Accounts, taxes and the investor's plan

Level 1 Plain words

For every reader: the idea in plain words, no formulas.

Where the money sits changes what you keep

An account is a wrapper around investments. The same index fund can sit inside a regular brokerage account, an IRA, a 401(k) or a college savings plan, and each wrapper has its own tax rules. Some let you skip tax on the money you put in. Some let the growth go untaxed for decades. One kind lets the money come out with no tax at all.

Taxes can cost more than fees. A bond fund paying 4 % a year in a regular account hands part of that income to the IRS every year, while the same fund inside an IRA keeps all of it working until you withdraw. We call the habit of putting each holding in the account that taxes it least asset location, and it costs nothing but attention.

Three tax treatments

Nearly every US account fits one of three patterns. In a taxable account you invest money you have already paid tax on, and you pay tax each year on interest, dividends and any gains you realise. In a tax-deferred account, such as a traditional IRA or a regular 401(k), you usually get a deduction when you put money in, the growth compounds without tax, and every dollar you take out counts as income. In a tax-free account, such as a Roth IRA, you put in money already taxed, and qualified withdrawals come out with no tax at all.

A plan written down

A written plan keeps decisions steady when markets are not. Professionals call it an investment policy statement: a page or two that says what the money is for, when the investor will need it, how much loss the investor can bear, what the mix of assets will be and when it gets rebalanced. Writing it down before a crash makes it easier to stick with the plan during one.

Level 2 How it works

For readers who want the mechanism, with the diagrams.

Beginner path stops here

The account types

The table lists the accounts most US investors meet. Yearly contribution limits, income limits and catch-up amounts change each year with the IRS's inflation adjustments, so we leave them out here and point to the IRS notice for the year in the Gaps section.

Rules this detailed reward a second read of the plan documents. Employer plans add their own terms on matching, vesting and loans, so the plan's summary description matters as much as the tax code.

Ordinary income and capital gains

The IRS taxes wages, interest, short-term gains and withdrawals from tax-deferred accounts at ordinary income rates, which rise in brackets. A gain on an asset held more than one year is a long-term gain, taxed at 0 %, 15 % or 20 % depending on taxable income. Holding one day past a year can cut the tax on a gain by more than half for an investor in a high bracket.

Losses work against gains. Short-term losses net first against short-term gains and long-term against long-term, and then the two net against each other. If losses exceed gains, up to $3,000 of the excess a year can offset ordinary income, and the rest carries forward with no time limit.

Qualified dividends and the NIIT

Most dividends from US companies, and from many foreign ones, count as qualified dividends and get the long-term capital gains rates, provided you held the shares more than 60 days in the 121-day window that starts 60 days before the ex-dividend date. Interest from bonds, most REIT dividends and dividends from money market funds get ordinary rates instead.

On top of the regular tax sits the net investment income tax, 3.8 % since 2013. It falls on the smaller of your net investment income and the amount by which your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly). Those thresholds have no inflation adjustment, so each year more households cross them.

Wash sales and basis methods

Selling at a loss to cut taxes goes by the name tax-loss harvesting, and the wash sale rule limits it. If you buy the same or a substantially identical security within 30 days before or after the sale, the IRS disallows the loss for now and adds it to the cost of the new shares. The window runs 61 days in all, and a purchase in your IRA counts. Investors who harvest usually switch to a similar fund that tracks a different index for the 31 days.

Your cost basis, roughly the price you paid, decides the gain when you sell. If you bought shares at several prices, the method you pick for which lot you sold changes the tax. First in, first out sells the oldest lots first, which in a rising market means the largest gains. Specific identification lets you name the lots, often the highest-cost ones. Mutual fund investors may also use the average cost of all their shares. Brokers report basis to the IRS for most shares bought since 2011, and you choose the method when you sell or set a default ahead of time.

