Ch5. Tax Saving Guide — Investment Income Tax Planning with IRAs, 401(k)s, and HSAs

How Investment Income Is Taxed

Types of Investment Income

Investment income refers to returns generated by financial assets rather than labor.

Interest income: Bank accounts, CDs, bonds, Treasury bills
Dividend income: Stock dividends (qualified vs. ordinary)
Capital gains: Profit on sale of stocks, funds, real estate

The Tax Treatment

Interest income: Taxed as ordinary income (10–37%)

Qualified dividends: Taxed at preferential long-term capital gains rates (0/15/20%)
  Requirements: Paid by US corporation or qualified foreign corporation;
                Stock held for more than 60 days in the 121-day window around ex-div date

Ordinary dividends: Taxed as ordinary income

Long-term capital gains (held > 1 year): 0%, 15%, or 20%
Short-term capital gains (held ≤ 1 year): Ordinary income rates (up to 37%)

Net Investment Income Tax (NIIT): Additional 3.8% on investment income for
high earners (MAGI > $200,000 single / $250,000 MFJ)

High-income taxpayers can face combined rates of up to 23.8% on long-term capital gains (20% + 3.8% NIIT) or up to 40.8% on ordinary investment income (37% + 3.8%). This is where tax-advantaged accounts become the primary planning tool.

Traditional 401(k) / 403(b)

What It Is

An employer-sponsored retirement savings plan that lets employees defer salary on a pre-tax basis.

Tax Benefits

2024 contribution limits:
- Employee elective deferral: $23,000
- Age 50+ catch-up: additional $7,500 (total $30,500)
- Total including employer contributions: $69,000 / $76,500 (age 50+)

Tax benefit:
- Contributions reduce taxable income dollar-for-dollar
- Investment growth is tax-deferred (no tax on dividends, interest, or gains inside the account)
- Distributions in retirement taxed as ordinary income

Example:
Salary $100,000; contribute $23,000 to traditional 401(k)
Federal taxable income reduced to $77,000
At 22% marginal rate: ~$5,060 annual tax savings

Roth 401(k) Option

Many plans offer a Roth 401(k) option: after-tax contributions, but qualified distributions are completely tax-free. No income limits apply (unlike Roth IRA).

Traditional IRA vs. Roth IRA

Traditional IRA

2024 contribution limit: $7,000 ($8,000 age 50+)
Deductibility (if covered by workplace plan):
  Single: Phase-out $77,000–$87,000 MAGI
  MFJ (covered): Phase-out $123,000–$143,000 MAGI
  MFJ (not covered, but spouse is): Phase-out $230,000–$240,000 MAGI

Tax treatment:
- Deductible contributions reduce current-year taxable income
- Growth is tax-deferred
- Distributions in retirement taxed as ordinary income
- Required Minimum Distributions (RMDs) start at age 73

Tax-deferred growth example:
Account earns $10,000 per year over 10 years
  Taxable brokerage: $10,000 × 15% (qualified dividend) = $1,500 tax annually
  Traditional IRA: $0 tax → $1,500/year reinvested → significantly larger account value
  Distributions eventually taxed at 22% (if lower rate than working years: net benefit)

Roth IRA

2024 contribution limit: $7,000 ($8,000 age 50+)
Income limits (contribution phase-out):
  Single: $146,000–$161,000 MAGI
  MFJ: $230,000–$240,000 MAGI

Tax treatment:
- Contributions are after-tax (no deduction)
- Growth is completely tax-free
- Qualified distributions are completely tax-free (age 59½ + 5-year rule)
- NO Required Minimum Distributions during owner's lifetime

Distribution tax rates at retirement:

| Account Type | Tax at Withdrawal |
|---|---|
| Traditional 401(k) / IRA | Ordinary income rates (10–37%) |
| Roth 401(k) / Roth IRA | Tax-free (qualified distributions) |

Ordinary brokerage account vs. Roth IRA:
10-year gain of $100,000 inside account:
  Brokerage: $100,000 × 15% (LTCG) = $15,000 tax
  Roth IRA: $0 tax

Backdoor Roth IRA

High earners above the Roth IRA income limit can contribute to a non-deductible Traditional IRA and then convert to a Roth IRA (the “backdoor” strategy). Consult a tax advisor regarding the pro-rata rule if you have existing pre-tax IRA balances.

Health Savings Account (HSA)

Overview

The HSA is the only account in the US tax code with a triple tax advantage: contributions are deductible, growth is tax-free, and qualified withdrawals are tax-free.

