Retirement planning is a complex process to say the least, especially when you have multiple accounts. Surely you want to know how your money is being treated but understanding how all your accounts are taxed isn’t so simple, so let’s bring in the buckets!
The 3 Tax Buckets
All your retirement accounts can essentially be categorized into three buckets:
• Bucket 1: Tax Me Now Bucket
• Bucket 2: Tax Me Later Bucket
• Bucket 3: Tax Me Never Bucket
Inside Bucket 1 – Tax Me Now
This first bucket, referred to as the tax me now bucket (or taxable bucket), includes assets that you pay taxes on right away, in other words, taxes that are incurred in the given year. Vehicles in this bucket include:
• Mutual funds
For example, let’s say you want to purchase shares of Apple stock. These shares could be held in any one of the three buckets. However, if you were to purchase $15,000 in shares in the “Tax Me Now” Bucket, and your investment grows to $20,000, the $5,000 gain you realize when you sell the shares is taxable in the current year at either the Capital Gains Tax Rate or Ordinary Income Tax Rate, depending on how long the shares were held. Let’s take a look at the difference between the two taxes.
Capital gains vs. ordinary income tax
As mentioned above, the gains realized in the “Tax Me Now” bucket are subject to taxes at the time of sale. If the investment has been held for more than a year, the gain would be subject to long term capital gains, which are typically more favorable than ordinary income tax rates. The long-term capital gain rate applied can be as low as 0% and no more than 20% and is based on your taxable income and filing status. If, on the other hand, the investment has been held for less than one year, the profit would be subject to a short-term capital gains tax, which is equivalent to your ordinary income tax rate. These tax rates can vary from 10% to as high as 37% and are determined by your taxable income for the calendar year.
Neither Voya Financial Advisors nor its representative offer tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.