Types of Accounts

When people talk about types of accounts, they are usually grouped into three main categories - plus a few special cases

• Taxable Accounts

  • Taxes are paid as you go.
  • How it works
    • You use after-tax money to contribute
    • You may owe taxes on interest, dividends, and capital gains
  • Examples
    • Checking accounts
    • Savings accounts
    • Brokerage/investment accounts (stocks, ETFs, mutual funds)
    • Money market accounts
  • Good for
    • Short-term goals
    • Flexibility (no penalties for withdrawals)

• Tax-Deferred Accounts

  • Taxes are paid later (usually at withdrawal).
  • How it works
    • Contributions are often pre-tax
    • Investments grow without annual taxes
    • Withdrawals are taxed as income
  • Examples
    • Traditional IRA
    • 401(k), 403(b), 457 plans
    • Traditional pension plans
    • Deferred annuities
  • Good for
    • Lowering taxable income now
    • Long-term retirement savings

• Tax-Free (Tax-Exempt) Accounts

  • Taxes are paid upfront; growth and withdrawals are tax-free (if rules are followed).
  • How it works
    • Contributions are after-tax
    • Growth is never taxed
    • Qualified withdrawals are tax-free
  • Examples
    • Roth IRA
    • Roth 401(k)
    • Health Savings Account (HSA)
      • *HSAs are sometimes called “triple tax-advantaged”:
      • Contributions: tax-deductible
      • Growth: tax-free
      • Withdrawals (for medical expenses): tax-free
    • 529 education savings plans

• Hybrid / Special-Purpose Accounts

  • These don’t fit perfectly into one bucket.
  • Education Accounts
  • Coverdell ESA
  • 529 Plans
    • Tax-free growth if used for education

Tax implications when a spouse inherits

• A surviving spouse has more options than any other beneficiary.

• In many cases, the spouse can:

  • Treat the account as their own
  • Delay taxes
  • Avoid early-withdrawal penalties

• Taxable Accounts (Brokerage, Savings)

  • Very tax-efficient to inherit
  • What happens at death
    • The account receives a step-up in cost basis
    • Assets are re-valued to market value on date of death
  • Taxes for the spouse
    • No inheritance tax (federal)
    • No capital gains tax on gains that occurred during the deceased spouse’s lifetime
    • Taxes only apply to future gains after inheritance
  • Example
    • Stock bought at $10 → worth $100 at death
    • New basis = $100
    • If spouse sells at $105 → tax only on $5 gain

• Tax-Deferred Accounts

  • (Traditional IRA, 401(k), 403(b))
  • Spouse has 3 main options
    • Option A: Treat as Their Own (Most Common). Best if spouse is under 73 and doesn’t need money yet
      • Account becomes the spouse’s IRA
      • No immediate tax
      • Required Minimum Distributions (RMDs) follow spouse’s age
      • Withdrawals taxed as ordinary income
    • Option B: Inherited IRA. Useful if spouse needs access to money earlier
      • Account stays as an inherited account
      • RMDs may start sooner
      • Withdrawals taxed as income
      • No early-withdrawal penalty (even if under 59½)
    • Option C: Lump-Sum Withdrawal. Usually the worst tax choice
      • Entire balance withdrawn
      • Fully taxable as income in that year

• Tax-Free Accounts (Roth IRA, Roth 401(k)). One of the best assets to inherit

  • Spouse can roll it into their own Roth
  • No income taxes on withdrawals
  • No RMDs (Required Minimum Distribution) for Roth IRAs during spouse’s lifetime
  • Roth must meet the 5-year rule to be fully tax-free

• Health Savings Accounts (HSA). Unique advantage only spouses get

  • If inherited by a spouse
    • Becomes the spouse’s own HSA
    • Keeps all tax benefits
    • Withdrawals for medical expenses remain tax-free

• Life Insurance

  • Death benefit is income-tax free
  • May be subject to estate tax if the estate is very large

Tax implications when a child or any non spouse inherits

The rules are slightly different for a minor child vs adult child. The following refers to adult beneficiaries

• Taxable Accounts (Brokerage, Savings). Very tax-efficient asset to inherit

  • What happens at death
    • Assets receive a step-up in cost basis
    • Value resets to market value at date of death
  • Taxes for the child
    • No income tax at inheritance
    • Capital gains tax only on growth after inheritance
  • Example
    • Parent bought stock for $20 → worth $120 at death
    • Child inherits with basis = $120
    • Sells at $125 → tax on $5 only

• Tax-Deferred Accounts - No required annual withdrawals—but the balance must be zero by year 10(Traditional IRA, 401(k), 403(b))

  • Key Rule: 10-Year Rule
  • Adult children cannot treat the account as their own
  • Must empty the account by December 31 of the 10th year after death
  • Withdrawals are taxed as ordinary income
  • Tax impact
    • Large withdrawals can push the child into a higher tax bracket
    • Strategy matters: spreading withdrawals over 10 years often reduces taxes

• Roth IRA / Roth 401(k) - One of the best assets for adult children to inherit

  • Still subject to the 10-year rule
  • Account must be emptied within 10 years
  • BUT withdrawals are tax-free (if 5-year rule met) - Best strategy
    • Let the Roth grow
    • Withdraw everything in year 10 (often optimal)

• Health Savings Account (HSA) - One of the worst accounts for children to inherit

  • For non-spouse beneficiaries
    • Account is fully taxable immediately
    • Entire balance is treated as income in the year of death

• Life Insurance

  • Income-tax free to children
  • Estate tax only applies if estate is very large