Eligibility and Limits

Requirement: Must be enrolled in a High-Deductible Health Plan (HDHP)
2024 HDHP minimum deductibles: $1,600 (self-only) / $3,200 (family)
2024 out-of-pocket maximums: $8,050 (self-only) / $16,100 (family)

Contribution limits:
- Self-only: $4,150
- Family: $8,300
- Age 55+ catch-up: additional $1,000

Three Tax Advantages

① Above-the-line deduction: HSA contributions reduce AGI
② Tax-free growth: Interest, dividends, and gains inside the account are not taxed
③ Tax-free withdrawals: No tax when used for qualified medical expenses

Qualified medical expenses include:
- Deductibles, copays, coinsurance
- Dental and vision care
- Prescription drugs
- LASIK, hearing aids, wheelchairs

Non-qualified withdrawals:
- Under age 65: Income tax + 20% penalty
- Age 65+: Income tax only (like a traditional IRA)

Rollover feature: Unlike FSAs, HSA balances roll over every year — no "use it or lose it."
Long-term strategy: Pay current medical expenses out-of-pocket; let the HSA compound.
After age 65, use accumulated HSA funds tax-free for Medicare premiums and other medical costs.

Taxable Brokerage Account Strategies

Asset Location Strategy

Place tax-inefficient assets in tax-advantaged accounts;
place tax-efficient assets in taxable accounts.

Tax-inefficient (put in IRA / 401(k)):
- Bond funds (interest taxed as ordinary income)
- REITs (dividends taxed as ordinary income)
- Actively managed funds (high turnover → short-term gains)

Tax-efficient (fine in taxable brokerage):
- Broad index funds (low turnover, qualified dividends)
- Individual stocks held long-term
- Municipal bonds (interest exempt from federal income tax)

Tax-Loss Harvesting

Sell positions at a loss to offset capital gains.

Rules:
- Net capital losses can offset capital gains without limit
- Net capital losses can offset up to $3,000 of ordinary income per year
- Excess losses carry forward to future years

Wash-sale rule (IRC § 1091):
Cannot buy "substantially identical" securities within 30 days before or after
the sale that generated the loss — the loss is disallowed if you do.

Example:
You sell Stock A at a $5,000 loss and Stock B at a $5,000 gain
Net: $0 capital gain → $5,000 of capital gains tax eliminated

Optimal Tax-Advantaged Portfolio — Example

Example: Single Taxpayer, $85,000 Gross Income

Priority tax-saving account allocations:
1. 401(k) up to employer match: $5,000 (employer matches 50% of first $10,000)
   → $5,000 in free employer contributions
2. Max HSA: $4,150 (enrolled in HDHP)
3. Max traditional 401(k): additional $18,000 (to reach $23,000 limit)
4. Max Roth IRA: $7,000

Annual tax savings:
- 401(k) $23,000 × 22% = $5,060 tax reduction
- HSA $4,150 × 22% = $913 tax reduction
Total: ~$5,973 in annual federal tax savings

Roth IRA: No current deduction, but decades of tax-free growth

Managing Investment Income Above Thresholds

When investment income (combined with ordinary income) pushes your MAGI above certain thresholds, additional tax layers apply.

Strategy 1: Use Tax-Deferred Accounts

Growth inside 401(k), IRA, and HSA accounts does not count as investment income — it is invisible to the NIIT and does not appear on your return until withdrawal.

Strategy 2: Spousal Account Splitting

If your spouse has lower or no income, using your spouse’s name for taxable investments can split income between two returns — reducing overall tax at the household level. (Note: gifts to a spouse are unlimited and gift-tax-free.)

Strategy 3: Municipal Bonds

Interest on state and local government bonds is exempt from federal income tax (IRC § 103) and often exempt from state income tax if issued in your home state. Useful for high-income taxpayers with taxable brokerage accounts.

Strategy 4: Qualified Opportunity Zones (IRC § 1400Z-2)

Invest capital gains in a Qualified Opportunity Fund to defer (and potentially reduce) capital gains tax. Gains held in the fund for 10+ years may be excluded entirely.

Key Warnings

Early Withdrawal Penalties

Traditional 401(k) / IRA — before age 59½:
- Income tax on the full withdrawal
- 10% early withdrawal penalty (IRC § 72(t))
- Certain exceptions apply (disability, first-time home purchase for IRA,
  substantially equal periodic payments, etc.)

Roth IRA — contributions can be withdrawn any time penalty-free
- Only earnings are subject to tax and penalty if withdrawn early
  before age 59½ or before the 5-year holding period

Required Minimum Distributions (RMDs)

Traditional 401(k) and IRAs require minimum withdrawals beginning at age 73 (IRC § 401(a)(9)). Failure to take an RMD results in a 25% excise tax on the amount not withdrawn (reduced to 10% if corrected promptly).

Key Summary

Account	Tax Deduction	Tax-Free Growth	Tax-Free Withdrawal	Recommended For
Traditional 401(k) / IRA	Yes	Yes (deferred)	No (ordinary income)	High earners expecting lower retirement rate
Roth 401(k) / Roth IRA	No	Yes	Yes (qualified)	Young earners; expecting higher future rates
HSA	Yes	Yes	Yes (medical)	Anyone with HDHP access
Taxable brokerage	No	No	LTCG rates	After maxing above accounts

Use all three tiers. The taxpayer who consistently contributes to a 401(k), IRA, and HSA throughout their career will accumulate hundreds of thousands of dollars that were never taxed — and in the case of the Roth, will never be taxed upon withdrawal either.

OIYO Editorial