Choosing the proper account type is a fundamental task in financial planning that shouldn’t be overlooked. If you can gather some basic knowledge on how each account works, and then pair that with your stated financial goals, you can start making decisions on what kind of account you need to open, fund, or transfer. Here are a few of the most common account types with a brief description about how they are taxed, how they can be used, and how they pass after death. Here's a chart for a quick visual aid.
Before we discuss the accounts specifically, let’s discuss basic account styles in two forms: Qualified and Non-Qualified. This determines the tax code in which the funds are subject.
Qualified money, or qualified retirement money, provides a tax wrapper around the funds in each plan that is labeled as “qualified retirement accounts”. Qualified accounts share some basic features that are congruent with most forms of retirement accounts. These features are as follows:
- Contributions can normally be deducted from earned income for tax purposes (except for Roth).
- Limits exist on annual contribution amounts.
- Funds inside qualified accounts grow tax deferred, meaning gains and income from the investments are not subject to capital gains taxation.
- All distributions are subject to income tax (except for Roth and in some cases where original contribution was not deducted from income)
- Unless an exception or loan is available, early withdrawals (prior to age 59 ½) are subject to a 10% penalty.
- If there have not been enough funds distributed by a certain age (currently varies but is between 72-74), a 50% penalty is assessed on the amount that should have been withdrawn (this is called a “Required Minimum Distribution” or RMD for short) for that year.
- Funds pass to a named beneficiary upon the death of the account owner. If no beneficiary is named, the funds pass to the decedent’s spouse or estate.
Non-Qualified money does not carry a tax wrapper. Many individuals have experience with non-qualified money in the form of bank accounts. Bank accounts are much simpler because the funds inside are generally cash, so there is very little –if any – growth. Features of non-qualified accounts are as follows:
- Contributions are made after tax and no tax deduction is available for contributions.
- There are no limits on the amount that can be contributed in any given year.
- Investments are subject to capital gains taxation upon a realized gain. A realized gain is the receipt of income or the sale of a security, even if the proceeds are reinvested.
- Distributions are a mix of taxed and already taxed. If there are gains embedded in the requested distribution, these may be subject to capital gains taxation. Any amount that has already been taxed does not get taxed again.
- There are no penalties or rules against early withdrawal. There are no penalties for early withdrawals. Additionally, there are no RMDs or penalties for holding onto the money for too long.
- Upon death, funds pass any way designated by the account owners.
The following items are descriptions of specific account types. They may fall under the Qualified money rules or Non-qualified money rules above. There are specific rules or purposes of each account, and this is a very brief description.
The Traditional Individual Retirement Arrangement, or IRA, is an individually owned retirement plan. The IRA is a popular account, and the IRA appears in various forms. IRAs (or any retirement account) are not in-and-of-themselves an investment. An IRA is just an account with specified tax rules. Investments are selected and put into the IRA. The IRA provides a means for an individual to personally own a qualified retirement account. The most important part of the IRA is the “I”. Since IRAs are individually owned, there are no vesting schedules (a period of time where employer-contributed funds are not “locked in” when employment is terminated).
IRAs are useful accounts for storing old retirement accounts in the form of a “rollover”. A rollover is a fancy term for a transfer without undergoing a taxable situation. Since retirement plans have deferred taxes embedded in them, rolling funds into an IRA continues to defer those taxes. The more granular rules of rolling funds into an IRA are as follows:
- Employment must be separated.
- To be treated as a rollover, the distribution check cannot be payable to account owner directly.
- The rollover funds must be deposited into an IRA within 60 days of receipt.
Sometimes it may make sense to keep an old retirement plan where it is, but here are some reasons someone would roll funds into an IRA:
- Simplicity or consolidation of accounts
- Greater investment choices
- You want an advisor to manage the funds
- You have a poor relationship or bitter feeling about the former company
When funding an IRA, you have a choice fund with pre-tax (tax deductible) contributions or after-tax contributions. If you fund with pre-tax contributions, the contribution and the investment growth are considered tax-deferred funds, and all distributions are taxable as income. If you choose to fund an IRA with after-tax money, withdrawal of the contribution will not be taxable to you; however, any investment gains will be taxable as income. To fund an IRA with after-tax money, you must notify the IRS by filing form 8606 with your tax return. Unless you immediately convert to Roth IRA, funding an IRA with after-tax contributions can greatly complicate the IRA reporting since the after-tax contributions need to be calculated and recorded each year.
For 2023, IRA (both Traditional and Roth) contribution limits are an aggregate $6,500. This means you can contribute a maximum of $6,500 to an IRA or multiple IRAs. If you fund both a Roth and a traditional IRA, you can fund $6,500 in total, split between the accounts. For example, you could fund $3,000 to your traditional IRA and $3,500 to your Roth IRA for a total contribution of $6,500.
IRAs carry some stringent withdrawal rules. The government identifies retirement beginning at age 59 ½, so there is a 10% penalty for distributing funds prior to this age. The penalty is 10% on the entire withdrawal, plus any income taxes payable on the withdrawal. Currently, it varies by age (age 70 ½ - 74, depending on current age), but there is a penalty for waiting too long to withdraw funds from an IRA. This year, the penalty is 50% of the amount that was supposed to be withdrawn, plus making the withdraw and paying all applicable taxes on the withdraw. The penalty, beginning in 2024, will be 25%. This leaves a 14 ½ year penalty-free withdrawal period from age 59 ½ to age 74, which illustrates some of the complexity and rigor of traditional IRAs.
