When it comes to investing, there are a number of choices available to you. In fact, more than half of U.S. households have some exposure to the stock market, according to the Pew Research Center. However, most of those stocks are held in tax-advantaged retirement accounts.
Although a tax-advantaged account can be a great help to your retirement savings, it’s not the only way to invest. In some cases, it might make sense to use a taxable account. Especially given all the apps changing how we invest.
Here’s what you need to know about using a taxable investment account and when it might (or might not) be a better fit for your financial goals.
What is a taxable account?
Basically, an individual taxable account is an investing account that doesn’t come with special tax benefits. It’s not a retirement account, like a 401(k) or individual retirement account (IRA), and it’s not an account like a health savings account (HSA) that comes with special tax treatment.
When investing money using a taxable account, any gains or losses you realize are reported on your taxes, and your tax bill is adjusted accordingly. Although many people like the idea of using a tax-advantaged account, there are times when it could make sense to use a taxable investment account instead or in addition.
7 times it might be better to invest with a taxable account
Even though your money is likely to grow more efficiently over time when you make use of tax-advantaged accounts, there might be times when an individual taxable account could help you better reach your money goals.
1. You want to use the money before retirement
With an IRA or 401(k), there are restrictions on when you can access the money in your account without paying an early withdrawal penalty. For example, most tax-advantaged retirement accounts levy a 10% penalty if you withdraw the money before age 59 1/2. Although there are exceptions to the penalty, for the most part, you’re restricted.
With other tax-advantaged accounts, like an HSA or a 529, the money might grow efficiently, but you must use it for specific purposes in order to avoid penalties. With an HSA, if you don’t use the money for qualified health care costs, you pay a penalty. The same thing is true for a 529 plan when you don’t use the money for qualified education expenses.
If you have goals for your money other than creating retirement income, and you don’t want to be stuck with penalties, a taxable account could be a viable choice. For example, I use a taxable investment account to help me reach my travel goals. Although I have to pay capital gains taxes if my investments appreciate, it’s usually a small price to pay for being able to travel regularly.
When you’re working toward other goals, a taxable account could make a difference — especially because you don’t have to worry about an extra penalty added.
2. You’ve maxed out your tax-advantaged accounts
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?
An individual taxable account can help you keep using the power of compounding returns to your benefit. Even if you can’t put more into a retirement account or some other account, you can keep investing and growing your wealth with a taxable account.
3. You earn too much to contribute to certain accounts
In some cases, there are restrictions on your income when it comes to contributing to certain accounts. Maybe you want to contribute to a Roth IRA, but you make more than the threshold set by the IRS. If that’s the case, a taxable investment account can make a difference. There are no limitations on who can invest using a taxable account, so if you’re trying to build wealth through investing and can’t use certain accounts, this can be a workable alternative.
4. You don’t want to deal with RMDs
The tax advantages to some accounts, like traditional IRAs and 401(k)s, also come with required minimum distributions, or RMDs. With an RMD, you’re required to withdraw a certain amount of money from your tax-advantaged account when you reach age 72. Using a set formula, you have to determine how much you’re required to take from the account — and then you’re taxed on that amount. In some cases, RMDs could move you into a higher tax bracket and increase your income tax rate.
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. Depending on the situation, you might be able to create a retirement plan that works better for you. With a taxable account, you can reduce your withdrawals (and tax bill) if needed. Tax-advantaged accounts that come with RMDs don’t allow you that option.
Keep in mind, however, that it doesn’t have to be an either-or situation. You could still use tax-advantaged retirement accounts in your long-term planning. However, adding taxable accounts to the mix could provide you with a little more flexibility.
Consider working with a financial advisor who is a retirement specialist to help you figure out a withdrawal plan 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.
5. You think you might change your investing plan
Because taxable investment accounts are more flexible and come with fewer restrictions, it’s easier to move your money around, take it out, or change your asset allocation or diversification strategy. If you need to take money out of the account, you’re better able to with your taxable account.
Realize, though, that you still have to pay capital gains taxes if you’ve seen increases in the value of your investments. Pay attention to capital gains tax rates to reduce your tax liability. For example, if you keep your investments for more than a year, you’ll pay a lower long-term capital gains rate compared to selling an asset sooner and being subject to short-term capital gains. Make sure you sell strategically if you want to reduce your overall tax bill and avoid selling assets you’ve held for less than a year.
