Taxable vs. Tax-Advantaged Accounts

Why this matters

Two people can own exactly the same investments and end up with different amounts of money, simply because they held them in different kinds of accounts. The type of account decides when you pay tax on your investments, and sometimes whether you pay it at all. It's one of the first decisions an investor makes, and one of the most consequential.

This lesson is an introduction. Part 6 has a full module on retirement accounts, including the current limits and rules.

Taxable accounts

An ordinary brokerage account is often called a taxable account. You can put in as much as you like and take money out at any time. In exchange, taxes apply along the way:

• Income, such as dividends, is generally reported and taxed for the year you receive it.¹
• Profits from selling are taxed when you sell. If you sell an investment for more than you paid, the difference is a capital gain. If you sell for less, it's a capital loss.² While you hold an investment that has risen, you don't owe tax on the increase yet.

The rates and rules for capital gains are covered in Part 6, in Short-Term vs. Long-Term Capital Gains.

Tax-advantaged accounts

A tax-advantaged account has special tax treatment, usually to encourage saving for retirement, education, or health costs. The best-known retirement accounts are:

• IRAs, individual retirement arrangements, which you open yourself.³
• 401(k)s and similar workplace plans, offered through employers.⁴

Inside these accounts, investments can grow without yearly tax on dividends or gains.³ The big question is when tax is paid instead, and that depends on whether the account is traditional or Roth.

Traditional and Roth

• In a traditional account, contributions can lower your taxes now. In a traditional IRA, they may be tax-deductible.³ In a traditional 401(k), they come out of your pay before income tax.⁵ Money generally isn't taxed until you withdraw it.
• In a Roth account, contributions aren't deductible, because you put in money that's already been taxed. Qualified withdrawals can then be tax-free.³

Account	Money going in	While invested	Money coming out
Taxable brokerage	Already taxed	Dividends and interest taxed yearly	Gains taxed when you sell
Traditional IRA or 401(k)	May reduce taxes now	Not taxed yearly	Generally taxed when withdrawn
Roth IRA or 401(k)	Already taxed	Not taxed yearly	Qualified withdrawals can be tax-free

This is a simplified summary of general rules. Eligibility, limits, and what makes a withdrawal "qualified" all have specific conditions, which Part 6 covers.

Which is better, traditional or Roth, often comes down to whether you expect your tax rate to be higher now or when you withdraw the money. Nobody knows future tax rates for certain, which is why the choice gets a lesson of its own: Traditional vs. Roth.

Key takeaways

• In a taxable account, dividends are generally taxed yearly, and gains are taxed when you sell.
• Tax-advantaged accounts like IRAs and 401(k)s let investments grow without yearly tax.
• Traditional accounts can lower taxes now and are taxed on withdrawal. Roth accounts are funded with taxed money, and qualified withdrawals can be tax-free.
• The tax benefits come with limits and early-withdrawal rules. A taxable account trades tax efficiency for flexibility.

Check your understanding

You bought shares in a taxable account for $2,000. They're now worth $3,000, and you haven't sold. What do you generally owe tax on right now?

1. The $1,000 increase, because a rise in value counts as income each year.
2. The full $3,000, because that's what the shares are worth now.
3. Nothing on the increase yet. Gains are generally taxed when you sell.

Which account is funded with money that's already been taxed, with qualified withdrawals that can be tax-free?

1. A Roth account
2. A traditional account
3. A taxable brokerage account

What's next

Once you have an account, you'll place orders. The next lesson, Order Types: Market, Limit, and Stop, covers the choices you make every time you buy or sell.