IRAs pass to a beneficiary (or beneficiaries), which the account holder chooses. If a spouse is the beneficiary, he or she can basically use the beneficiary IRA as his/her own IRA. If a non-spouse (this includes a trust, even if the trust solely benefits the spouse) receives the account, the beneficiary IRA rules can be complicated. In short, once the account is received by a non-spouse beneficiary, the beneficiary essentially has 10 years to spend the account balance to zero (and pay taxes on all distributions) or pay penalties plus taxes on the amounts left over.
Roth IRAs have some nice advantages over traditional IRAs, as the taxation is generally more favorable. The main difference between a Roth vs. a traditional IRA is the tax on distribution. Roth IRA contributions must be made after-tax. Like a traditional IRA, investment growth is tax deferred. Distributions, as long as a few conditions are met, are income tax-free. This tax-free distribution is what makes Roth IRAs favorable.
Roth IRAs can be funded by contributions (the same contribution limits as traditional IRAs) or via rollover proceeds. Some retirement plans have Roth options available, and these plans need a Roth IRA to receive the rollover proceeds.
While there are early withdrawal penalties in Roth IRAs, they aren’t nearly as stringent as traditional IRAs. All contributions are made on an after-tax basis, and all contributions can be withdrawn without tax or penalty if the Roth IRA has been open for at least 5 years or you are at least 59 ½, whichever comes first (Side note on the “5-year rule” for Roth IRAs: As long as any Roth IRA has been opened at least 5 years ago, you will be able access contributions income-tax and penalty free. This rule doesn’t necessarily apply to the Roth IRA to which you are making the withdrawal if you have multiple Roth IRAs.) Any growth on the investments inside the Roth IRA do carry a 10% penalty if withdrawn prior to age 59 ½. Contributions are always withdrawn first in a Roth IRA. Since there are no taxes on distributions, there are no required minimum distributions, so if you don’t need the money in retirement, you won’t be penalized for letting the deferred growth compound during retirement.
Like a traditional IRA, Roth IRAs are passed to a beneficiary (or beneficiaries) of the account holder’s choosing. If the beneficiary is a spouse, the spouse can basically act like the Roth IRA is his/her own Roth IRA. If the beneficiary is a non-spouse, the Roth IRA needs be spent or transferred in full within 10 years. There is no tax due on these distributions, but the IRS does not want tax-deferred growth and tax-free distributions to be a legacy asset.
The term “Taxable Accounts” is really a catch-all term for any account that falls under the capital gains taxation rules. A taxable account, to some degree, can be set up any way you want it. Unlike an IRA (which can be owned by only one individual), taxable accounts can be owned by one owner, multiple owners, trusts, business entities, etc. There are no contribution limits, early withdrawal rules, or required minimum distributions. A taxable account can be a checking account, CD, investment account, etc.
Taxable accounts fall under the capital gains tax treatment, which can be either favorable or unfavorable, depending on how the growth in the account is handled. The contributions have already been taxed, so there isn’t any tax on the contribution again. The growth is what generates the capital gains tax, and the holding period of the asset prior to the growth being realized (or being available to the account holder, e.g., shares sold, income received, etc.) determines what kind of capital gains tax applies.
Short-term capital gains occurs when an asset’s growth is realized while it is held for one year or less. The tax rate on short-term capital gains is your ordinary income tax rate. If you are in the 34% income tax bracket, then you will owe 34% of taxes on any investment growth or income.
Long-term capital gains tax occurs when an asset’s growth is realized while it is held for more than one year. The tax rate varies based on the individual’s tax bracket, and the long-term capital gains rate can range from 0% to 20%.
In addition to long-term and short-term capital gains, there can be long-term and short-term capital losses in taxable accounts. The losses can offset gains, and these losses can even be deducted against earned income, up to $3,000 per year with amounts carried over to future years. Utilizing losses to offset gains can be a great strategy to manage the tax impact of taxable investments.
For those in the highest income tax brackets, there is an additional tax on capital gains of 3.8% called the Net Investment Income Tax (NIIT). While this is not considered a capital gains tax per se, it can impact your effective tax rates.
While there are many more account types, a few popular ways to set up taxable accounts are Individually Owned with Transfer on Death (TOD), Joint with Rights of Survivorship, and Trust accounts. The way the account is established ultimately determines how the funds are passed, so let’s look at the three account types listed.
Individually Owned with Transfer on Death (TOD): This is an individual account that has a beneficiary designation attached to it. Some people like to hold these accounts individually for multiple reasons, such as:
- They are single
- They want to separate funds from other funds
- They want to fund a trust
- Funding is to fulfill a specific objective, e.g., college funding, business objectives, etc.
The TOD designation can be added to other accounts, such as a joint account, but I usually see the TOD designation added to individual accounts most often.
Joint with Rights of Survivorship (JTWROS):
This account type is often suited for jointly held assets, whether it be with spouses or even with parents and children when the asset is equally owned (be aware that certain gift tax issues can come in to play when owning assets jointly with children). The Joint with Rights of Survivorship (JTWROS) account holds the assets where every account owner (there can be more than two) owns equal shares in the account. Upon the death of an account owner, the balance of the assets are automatically redirected to be owned by the surviving owners. For example, if two spouses own a JTWROS account and one dies, the surviving spouse would automatically be the sole owner of the account.
Trust accounts are just as they sound: accounts held in trusts. Unless a trust is already established before an account is opened and funded, a joint or individual account may need to be retitled as a trust account. This process is simple, as it is just opening a new account and transferring assets into it. To have assets be “in” a trust, the trust must own the account. The rules governing the trust then affect how the assets pass accordingly.
A basic understanding of account types, tax treatments, and estate planning methodology is necessary in utilizing the proper account type in financial planning. While this quick guide may prove helpful, it certainly is not exhaustive. No matter which account type is appropriate, thinking of goals and ideal life objectives is the first step. The account type is simply an application of the “bigger picture” when it comes to the overall picture of crafting a financial plan.