Without question, accumulating money for retirement and other long-range purposes in a tax-advantaged account is a good deal for just about everybody. You get to combine the power of compounding and growth over time with the benefit of not paying taxes on the growth achieved by the investments in the account. And, with a Roth account, you can even avoid paying taxes on the funds you withdraw after age 59 ½.
But never forget that taxable accounts have their advantages, too. In fact, there are certain situations when the use of a taxable investment account may make more sense than one of the tax-advantaged alternatives. Let’s take a look.
When your objectives are short-term.
Maybe you’re saving up for a down payment on a new home in a few years. You want the funds to grow as much as possible, but you know you’re going to need at least some part of them well before the age when you can withdraw from a retirement account without paying a tax penalty. In this case, it could make sense to use a taxable brokerage account, especially one with the ability to hold non-cash investments like ETFs, mutual funds, stocks, or bonds. Sure, you’ll owe tax on a portion of your dividends, interest, and capital gains, but leveraging the growth characteristics of your investments will help you build a bigger nest egg for the future and work towards intermediate-term non-retirement goals too.
When you want or need to diversify your holdings beyond the annual contribution limits for tax-advantaged accounts.
There are no limits to the amount you can put in your taxable investment account each year, as there are with tax-advantaged accounts. If your earnings allow it, you can put as much extra money in a taxable account as you want and invest the funds in any way you choose. Or, suppose you receive a windfall—an inheritance, company stock or options from an IPO, winning the lottery, or some other source. Depositing the money in a taxable account allows you to put the funds to work (though it might be wise to segregate a portion for taxes, especially that first year).
As an “early retirement” nest egg.
You may have a goal of retiring before you become eligible to withdraw funds from your retirement accounts (typically at age 59 ½). With a taxable account, you can invest for long-term growth and then begin making withdrawals to support your retirement lifestyle at any age you choose. Once again, you will have paid taxes on dividends, capital gains, and interest earned, but you’ll have funds available for withdrawal with no tax penalty, even before age 59 ½.
For estate flexibility.
While IRAs, 401(k)s, 403(b)s, and other tax-advantaged accounts can be transferred to heirs and others by simply designating them as beneficiaries, inheriting these accounts also obliges non-spousal beneficiaries to liquidate them over a maximum 10-year period. This has the potential of pushing heirs into a higher tax bracket. A taxable account, however, is typically received by non-spousal heirs on a stepped-up cost basis (its fair market value at the time of the inheritance) and the only taxes due would be assessed on the dividends and capital gains earned in each tax year. Also, the heirs can control how much, if any, is withdrawn from the account in a given year.
Other Benefits
Those concerned about increasing their tax burden by owning a taxable account may wish to explore non-taxable assets like municipal bonds, which earn interest that is not subject to federal taxation (and may be exempt from state taxation if the bond was issued by an entity in the same state). Tax-exempt bonds and mutual funds can be held in most investment accounts and the interest payments can be deposited into a companion money-market or other liquid account.
Investors may also exercise tax-loss harvesting to potentially reduce the amount of taxes they owe on investments held in taxable accounts. Tax-loss harvesting involves selling an asset that has dropped in value below its purchase price, thus creating a loss in the account. Such losses can then be used to offset gains in other assets, reducing the overall amount of tax that must be paid on capital gains. It’s important to be aware of IRS rules for tax-loss harvesting, especially when re-purchasing assets that have previously been sold at a loss. Always consult with your tax expert before implementing this strategy.
At The Planning Center, we help clients use all the tools at their disposal to create and grow wealth over time. To learn more, please visit our website and read our article, “Tax Efficiency and Investment Gains.”
