The taxable status of an investment account refers to the whether any income earned in the account is taxable at the time of earning. For example if you have a 401k (non-taxable) and your investment earns an interest payment or dividend payment then there will be no taxes paid on that payment. On the other hand if you have a taxable account such as a cash account at a brokerage then any earnings (such as a dividend) will be taxable in the year it is received.
Where does “tax-deferred” fit in?
One important thing to remember about non-taxable accounts is that they might be tax-deferred accounts. This means that there are no taxes to be paid on any earnings as long as they stay in the account. There will be taxes paid on the withdrawal. Going back to our 401k example – no taxes will be paid on investments inside the account but all withdrawals amounts are considered income. A Roth IRA on the other hand is a non-taxable account and there also no taxes paid on withdrawals.
Why does this matter?
The taxation of investment accounts is important for the following reasons:
- Tax filing – you need to make sure you are declaring investment income only if applicable.
- Investment selection – some investments are more tax-efficient (have less tax to pay) than others. Assuming you have both taxable and non-taxable investment accounts, the more tax-efficient investments should be in the taxable accounts and vice-versa.
How about some examples?
- Any kind of cash, open or individual account where you can purchase an investment.
- Bank account – ie high interest savings account. A money market mutual fund would be another example if it is in an open account.
- Any kind of retirement account such as 401k or IRA.
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