Most people measure their investment success by the balance they see on the screen.
But that number isn’t the full story. The IRS is a silent partner in your portfolio. And whether you realize it or not, how much you keep depends less on your rate of return and more on when and how those dollars get taxed.
Here’s how the three categories—tax now, tax later, and tax never—actually work.
Tax Now (Taxable Accounts)
This is the default if you invest through a regular brokerage account.
- You start with after-tax dollars. If you earn $100,000, pay $25,000 in taxes, and invest $75,000, that $75,000 is already taxed once. No extra deduction.
- Interest income = ordinary income. Bond interest, CD interest, and most savings account earnings are taxed the same way your salary is. If you’re in the 24% bracket, you’ll pay 24% on that interest.
- Dividends are split:
– Qualified dividends (from most U.S. companies you’ve held long enough) are taxed at lower long-term capital gains rates: 0%, 15%, or 20%, depending on your income.
– Non-qualified dividends are taxed as ordinary income, which could be much higher. - Capital gains depend on holding period:
– Less than a year = short-term gain, taxed like your paycheck.
– More than a year = long-term gain, taxed at capital gains rates. - Surprise taxes. If you own mutual funds, you can be taxed on capital gains the fund itself generates—even if you didn’t sell anything.
The takeaway? Every year, some portion of your returns leaks out in taxes. Instead of compounding fully, your money compounds at a reduced rate. That “tax drag” makes taxable accounts less efficient for long-term growth.
Tax Later (Tax-Deferred Accounts)
This is where most retirement accounts live: 401(k)s, 403(b)s, Traditional IRAs, some annuities.
- Pre-tax contributions. Money goes in before you pay income tax, so you get an immediate deduction. Contribute $20,000 and you lower your taxable income by $20,000 this year.
- Tax-deferred growth. Once inside, your investments grow without annual taxation. No tax on dividends, interest, or gains while you’re accumulating.
- Taxed at withdrawal. When you retire and start taking money out, every dollar—your contributions and the growth—is taxed as ordinary income. No capital gains rates here. If you withdraw $50,000, it’s just like earning $50,000 in wages.
- Required Minimum Distributions (RMDs). At age 73 (current law), you’re forced to begin withdrawing a minimum amount each year—even if you don’t need the money. That ensures the IRS gets its share.
- Uncertain tax bill. Your future withdrawals will be taxed at whatever income tax rates exist then. If rates go up, your bill goes up too.
This setup can make your balance look larger on paper, but it’s not all yours. Part of it belongs to the government, and how big that part is depends on future tax policy.
Tax Never (Tax-Free Accounts)
These are the rare but powerful ones: Roth IRAs, Roth 401(k)s, and properly structured cash value life insurance.
- After-tax contributions. Like taxable accounts, you pay income tax before you contribute. No upfront deduction.
- Tax-free growth. Once invested, your money compounds without annual tax drag—same as tax-deferred accounts.
- Tax-free withdrawals. Follow the rules (age 59½ and account held for 5 years in the case of Roths), and both your contributions and the growth come out with no taxes owed.
- No RMDs for Roth IRAs. Unlike tax-deferred accounts, Roth IRAs don’t force you to pull money out during your lifetime. That means you can let money grow tax-free for as long as you want. (Note: Roth 401(k)s do have RMDs unless rolled into a Roth IRA.)
- Life insurance variation. With certain permanent life insurance policies, you can build cash value that grows tax-deferred and can be accessed through loans. Loans aren’t taxable as income if structured properly, which can mimic tax-free withdrawals.
This category gives you the most control and predictability. Once you’ve paid taxes on the seed money, the harvest is yours to keep.
So Which One Is Best for You?
There isn’t a one-size-fits-all answer. The right mix of taxable, tax-deferred, and tax-free investments depends on your income today, your goals for the future, and what you expect taxes to look like when you’ll need the money.
What matters most is having a plan that matches your situation—not just picking an account at random. That’s where guidance makes the difference.
If you’re not sure which strategy is right for you, connect with a financial professional at The World Changers. We’ll walk you through your options, help you understand the tradeoffs, and design a path that makes sense for your future.