Another advantage of a taxable account is that you have more control over your portfolio in general. Many tax-advantaged retirement accounts — especially those through your workplace — offer a limited selection of mutual funds to invest in. With an individual taxable account, you can choose your assets, including individual stocks, bonds, exchange-traded funds (ETFs), and other assets in addition to mutual funds. Sometimes it’s easier to change your asset allocation as well.
If you think you’ll need to change up your investing plan, and you want more freedom and flexibility to do so, a taxable account could be appropriate.
6. You’re considering how much taxes your heirs will pay
Depending on the situation, your heirs might get better treatment on a taxable account than an inherited IRA. If you’re concerned about your posterity and what your heirs will end up dealing with, a taxable investment account could reduce the headaches.
One of the biggest issues with a traditional IRA is that there isn’t a step-up basis involved with an inherited IRA. In general, when you die, your heirs will see an adjustment to the original basis, dating from your death. This is known as a step-up. If your heirs sell assets, the step-up basis starts them at a higher value, and can potentially eliminate the need to pay capital gains taxes. This doesn’t occur with an inherited IRA. Instead, the original basis remains intact, so all the gains made over the years are taxed when your heirs sell their assets. On top of that, there are time limits imposed, forcing your posterity to liquidate the IRA within a set period of time.
If you want to save your heirs some money in taxes, focusing on a taxable account could be one way to do so. Be sure to consult with an estate planning professional and a tax professional to make sure you understand the tax consequences for your heirs.
7. You want to take advantage of tax-loss harvesting
We’ve looked at capital gains, but what happens if you lose money on your investments? If you want to be able to turn your investment losses into a tax break, you could take advantage of tax-loss harvesting. With this process, you could use losses from your investments to offset your capital gains. You could even take a tax deduction for the losses in some cases.
I’ve used tax-loss harvesting in the past to my own advantage. When my basement flooded, I sold some of my investments at a loss. I used the proceeds to pay the costs related to cleaning up the mess and then deducted those losses on my taxes. My taxable account gave me a way to deduct this expense on my taxes.
How to open a taxable account
Opening a taxable account is fairly straightforward. You can use one of the best brokerage accounts to get started. Many brokers offer individual taxable accounts that allow you to set up your own investing plan or trade how you wish. There are a number of brokerages today that don’t require minimum deposits and don’t charge a fee when you trade stocks or ETFs.
It’s also possible to open a taxable account using one of the best robo-advisors. Rather than putting together your own portfolio, a robo-advisor will ask you a few questions to determine your risk tolerance and goals and then create a portfolio (usually using ETFs) designed to help you reach your objectives. You can withdraw money from your account as needed, but a robo-advisor can handle some of the heavy lifting when it comes to portfolio management.
When deciding how to proceed, consider your individual needs and preferences. If you’re more hands-off and just want a place to consistently invest and access your money as needed, a robo-advisor could be a good choice. If you want more control over your portfolio and access to a wider variety of assets, more traditional online brokerage accounts might work better for you.
In most cases, you can open a taxable account with a little bit of personal information, including your address and birthdate, as well as simple documentation, such as your driver’s license. You also need to provide bank account information so the broker or robo-advisor can fund your account. Depending on the brokerage or robo-advisor, you can usually open an account in a few minutes. Once the money is transferred from your bank, you can start investing within a few days.
Is a Roth IRA a taxable account?
No, a Roth IRA is not a taxable account. A Roth IRA is a type of tax-advantaged retirement account. With a Roth IRA, you use after-tax dollars to fund the account. The money grows tax-free, and, when you withdraw the money after age 59 1/2, you don’t have to pay taxes on it.
What is the difference between taxable and tax-deferred accounts?
With a taxable account, you pay taxes in the year you realize gains. So if you sell an asset for a gain in that year, you have to pay taxes on the amount of the increase during that year. With a tax-deferred account, like a traditional IRA or 401(k), you don’t have to pay taxes until you actually withdraw money from the account later. So even if you sell assets within that account, the gains remain in the account and you don’t pay taxes until a later date when you take distributions from the 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. When you need access to the money without restrictions, such as your age or types of expenses, an individual taxable account could make sense. 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 account could be a good complement to other types of investment accounts you have. With a taxable investment account, you could have more control over your assets and more choices when it comes to growing and accessing your wealth. Depending on your situation, adding a taxable account as part of your financial plan could make sense when it comes to your investment income or your retirement planning.
When using an individual taxable account in conjunction with a tax-advantaged account, pay attention to your withdrawal plan and consider getting planning help from a financial planner who is an investment professional.