Required minimum distributions

Tax-deferred money cannot stay deferred forever. Starting at age 73, under the SECURE 2.0 Act, the holder of a traditional IRA or a 401(k) must take a required minimum distribution each year, and that age rises to 75 from 2033. The amount equals the prior year-end balance divided by a life-expectancy factor from an IRS table. Since 2024 Roth 401(k) accounts need none during the holder's life, matching Roth IRAs. Missing one brings an excise tax on the shortfall.

Step-up in basis at death

Heirs who inherit a taxable account get a new cost basis equal to the value on the date of death. Gains built up over the holder's lifetime then escape capital gains tax for good. That step-up in basis changes the math of selling late in life: an older investor with large gains may do better holding them and spending from other assets. Inherited IRAs get no step-up, because nobody has paid tax on that money yet; the heir pays ordinary income tax on withdrawals.

The investment policy statement

An investment policy statement turns the rest of this series into a page of decisions. The CFA Institute's framework sets it out as return and risk objectives followed by five constraints: time horizon, liquidity needs, taxes, legal and regulatory limits, and unique circumstances. Then come the strategic asset allocation, the ranges around each target, the rebalancing rule, how performance gets judged against a benchmark, and who reviews the statement and when.

Writing the return objective as a number forces honesty. If an investor needs $60,000 a year from a $1,500,000 portfolio and wants that spending to keep pace with inflation, Level 3 shows the return the plan must earn. A required return far above what the chosen mix can expect is a sign to save more, spend less or work longer, and the statement is the place to see it.

Risk capacity and risk tolerance

Two questions sit behind the risk objective. Risk capacity is the ability to bear loss: horizon, income, other assets, and how much the goal depends on this money. Risk tolerance is the willingness to bear it, the part a questionnaire measures and a bear market tests. A young doctor with a long career ahead has high capacity even if a 30 % fall would frighten her. A retiree living on the portfolio has lower capacity even if he enjoys market swings. When the two differ, sound practice follows the lower of the two, and the gap is a subject for education rather than a reason to change the plan. Capacity also changes over a life. It tends to be highest early in a career, when future earnings dwarf the portfolio, and to fall as retirement nears and the portfolio becomes the income. Tolerance can shift after a bad year, so a statement written in calm markets records it before fear does. Series 65 questions often give a client profile and ask which of the two limits binds; the answer is the one with less room.

Level 3 The math

For Series 65 and CFA readers: formulas and worked examples.

Series 65 path stops here

Asset location drag

Any holding that throws off taxable income every year loses part of its return to tax. With yield $y$ and an ordinary tax rate $t$, the yearly drag is their product.

In words, the return lost to tax each year equals the yield multiplied by the tax rate on it.

Location gets less simple once expected returns differ. Bonds in the tax-deferred account grow slowly, which keeps future RMDs smaller, while a Roth full of stocks compounds tax-free. Professionals compare the after-tax wealth of each layout over the horizon rather than applying the rule of thumb blindly.

Muni or taxable: the taxable-equivalent yield

A municipal bond's interest is free of federal tax, so its yield needs grossing up before you compare it with a taxable bond.

In words, the taxable-equivalent yield is the tax-free yield divided by one minus the investor's tax rate.

Roth or traditional: the break-even tax rate

Take one dollar of pre-tax earnings. In a traditional account it goes in whole, grows at $r$ for $n$ years, and gets taxed at the retirement rate $t_r$ on the way out. In a Roth it gets taxed now at $t_c$ and the rest grows untaxed.

In words, the traditional account's after-tax value is the grown dollar less the tax at the later rate.

In words, the Roth's value is the dollar after today's tax, grown untaxed.

Multiplication does not care about order, so the growth factor cancels and the two accounts end equal when $t_r = t_c$. With a 24 % rate today the break-even retirement rate comes out at 24 %, whatever the return or the horizon.

