Tuesday, March 16, 2010

Tax Reporting Basics for Taxable and Tax Privileged Accounts

As an investor, you should understand the difference between your taxable and tax privileged accounts with respect to tax reporting.  I've noticed that novice investors sometimes get confused about this, especially when they have both taxable and tax privileged accounts at the same financial institution (e.g., Vanguard, Fidelity, Schwab, etc.).  For example, they may hold the same mutual fund in both a tax privileged and taxable account, and they wonder why they got a 1099 tax form for one and not the other.  This article doesn't get into details about tax reporting for earnings from taxable accounts, but just tries to distinguish between tax reporting for taxable and tax privileged accounts at a high level.

In a tax privileged account, taxes on earnings (dividends, interest and capital gains) are either deferred or not paid at all.  In a taxable account, earnings are taxed in the year received.

When you look at your accounts, either online or in your statements, a taxable account will usually be listed as an "individual" account, unless you have a living trust, in which case it will be listed as a trust account.  Your tax privileged accounts will be named according to the type of account; e.g., IRA, Roth IRA, 401(k), etc.

For earnings in a taxable account, you will receive either a 1099-DIV (for dividends), 1099-INT (for interest) or 1099-B (for capital gains) from the financial institution at which have your account.  These tax forms report the amount of earnings, and are usually sent to you in January or February.  The amounts reported on your federal and state tax returns must include the amounts on the 1099 forms you receive.  You may be taxed at lower rates on long term capital gains and qualified dividends, but that's not the focus of this article.

In a traditional IRA, 401(k) or 403(b) account, taxes on earnings are deferred (until you start taking withdrawals).  In a Roth IRA or Roth 401(k) account, taxes are not paid at all on earnings.  For these types of accounts (tax privileged), you do not receive any 1099 forms for earnings, and therefore you don't include any of these earnings on your tax returns.  Once you start taking withdrawals in retirement, you will receive a form 1099-R (for each account) showing your total withdrawals for the year, and you will report this income on your tax returns.  You will never receive a 1099-INT, 1099-DIV, or 1099-B for a tax privileged account, even once you start taking withdrawals.  You can think of it this way:  any money you make within a tax privileged account is invisible from a tax perspective, so you never get directly taxed on interest, dividends or capital gains.  You only get taxed when you pull money out of a tax deferred account, and the IRS doesn't care whether the earnings are from interest, dividends or capital gains (remember, you never get taxed on anything you withdraw from a Roth account, as long as you follow the rules).

As an example of some of the above points, one of my daughters has a traditional IRA, a Roth IRA and an individual (taxable) account at Vanguard, and she owns shares of the Total Stock Market Index fund in each account.  This fund paid dividends in 2009, so if she looks at the transaction history for this fund in each account, she will see these dividend payments.  She received a 1099-DIV for the individual account, and reported the dividends from Total Stock Market Index fund in this account on her 2009 tax return.  However, since the she didn't take any withdrawals from either of the IRA accounts (i.e., the dividend payments remained within the IRA accounts), no 1099s were received for either of these accounts, and the dividend payments from the Total Stock Market Index fund in these accounts were not reported on her 2009 tax returns.

There's much more complexity to tax reporting for investments than touched on here, but hopefully this at least clarifies some of the basic differences in tax reporting between taxable and tax privileged accounts.


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