All investment options are not taxed the same. To make the most of your investments, you should understand the tax implications of your savings accounts and investments and when to use each type.
A general savings account, rainy day fund, or a brokerage account are examples of accounts where you deposit or invest after-tax dollars – that is, dollars that have already been taxed. In addition, any earnings on these investments are taxed in the year they are earned. You do not pay taxes when you withdraw funds because taxes were paid when the income was earned.
Some investment options, particularly retirement savings accounts, allow you to defer taxes until a later date and sometimes to avoid taxes on investment earnings altogether. As a result, these accounts often have restrictions on when distributions can be taken and how the distributions can be used. Costly tax penalties can be assessed if you take distributions that fall outside of the restrictions. Some types of such accounts are:
Pre-tax contribution savings accounts offering tax deferrals on earnings. These accounts allow you to invest pre-tax or tax-deductible funds, thereby reducing your current income and taxes. They are mainly used for retirement savings. The earnings on these investments grow free from current taxation. Distributions without penalty can be taken at age 59½ (if permitted under the applicable plan), and IRS required minimum distributions (RMD) must be taken no later than April 1st following the calendar year after you attain age 72 (other rules may have applied if you turned age 70½ prior to January 1, 2020). Taxes are paid when distributions are taken. Examples include:
- — 401(k)s and 403(b)s are employer-sponsored retirement accounts. The IRS sets limitations on annual allowable contribution amounts. Learn more at the IRS’s website about 401(k)s and 403(b)s.
- — Traditional IRAs are individual retirement accounts; that is, they are not employer-sponsored. The IRS allows limited annual contributions based on adjusted gross income levels. Learn more at the IRS's website and Fidelity's website.
After-tax contribution savings accounts offering tax deferrals or no taxes on earnings. These accounts allow you to invest after-tax dollars and not pay taxes each year on the earnings. When you withdraw the funds, the earnings may or may not be taxable. Examples include:
- — 529 college savings plans are used to encourage savings to fund college expenses. Earnings on the savings are not taxed if they are used for qualifying college expenses. Learn more at investor.gov and savingforcollege.com
- — Roth IRAs offer tax-free earnings and distributions once you have reached age 59½ and the account is open for at least five years. The IRS allows some tax-free withdrawal exceptions to the above rule in certain instances such as for first-time homebuyers and college expense payments. Learn more at the IRS's website and Fidelity's website
- — Non-deductible IRAs allow earnings to grow free from current taxation, but you will owe taxes on the earnings when you withdraw funds. Learn more at the IRS's website