You may have already started investing in your workplace’s retirement plan or IRA (individual retirement account). Investors typically get tax breaks for investing in these accounts, so it makes sense for them to be the first place people invest. Even so, investing in a retirement account may not always be the best fit.
A taxable investment account could provide more flexibility for your needs. These accounts are usually easier to open, have more investment options, and don’t have any of the major restrictions of tax-advantaged accounts. Here’s what you need to know about how they work, when you should consider using one, and how to tie them into your investing strategy.
What is a taxable account?
A taxable account is an investment brokerage account without any special rules. You don’t get a tax break for putting money into the account, and you don’t get to withdraw money tax-free in retirement. Depending on how you use the account, you may also have to pay taxes each year. There aren’t any contribution limits or withdrawal restrictions with these accounts, which allows you to put away as much money as you decide.
You can open a taxable investment account at any firm that offers one. Providers for workplace or state tax-advantaged plans usually limit your investments to a small selection. Taxable accounts don’t have this limit, which provides a great deal of flexibility and tax diversification for investors.
How do taxable investment accounts work?
Opening and using a taxable investment account is a simple process. First, find a brokerage firm that offers the investment options you want to learn how to invest money in. Be sure to consider any fees because high investment expenses can eat up a substantial portion of your returns. Once you’ve chosen a brokerage, transfer funds into the account to buy the investments you prefer.
The investments you can choose within a taxable brokerage account depend on the brokerage firm. Brokerages may allow you to invest in stocks, bonds, mutual funds, exchange-traded funds, options, commodities, cryptocurrency, and more.
Before you invest, consider the tax implications of putting money into these accounts. You may end up owing federal income tax or state income tax on your investment income, and it could also impact your tax bracket. Investment taxation varies by state. Check your state’s rules on taxable income to understand how they’ll impact you.
In general, you pay federal taxes on investment income from the account. Interest and dividend payments from your investments result in taxable events. Selling investments at a gain also requires you to pay capital gains taxes. That said, losses from selling other investments can offset these gains.
There are two types of capital gains tax rates. Short-term capital gains are taxed at your ordinary income tax rates. Long-term capital gains, which are assessed on assets held more than one year before the sale, are taxed at lower long-term gains tax rates.
Capital gains taxes are generally incurred when you sell your investments. Mutual funds can result in capital gains distributions as well. Investing in tax-efficient assets, such as ETFs that don’t pay dividends can help decrease your tax burden. Holding assets for a long time could also help.
7 benefits of a taxable account
1. No income limits
Tax-advantaged retirement accounts often require you to meet income requirements to contribute or receive tax benefits. Taxable investment accounts have no income limits, which makes them easy to open and use even if you don’t have a ton of money in the bank.
2. No contribution limits
Every year, the IRS sets contribution limits on tax-advantaged accounts. If you can max out your account and let your money grow in a tax-efficient manner for the long term, you can reap those benefits. But what happens after you max out your contributions and still have money to invest?
You can contribute as much money as you want with a taxable account. Tax-advantaged accounts may limit the amount of money you can add per year. A taxable account could be a good option if you run out of tax-advantaged possibilities and want to invest more.
3. No investment restrictions
Workplace retirement accounts restrict your investment options to those offered by the plan. Brokerage firms provide a wider variety of investments, which is ideal if you want to diversify your portfolio. The best brokerage accounts for you are those that offer the options you want to invest in.
4. No withdrawal restrictions or early withdrawal penalties
Tax-advantaged accounts only allow tax-free and penalty-free withdrawals under certain circumstances or when you reach a particular age. This could present problems if you plan to retire early.
To withdraw funds before the set age, you’d have to pay penalties or use complex rules. Taxable accounts allow you to withdraw money without penalty at any time. In some cases, taxable accounts may offer more favorable long-term capital gains tax rates as well.
5. No required minimum distributions
Most tax-deferred retirement accounts force you to take RMDs (required minimum distributions). These now normally start at age 72. If you don’t take them, you may have to pay a 50% excise tax. If you don’t want to deal with RMDs, an individual taxable account can be a help. These accounts give you more control over how much you withdraw and when you take the money out. With a taxable account, you can reduce your withdrawals (and tax bill) if needed.
Keep in mind, however, that it doesn’t have to be an either-or situation. Consider working with a financial advisor who is a retirement specialist to help you figure out a financial plan for withdrawals that incorporates your tax-advantaged and taxable accounts in a way that maximizes your tax efficiency while still helping you reach your long-term financial and wealth goals.
6. Can participate in tax-loss harvesting
A taxable retirement account gives you the ability to take advantage of tax-loss harvesting. Tax-loss harvesting is a way to decrease your tax burden. It works by selling your investments at a loss and then using that loss to offset other gains. Although some of the best robo-advisors take care of this automatically, you can manually participate by making trades yourself.
If you don’t earn money on your investments, you can use losses to offset up to $3,000 of ordinary income per year. Ordinary income is often taxed at a higher rate than long-term capital gains, offering an excellent tax planning opportunity. Tax-advantaged retirement accounts don’t use this strategy due to their structure.
7. Easy to get started
Opening a taxable investment account is straightforward. You sign up for an account, pick your investments, and start investing. You don’t have to worry about any of the complexities, requirements, and deductibility rules that some tax-advantaged accounts come with.