Several things move the answer away from the simple rule. A Roth holds after-tax money, so an investor who contributes the maximum to a Roth shelters more spending power than one who maxes a traditional account. Roth IRAs have no RMDs, which keeps them growing for heirs. Traditional withdrawals can push Social Security benefits and Medicare premiums into higher tiers. Most investors hold some of both, which hedges the forecast.

What a harvested loss is worth

A harvested loss saves tax now but lowers the basis of the replacement shares, so part of the saving comes back as tax later. With a loss $L$, a rate $t_{\text{now}}$ on the gains it offsets today, a rate $t_{\text{later}}$ on the eventual gain, a horizon $T$ and a discount rate $d$:

In words, the value of a harvest is the tax saved today less today's value of the extra tax due when the investor sells the lower-basis shares.

The NIIT, an RMD and a step-up in numbers

A required return for the policy statement

The return objective in an investment policy statement compounds spending and inflation.

In words, one plus the required return equals one plus the spending rate times one plus inflation.

Taxes enter this formula through the return. A portfolio earning 7 % before tax in a taxable account, with a third of its return taxed each year at 32 %, keeps noticeably less, so the after-tax return is the one to set against the requirement. Asset location, the Roth choice and harvesting all raise that after-tax figure without adding market risk. Spending rules then close the loop. Many plans state a spending rate and a band around it, cutting withdrawals after a bad year and raising them after a good one, which keeps the required return within reach.

Level 4 History, analysed

For readers who want past episodes run through the Level 3 math.

The 2003 cut in dividend tax

For a top-bracket investor the change raised what a dollar of dividends left after tax. Out of $100 of dividends, the 2002 top rate left $61.40; the 2003 rate left $85.00, a rise of +38.4 %. Raj Chetty and Emmanuel Saez studied the response and found a sharp rise in companies starting or raising dividends after the cut, concentrated in firms whose executives or large holders gained most.

Later laws moved the rate up again. From 2013 the top qualified dividend rate became 20 %, and the 3.8 % net investment income tax applies on top for higher incomes, so the top combined rate became 23.8 %. On the same $100 that leaves $76.20, still well above the 2002 figure.

The 2017 Tax Cuts and Jobs Act

Corporate earnings are what equity investors own, so we can run the cut through the valuation math of Chapter 10. Of $100 of pre-tax profit, a 35 % rate leaves $65.00 and a 21 % rate leaves $79.00, a rise of +21.5 % in after-tax earnings. With an unchanged price-to-earnings multiple, a company paying the full statutory rate would be worth that much more. Few companies paid the full rate before the law, so the gain varied widely by company.

For individuals the doubled standard deduction meant most households stopped itemising, and the deduction cap hit high-tax states hardest. The act set its individual provisions to expire after 2025; a 2025 law extended them, and readers should check the rules for the year they file.

The SECURE Acts of 2019 and 2022

The first SECURE Act, in December 2019, had already raised the RMD age from 70½ to 72 and ended the stretch IRA for most heirs other than a spouse. Those heirs now must empty an inherited IRA within ten years. A $1,000,000 inherited IRA spread evenly over ten years means withdrawals near $100,000 a year before growth, often during the heir's own peak-earning years and at their highest bracket.

Raising the RMD age gives tax-deferred money more time to compound and more room for Roth conversions in the years between retirement and the first distribution. The first distribution is also larger for an older holder: on $1,000,000, the divisor at 72 gives $36,496 and the divisor at 73 gives $37,736. Planners use the gap years to convert part of a traditional IRA to a Roth at a lower bracket, which shrinks later RMDs and the tax heirs pay under the ten-year rule. Each conversion is a Roth-versus-traditional choice made one year at a time, so the Level 3 arithmetic applies: a conversion pays when today's rate is below the rate expected on the money later. For a retiree at 66 in a 22 % bracket who expects RMDs to push income into the 32 % bracket from 73, the arithmetic favours converting some each year. One who expects the same bracket throughout gains little and pays the tax early. Heirs' brackets count too, since they will pay ordinary rates on whatever the ten-year rule forces out.