtesy of Ralph Wanger, a portfolio manager from the Acorn Fund:
He likens the market to an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner."
Thank you for reading!