Opening a taxable account with a robo-advisor, such as Wealthsimple, is even easier with a guide through the sign-up process. These companies can help you pick which investment portfolio option best fits you too. Some offer automatic portfolio rebalancing, which could be ideal if you’d prefer a hands-off approach to investing.
4 drawbacks of a taxable investment account
1. No major tax breaks
With a taxable investment account, your contributions don’t result in a tax break now or in the future. Earnings in pre-tax retirement accounts like traditional IRAs or Roth IRAs generally grow tax-free or tax-deferred, whereas taxable account earnings are taxed as you earn them.
2. Capital gains taxes
Roth retirement accounts allow you to withdraw your money tax-free. This is because you paid taxes on the money when you earned the income. Then you use the after-tax money to make contributions. When you sell investments in a taxable account, you’ll need to pay applicable capital gains taxes.
Even so, you can qualify for long-term capital gains rates in a taxable account. To do this, you must hold your investments for more than a year. These tax rates are less than ordinary income tax rates, but they aren’t usually as beneficial as retirement account tax advantages.
3. May lose money
As with all investments, you can lose money investing in a taxable account. This isn’t any different from investing in tax-advantaged retirement accounts. It’s still important to keep in mind, though.
Thankfully, you could use any losses you realize when selling investments to offset other gains. If you don’t have gains, you could offset up to $3,000 per year of ordinary income.
4. Easy to get overwhelmed with too many investment options
You can invest almost anywhere in virtually any investment option with a taxable account. You just have to find the right brokerage firm that offers the investment option you want. Too many options can be paralyzing to someone new to investing, though.
Choosing the right taxable account for you
Choosing a taxable investment account may feel overwhelming, but it doesn’t have to be. First, consider how much you plan to invest in the account. Based on that, you can identify brokerages that fit your investment amount.
Some brokerages require a minimum investment to get started. If you can’t afford to invest the minimum amount, look for another brokerage firm. Some online brokerages, such as Stash, allow you to open an account with no minimums.
Look closely at which investment options a brokerage offers. Make sure they provide options that match your risk tolerance, financial goals, and investment timeline. Many brokerages are self-directed, which means you get to choose what you invest in on your own.
If you aren’t comfortable choosing investments on your own, you may want to consider a robo-advisor. Robo-advisors, such as Wealthfront, help you invest by using sophisticated algorithms to allocate your assets. Technology automates some processes, so you’ll likely pay a lower fee than traditional financial advisors charge.
When you sign up with a robo-advisor, you’ll answer questions about your risk tolerance, investment style, goals, and time frame for investing. They then suggest an investment portfolio based on your answers. Robo-advisors also keep your investments properly balanced, and some offer tax-loss harvesting to make tax planning easier for you.
As you’re considering a brokerage, don’t forget to look at the fees. Although robo-advisors offer convenient features that can simplify investing, they generally come with more fees than investing in low-cost index funds yourself. You won’t get to keep as much of your investment returns if you choose a brokerage that charges fees.
FAQs about taxable accounts
Is it a good idea to open a taxable account?
Opening a taxable account isn’t a good or bad idea. It’s an option to consider as part of your overall investment strategy. Depending on where you are in your financial journey, it may be a smart decision. Others may be better off fully funding other tax-advantaged accounts first.
What's the difference between taxable and tax-deferred accounts?
With a taxable account, you’ll likely need to pay federal taxes and potentially state taxes on your earnings. Taxable events can happen in any year, depending on your investments and actions. The tax impact is not limited to when you withdraw money from the account.
Tax-deferred accounts typically give you a tax deduction when you contribute to the accounts. Earnings on your investments are tax-deferred until you withdraw them. The total withdrawal amount is usually subject to applicable state and federal ordinary income taxes when withdrawn. You may be subject to early withdrawal penalties for withdrawing the funds before the proper age.
Is a Roth IRA a taxable account?
A Roth IRA is not considered a taxable account. With a Roth account, you use after-tax dollars to fund the account. The tax benefit comes when your investments grow, and you withdraw your earnings. Earnings and eligible withdrawals don’t incur taxes with this type of account.
When should I invest in a taxable account?
There's no rule about when someone should or shouldn't invest with a taxable account. A taxable investment account could provide a nice complement to tax-advantaged accounts.
An individual taxable account could make sense when you need access to the money without restrictions, such as your age or type of expenses. This might provide you with a way to have more control over when you withdraw the money for your benefit. Consider speaking with a financial professional to help you decide how to incorporate taxable accounts into your long-term financial and tax planning.
A taxable investment account could be a powerful tool for your investing strategy. It may be ideal for early retirees who can’t access retirement savings without penalties or complex rules. Once you’ve evaluated your options, you can choose a brokerage that fits your needs. You don’t have to worry about restrictions like contribution limits, income limits, withdrawal requirements, or limited investment choices.
Taxable accounts do require you to pay taxes on interest, dividends, and gains. At the same time, they don’t provide any tax advantages beyond long-term capital gains tax rates. Even so, they offer an option to invest once you’ve maxed out tax-advantaged accounts. When used appropriately, taxable investment accounts could provide more tax planning opportunities. You could even sell your investments and withdraw the money at any time for any reason.
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