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By Sam Farrington
We hear it time and again: Invest in a 401(k), Roth IRA and/or traditional IRA to save for retirement. Invest in a 529 plan to save for your children’s college expenses. These accounts offer excellent tax advantages, but that doesn’t mean investors should overlook the benefits associated with taxable investment accounts.
IRAs and 401(k)s enjoy tax-deferred growth (tax-free growth for Roth IRAs and 529s), but they also come with restrictions that might not be ideal if you’re unsure when you’ll need retirement money or whether your children will even attend college. On the other hand, many investors tend to look at taxable accounts, such as a traditional investment account with a brokerage firm, as unfavorable because of the taxes associated with them. But taxable accounts offer exceptional flexibility and come with their own set of tax advantages.
Restrictions on tax-advantaged accounts
The main challenges with retirement accounts are the often confusing restrictions regarding when you can take money out, and investors might be concerned about waiting until age 59½ to tap into their 401(k)s, Roth IRAs or traditional IRAs.
While there are some exceptions, the general rule of thumb is that you likely would need to pay a 10% withdrawal penalty if you were to tap into your 401(k) or traditional IRA early. Roth IRA investors can tap into the amount they’ve contributed without penalty because income taxes were already paid on those amounts, but any distributions above the contributed amount prior to age 59½ could incur a penalty.
Since 529 plans are specifically designed to help families pay for college, you will pay federal income tax and a 10% early withdrawal penalty on nonqualified withdrawals (those that are not used for education expenses). Similar to a Roth IRA, 529 contributions are made with money that you’ve already paid income taxes on, so only the growth portion is taxed. The difference with 529s is that every nonqualified withdrawal will have a portion that is subject to taxes and penalties, whereas with a Roth you will be subject to tax and penalty only when you start withdrawing more than you’ve put in.
Benefits of taxable accounts
When you consider the various withdrawal rules and penalties associated with 401(k)s, IRAs and 529s, you might find the ease and flexibility of a taxable account can make it a more appealing option. Taxable accounts impose fewer restrictions for investors, and here are some other key benefits:
With a taxable account, you can withdraw your money at any time for any purpose without having to pay income taxes or a penalty. As long as you hold your investments for more than a year, you'll pay only the long-term capital gains rate — which ranges from 0% to 20% depending on what tax bracket you’re in — on any gain you have.
If you hold your investments for less than a year, you’ll pay the equivalent of your income tax rate on your gains (short-term capital gains). Remember, investing should be for the long term.
» Learn more: How to choose a brokerage account
Minimization of taxes with the right investments
These are taxable accounts, but by carefully considering which types of assets you hold in them, you can minimize your tax liability.
What’s ideal for a taxable account? Think broad-range index exchange-traded funds or index mutual funds for your equity portion. Your goal is to have low turnover (how often stock is purchased and sold within the fund) and thus low capital gains distributions. On the bond side of the portfolio, municipal bonds might have a place in your taxable account because their income is exempt from federal taxes and, in some cases, state taxes too.
Creating a tax-efficient portfolio in your taxable account can significantly minimize any capital gains taxes you might have to pay.
» Learn more: How to invest with mutual funds
No required minimum distributions
Traditional IRAs and 401(k) plans force you to start withdrawing money when you reach age 72. Uncle Sam wants his portion of those accounts. However, if you have money socked away in a taxable account, there is no need to take it out unless you want to.
Potential tax savings for your heirs
If you should pass away with money in your taxable account, your heirs will receive the investments with what’s called a step-up in basis. This means when your heirs eventually sell the investments, they will be taxed as if they bought them for what they were valued on the day you died, not at the price you bought them. You didn’t pay capital gains on the growth portion of the portfolio, and now your heirs reap the benefits of a stepped-up basis.
Traditional IRAs, on the other hand, do not receive a stepped-up basis. Heirs eventually will pay income taxes on the entire amount. (One exception is if the original IRA owner made nondeductible contributions, in which case that after-tax amount would be passed on to any heir or beneficiary.)
So remember to keep your beneficiaries up to date in all of your investment accounts.
More control when you retire
Using a taxable account in retirement allows you to plan more effectively for your tax bills. Because you will pay ordinary income tax on withdrawals from your 401(k) and traditional IRAs, having a taxable account can come in handy if you are nearing the next tax bracket, but want to stay in a lower bracket until year’s end.
For instance, let’s say you're retired and in the 12% tax bracket. If you want to withdraw $10,000 from your traditional IRA (assuming pretax contributions), it could bump you up into the 22% tax bracket.
This might not sound like a big deal because the higher 22% taxes are paid only on the next dollars, not on your entire income. But bumping into a higher tax bracket may cause the long-term capital gains rate you pay to increase.
However, if you were to simply withdraw the $10,000 from a taxable account (or a Roth IRA) instead, it’s probable that you’ll stay in the 12% tax bracket because it's not considered taxable income. This means you’d pay 0% capital gains on the $10,000.
Did you know you can offset $3,000 of ordinary income with $3,000 of investment losses each year on your tax return? Many financial advisors use tax-loss harvesting as an added benefit for their clients, automatically selling any loser and then buying a similar asset (to keep the portfolio allocation appropriate). It's just another way to minimize any tax hit you might take when investing in a taxable account.
Tax-advantaged retirement accounts are already tax-free or tax-deferred, which means it’s not possible to harvest losses in these accounts to reduce taxes. However, if you have a taxable account and an IRA, you can properly coordinate tax-loss harvesting across those accounts if you pay special attention to IRS rules regarding the purchase of replacement securities.
Back to No. 1
Did I mention you can use the money in a taxable account for anything you want at any time you want without penalty? This advantage deserves to be mentioned first and last. You can use your taxable account for retirement income, college expenses, vacations, a car or even as a savings account. And you won’t pay a penalty for using it.
But make sure you are disciplined with your account. You shouldn’t spend all of the money from your taxable account on vacation and dining out if a portion of it is still needed for retirement or college expenses. These accounts offer freedom and flexibility, but they also require responsibility and maturity to ensure the money is used for its planned purpose.
If the restrictions and cumbersome rules of tax-advantaged accounts such as 401(k)s, IRAs and 529s frustrate you as an investor, then the often-overlooked taxable account might be just what you’re looking for. Talk to a financial advisor about how a taxable investment account might fit into your portfolio.
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