Investing 101
IN THIS LESSON
Withdrawals from investment accounts can create a taxable event depending on the type of account and the nature of the withdrawal. Here are some common scenarios where withdrawals may be subject to taxation.
Understanding the intricacies of taxation when it comes to withdrawing funds from investment accounts is crucial for anyone seeking to optimize their financial strategies. Whether you’re planning for retirement, funding a child’s education, or simply looking to grow your wealth, being aware of how withdrawals may impact your tax liabilities can make a significant difference in your overall financial health.
Each type of account has its own set of rules and regulations governing taxation, and navigating this terrain requires a nuanced understanding of the tax code.
Uniform Gifts to Minors Act (UGMA/ UTMA):
UGMA/ UTMA accounts are custodial accounts established to hold and manage assets for minors. These accounts allow parents or guardians to transfer assets to a child while maintaining control over the account until the child reaches the age of majority (typically 18 or 21, depending on the state).
Income Earned: Any income generated by investments held in a UGMA account, such as interest, dividends, or capital gains, is generally taxed at the child’s tax rate. This can be advantageous if the child is in a lower tax bracket than the parents.
Kiddie Tax: The “kiddie tax” rules may apply to unearned income (such as investment income) above a certain threshold for children under the age of 19 (or under 24 if a full-time student). Under these rules, a portion of the child’s unearned income may be taxed at the parents’ tax rate, which could result in higher taxes.
Gift Tax: Contributions to UGMA accounts are considered completed gifts to the child and may be subject to gift tax rules if they exceed the annual gift tax exclusion amount (which is $15,000 per donor in 2021). However, there are special rules that allow individuals to contribute up to $75,000 (or $150,000 for married couples) in a single year to a UGMA account without triggering gift tax, using the five-year gift tax averaging rule.
Roth IRA Accounts:
Contributions to Roth IRAs are made with after-tax dollars, so qualified withdrawals (those made after age 59½ and held for at least five years) are generally tax-free.
However, early withdrawals of earnings (before age 59½ and/or before the account has been open for five years) may be subject to income tax and a 10% penalty, unless an exception applies.
529 College Savings Plans:
Withdrawals from 529 college savings plans are generally tax-free when used for qualified education expenses, such as tuition, fees, books, and room and board. However, non-qualified withdrawals may be subject to income tax and a 10% penalty on the earnings portion.
TL;DR: Withdrawals from investment accounts can trigger taxable events depending on a range of factors, including the type of account, the nature of the withdrawal, and the purpose of the funds.
This information is general in nature and is not intended to serve as the primary or sole basis for investment or tax-planning decisions.
Taxable Investment Accounts (Brokerage Accounts):
Brokerage Accounts are most often used for general investing (non-retirement).
Capital Gains: If you sell an investment in a taxable brokerage account for more than you paid for it (capital gain), you will owe taxes on the profit. The tax rate depends on how long you held the investment before selling it (short-term capital gains are taxed at higher rates than long-term capital gains).
Dividends: If your investments pay dividends, these distributions are generally taxable in the year they are received, regardless of whether you reinvest them or receive them in cash.
Interest: Interest earned on investments such as bonds or savings accounts is generally taxable as ordinary income in the year it is received.
Retirement Accounts
Traditional IRA and 401(k) Accounts:
Withdrawals from traditional IRAs and 401(k) accounts are generally taxed as ordinary income in the year they are withdrawn. This includes both contributions and any earnings on those contributions.
Required Minimum Distributions (RMDs): Once you reach a certain age (usually 72 for traditional IRAs and 401(k) accounts), you are required to take minimum distributions from these accounts each year. These distributions are subject to income tax.
Beneficiary Accounts