Assets, including investment accounts, are taxed differently depending on their type. Taxation is a complex topic but is discussed in greater detail in Tax Knowledge is Table Stakes: An Introduction to Taxation of Income, Interest, Dividends, and Capital Gains. Understanding specific tax implications is helpful, but for the moment let’s consider how the timing of these will transpire throughout your lifetime. All your assets, including investment accounts, are taxed in one of three time periods. They are either being taxed annually, will be taxed in the future, or have already been taxed and will never again be taxed.
Tax Annually: Investment accounts subject to annual taxation include individual and jointly owned nonqualified accounts. These accounts generate interest, dividends and capital gains, each of which is taxed differently. The reason these are considered annually taxable is because growth is not subject to tax deferral. Interest, dividends, and capital gains are taxed in the year they occur.
Tax Later: There are several versions of accounts that benefit from tax deferred growth. Since taxes are deferred, future withdrawals are often taxable. There are several versions of these accounts but the most common types include traditional IRAs, and employer sponsored retirement accounts such as 401(k)s, 403(b)s, and 457(b)s. Contributions to these accounts are usually deducted from income but future distributions from these accounts are considered income and subject to ordinary income tax.
Tax Never Again: Accounts that are never again taxable include Roth accounts such as Roth IRAs, Roth 401(k)s or Roth 403(b)s. Contributions to these accounts are not deducted from income. The trade-off being non-taxable distributions in future years. This is true for contributions to these accounts, as well as investment growth.
Knowing the tax diversification of your assets is important. As you’re taking inventory of your personal assets, you would be well served to consider how you’re diversified among these categories. The mistake I notice many people making is funneling the majority of assets into accounts that will become taxable in future years. It’s important to understand your options and the future tax implications of each because you have some choice in the extent to which you utilize each account type. Having the majority of your assets in tax deferred accounts isn’t always problematic. The precise timing these assets will become taxable is also important, but considering your general arrangement will help to gauge how closely this needs monitoring.