All DIYers must understand taxes because it offers some of the greatest areas for improvement. Tax treatment of retirement accounts is different than non-qualified accounts. Retirement accounts are subject to federal and state income taxes. Taxation of non-qualified individual and joint accounts is more nuanced. These accounts will likely generate dividends or interest income as well as capital gains. Dividends are taxed differently depending if they are qualified or ordinary. Capital gains are taxed differently depending if they are short term or long term.

Federal Income Tax: Not all income is taxable. We receive income adjustments and deductions which reduce the amount of income subject to income taxes. To discuss the possible adjustments and deductions is beyond the scope of this post. One deduction worthwhile mentioning in this post is the standard deduction. Whether you’re single or married, rich or poor, standard deductions represent an amount of income that’s not taxed.  The standard deduction amount in 2019 is $12,200 for single taxpayers and $24,400 for married filing joint taxpayers (MFJ). You can choose to itemize your deductions if they exceed standard amounts but few people do this.

Income net of adjustments and deductions is referred to as taxable income, and is progressively taxed in tiers called brackets. As it stands today, there are 7 brackets ranging from 10% to 37%, as such:

• 10% for incomes of single individuals up to $9,700 and up to $19,400 for MFJ.
• 12% for incomes of single individuals over $9,700 and over $19,400 for MFJ.
• 22% for incomes of single individuals over $39,475 and over $78,950 for MFJ.
• 24% for incomes of single individuals over $84,200 and over $168,400 for MFJ.
• 32% for incomes of single individuals over $160,725 and over $321,450 for MFJ.
• 35% for incomes of single individuals over $204,100 and over $408,200 for MFJ.
• 37% for incomes of single individuals over $510,300 and over $612,350 for MFJ.

Income is taxed according to the bracket it resides. For instance, a married couple with a taxable income of $200,000 would be taxed in tiers as follows:

Bracket	Taxable Amount	Amount of Tax Owed
10%	$19,400	$1,940
12%	$59,550	$7,146
22%	$89,450	$19,679
24%	$31,600	$7,584
Total	$200,000	$36,349

The couple in this simplified scenario paid a cumulative amount of $36,349 in federal income tax. The cumulative tax could be reduced by tax credits if they qualified for any but this is outside the focus of this post.

If this couple had decided to make contributions to an investment account they would most likely receive deductions for contributions to traditional retirement accounts (assuming no effect from income limits). Contributions to roth and nonqualified accounts would have no effect on taxable income.

State Income Tax:  Most states tax their resident’s income progressively, like the federal government does. These tax brackets are specific to the state and I encourage you to research them. Keep in mind there are seven states that don’t tax income and 11 that impose a flat tax. Prior to 2018 state taxes were deductible from federal taxable income but this was changed with the tax cuts and jobs act.

Taxation of Interest: Most interest will be taxable as income the year it is received or credited. There are a handful of exceptions but these are beyond the scope of this article and will be addressed in a future post.

Taxation of Dividends: Ordinary dividends are taxed as income the year they’re paid out. Qualified dividends are taxed at capital gains rates. This could turn into a lengthy conversation but I’ll only briefly address this. For dividends to be qualified they must meet the following three specific criteria:

• “The dividends must have been paid by a U.S. corporation or a qualified foreign corporation.”
• They are not specifically excluded from being qualified according to the IRS.
•  You meet the required holding period as specified by the IRS.

It’s not uncommon that dividends are qualified and subject to capital gains rates but this is best-case. Worst-case they will be taxed at income rates.

Capital Gains Tax: The sale of capital assets could generate capital gains. These are either classified as short term or long term. This is another topic that could turn into a lengthy conversation. Generally speaking, an asset is considered short term if it was owned for less than one year. Short-term capital gains are taxable at ordinary income rates. Long-term capital gains are taxed at progressive rates and will either be 0%, 15%, or 20% depending on your taxable income. The capital gains rate is directly related to your ordinary income bracket as such:

•  0% tax for the amount of gains that fit in the first two income brackets, including other income. 
• 15% tax for the amount of gains that fit in the 3^rd – 6^th income brackets, including other income.
• 20% tax for the amount of gains that fit in the top income bracket (currently 37%), including other income.

For instance, let’s imagine a married couple with a taxable income of $60,000. Imagine they sold appreciated stocks which generated $25,000 in long-term capital gains. For calculation purposes, the IRS will take into consideration the amount of taxable income for the year and tax capital gains as follows:

• 0% owed on the amount of gains fitting in the 10% and 12% ordinary income bracket. The top end of the 12% bracket is $78,950. The amount of gain subject to 0% tax can be calculated the following way: $78,950 – $60,000 = $18,950 taxed at 0%.
• 15% owed on the remaining gains in excess of the first two brackets. If $18,950 of their $25,000 gain fit into the first two income brackets, this leaves $6,050 to be taxed at 15%. The total capital gain tax owed from this transaction would be $908.

As you can gather from this discussion, non-qualified accounts are generally taxed at lower rates than ordinary income rates. That being said, the value of retirement accounts comes from tax-deferred growth and the limited control they provide in manipulating taxable income. Investment growth in retirement accounts is sheltered from tax until withdrawals are made, unlike non-qualified accounts that are taxed the year gains occur. Although, as you noticed from the information provided above, taxes on non-qualified accounts can be modest. Generally speaking, you don’t need to be afraid of taxes on non-qualified accounts.

This isn’t a comprehensive guide to taxation but is important to understanding taxation. Understanding this information and being cognoscente of how taxes impact your current and expected situation allows you to plan and potentially reduce your tax liability. The practical application of this information is to optimally manage account allocations and being intentional with asset location, as will be discussed in an upcoming post.