Many people understand that in order to live a comfortable lifestyle in retirement they will need to save money as they go through their working life. For many people this means that they will put some into their 401(k) that is provided at work. For others they will contribute to their IRA or Roth IRA. Still others will choose to utilize an annuity or a non-qualified account. Most people have been led to believe that putting money into their 401(k) or their IRA is the best way to maximize taxes. However, there is another way.
How an IRA or 401(k) Works
An IRA, or Individual Retirement Account, works in the same way as a 401(k). The only difference is that the 401(k) is sponsored by the employer rather than being an individual account. There are a few other details that determine contribution limits, but the tax mechanisms are the same.
When a person contributes to an IRA the amount of their contribution is deductible from their income taxes for that year. This means if someone contributes $1,000, his or her taxable income is lowered by that $1,000 amount.
The government, however, is not in the business of letting people get off without paying any taxes. When it is deductible at the time of contribution, the taxes must be paid when the money is withdrawn. As long as that withdrawal happens after the age of 59.5, there are no penalties that go along with the taxes.
For someone who is in the 25% tax bracket at the time the money is withdrawn, they will pay taxes on the full amount coming out. Suppose that $1,000 contribution has grown to $2,000. If the individual wants to withdraw the $1,000 in growth, he or she will pay $250 in taxes based on their tax bracket.
How a Non-Qualified Account Works
There are fewer restrictions and regulations that go into a non-qualified account. This account is not tax advantaged, and a person can put in as much, or as little as he or she wants to put in. As in the scenario above, lets suppose the individual contributes $1,000. This contribution is not deducted off their taxes.
Growth on a non-qualified account is only taxed when the gain is realized. That means as long as the individual does not sell any of their stocks, bonds, or mutual funds, they will not be taxed on the growth they have experienced. But if you dont sell, then you cant access your money. So the government looks at taxation in two different ways. First, if the gain is realized within one year of purchase, it is called a short-term capital gain. This gain is taxed at the owners regular income tax rate (in our case that is 25%). However, if the security is held for longer than 12 months, it is now considered a long-term capital gain. The government has various tax rates depending on a persons income. For those in the 25% income tax bracket, the long-term capital gains taxes are only 15%.
Lets again look at our $1,000 investment. Suppose this investment grows to $2,000 over the course of many years and the individual would like to withdraw the gain. By taking out the $1,000 in gains, this person only pays long-term capital gains taxes, or $150.
Wrapping it Up
There are a lot of numbers shown in the two examples above, and they both require some basic knowledge of investments and how taxation works. For those who are now completely lost, the important thing to keep in mind is that a tax qualified account, such as an IRA or a 401(k), may end up requiring you to pay more in taxes rather than less. When structured properly, many people can reap the rewards of a non-qualified account.