How Do Taxes Work With Investing?

When we talk about taxes and investing, it helps to zoom out first. There are really three main types of investment accounts, and each one is taxed differently.

First are tax-deferred accounts, like traditional IRAs and 401(k)s. With these, you typically get a tax deduction in the year you make the contribution, and you pay taxes later when you take the money out in retirement.

Second are tax-free accounts, like Roth IRAs. Here, you pay taxes on your income today, but when you take the money out in retirement, those withdrawals are generally tax free.

Third are taxable investment accounts. In these accounts, you pay taxes each year on dividends, interest, and any gains you realize.

Taking advantage of tax-advantaged accounts — things like Roth IRAs, 401(k)s, and traditional IRAs — is usually a smart way to plan for taxes. Taxable accounts tend to involve more nuance. If you hold an investment for less than a year, those gains are taxed at ordinary income rates. Hold it longer than a year, and long-term gains typically receive lower tax rates.

The key thing to understand is this: there’s no account that completely avoids taxes. There are ways to defer taxes, and there are ways to be more tax efficient. The strategy is making sure your money is in the right type of account and, especially in taxable accounts, invested in a tax-efficient way.