What are Taxable Investment Accounts?
There’s a reason so many people contribute to qualified retirement accounts—it’s because they’re tax-advantaged, allowing investors to keep more of their wealth. But many investors also maintain taxable investment accounts in addition to their retirement accounts. These are investment accounts taxed at a standard rate; they’re not tax-advantaged. And while no one likes the idea of paying out capital gains tax, there are some key advantages that accompany taxable investment accounts.
Anyone can open a taxable investment account—all you need to do is choose a broker. Once it’s open and funded, your path to most investments is clear: from individual stocks, to ETFs and mutual funds, to index funds and beyond. Here’s a look at taxable investment accounts and the role they play in an investment portfolio, and how to leverage them alongside tax-advantaged accounts.
Taxable vs. Tax-Advantaged Accounts
Where tax-advantaged accounts offer investors deferred or mitigated taxation, taxable accounts offer no such benefits. You’ll make contributions with post-tax dollars and pay capital gains tax on any profits you accumulate upon withdrawal. As soon as you realize losses or gains through the sale of securities, it becomes a taxable event.
The upside to a taxable investment account? There are no stipulations to govern how someone invests, what they invest in or when they choose to take profits. Tax-advantaged accounts lock up funds under pain of penalty before a certain age or in the face of certain criteria. Investors willing to face capital gains tax can manage their investments however they so choose.
Short- vs. Long-Term Investment Taxation
How long you hold investments dictates how much you’ll pay in taxes. The IRS recognizes any security held for more than one year as a long-term investment. Anything bought and sold in under a year is a short-term investment.
- Long-term investments are subject to capital gains tax at either 0%, 15% or 20%, depending on your income.
- Short-term investments realize an effective tax rate that corresponds to ordinary income tax rates: 10%, 12%, 22%, 24%, 32%, 35% or 37% based on income.
Most people are wise to hold investments for more than a year when investing through a taxable account. However, there are extenuating circumstances that can make it advantageous to sell securities in the short-term. For example, tax loss harvesting short-term losses can offset long-term gains.
The Benefits of Taxable Investment Accounts
It’s easy to stack up tax-advantaged accounts next to taxable accounts. That said, there are plenty of benefits associated with taxable investment accounts. Here are some of the most important to consider:
- Wealth accumulation. Once you’ve met contribution thresholds for qualified retirement accounts, taxable accounts are a great place to continue growing your wealth. Savings accounts will actually lose money due to inflation and fixed-income securities tend to have abysmal ROI as investment vehicles.
- Hedge against inflation. If you’re not earning at least 2-3% on your money each year, you’re losing purchasing power due to inflation. While capital gains can take a chunk out of investment returns, even your real rate of return is likely to outpace inflation.
- Flexible investments. One big advantage taxable investment accounts have over tax-advantaged accounts is flexibility. Many tax-advantaged accounts come with big penalties, and there are restrictions on what types of investments you can hold. Through a regular brokerage account, you can invest in whatever you want, whenever you want, for as long as you want.
- No required distributions. When you hit retirement age, you’ll need to start taking required minimum distributions from tax-advantaged accounts. Such is not the case with taxable accounts. Again, it’s investing on your terms. That means continued wealth accumulation, even in retirement.
- Tax-loss harvesting. While capital gains can take a big chunk out of your investment returns, locking in losses can offset those gains. If you’re sitting on an investment with no hope of recovery, exiting the position at a huge loss can cancel out some or all of your capital gains earnings from a profitable sale.
Investing through taxable investment accounts comes with a lot of control. Buy and sell when you want. Invest in the securities and products that appeal to you. Lock in gains or losses as you see fit. Smart investors will use the freedom of a regular brokerage account to plan-for and mitigate capital gains smartly.
A Two-Pronged Investing Strategy
Tax-advantaged and taxable investment accounts represent two sides of the same coin. They’re both wealth generation vehicles, but serve different purposes.
Where tax-advantaged accounts accumulate over the long-term, free from tax burdens, investors can’t touch them without triggering massive penalties. Instead, they rely on liquid capital in taxable investment accounts to grow in the short-term, protected against inflation. Ultimately, taxable accounts offer a level of flexibility that many tax-advantaged accounts can’t. For former is your hedge against inflation; the latter is your vehicle for wealth accumulation.
And accumulating wealth is vital to preparing for your retirement. To learn more, sign up for the Wealthy Retirement e-letter below. You can learn how to manage your investments properly so that you can retire on your own terms.
When in doubt, it’s best to invest in tax-advantaged accounts first. When your contributions run over the threshold for tax benefits, it’s time to start looking at a taxable investment strategy in addition to retirement savings.