Taxable accounts are any investments in which your money does not grow on a tax-deferred basis. Anyone with earned income can invest money in a taxable investment account or in a nondeductible individual retirement arrangement (IRA). You can only invest money in either of these account types if you have already paid income tax on those funds. Furthermore, you can invest nondeductible IRA money into the same kind of investment instruments that you can buy with taxable funds. Despite these similarities, there are many differences in terms of how taxable accounts and nondeductible IRAs work.
You can invest money that you earned during the current tax year in a taxable investment, but you can also invest money that you earned in prior years by liquidating accounts that you already own and reinvesting the proceeds. You can only use funds that you earned during the current tax year to fund your nondeductible IRA. As of 2011, you can deposit the lesser of your annual income or $5,000 per year into your IRA, although this limit rises to $6,000 when you reach the age of 50. No limits exist on contributions to taxable accounts.
You have to pay taxes on any money that you earn on your taxable investments. The money that you invest in a nondeductible IRA grows within a tax shelter, which means that you pay no money until you withdraw funds from the account. When you make a withdrawal, you pay tax on your earnings, but you pay no tax on your return of principal. Under federal tax rules, you incur a 10-percent tax penalty on withdrawals of earnings if you access your nondeductible IRA funds before you are 59.5. You do not pay the penalty if you use the money to cover certain allowable expenses, such as college tuition fees.
The Internal Revenue Service refers to your investment earnings as capital gains, and you eventually have to pay tax on gains in both nondeductible IRAs and taxable accounts. If you sell a taxable investment within 12 months of the purchase date, you have to pay ordinary income tax on your capital gains. You also pay ordinary income tax on withdrawals of earnings from a nondeductible IRA. Depending on your tax bracket, you may pay as much as 35 percent income tax on short-term gains from a taxable account or any gains from a nondeductible IRA. However, if you hold a taxable account for more than a year, you pay the long-term capital gains tax rather than income tax on your earnings. Long-term capital gains tax amounts to just 15 percent.
The annual contribution limits on IRAs apply to the cumulative contributions that you make to both your nondeductible IRA and your pretax traditional IRA. Therefore, you cannot contribute to a nondeductible IRA if you already made the maximum contribution to your traditional IRA. Although taxes are higher on nondeductible IRA withdrawals than on withdrawals from taxable accounts, you may still come out ahead with the IRA. Depending on the investment type, you pay either capital gains or ordinary income tax on dividends and interest from your taxable accounts. In a nondeductible IRA, those dividends are reinvested and add to your tax-deferred growth. The more you earn on your investment, the more you save with tax deferral.
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