Embracing the Flexibility of the Taxable Brokerage

Taxable accounts have a lot to offer.

There are many ways you can reduce your tax burden when investing. Traditional IRAs and 401(k)s let you defer taxes till you make withdrawals in retirement. Roth IRAs and Roth 401(k)s give you the option to pay taxes now and never again on any growth. HSAs reduce your taxes today, and if you use them for qualified medical expenses, taxes never come due.

But amidst the pursuit of tax optimization the taxable brokerage account remains deeply underrated. While tax-advantaged accounts help you save on taxes in exchange for restrictions on how and when you can use your money, taxable accounts offer flexibility that tax-advantaged accounts don’t.

What Taxable Accounts Offer

While you’ll get hit with a 10% penalty and income taxes for early withdrawals from a 401(k) or Roth IRA, taking money from a taxable account only incurs capital gains taxes. Short-term gains, held for less than a year, are taxed as regular income. But by holding assets in a taxable account for a year or more, you can qualify for more favorable long-term capital gains tax rates of 0%, 15% and 20%.

Tax-advantaged accounts have annual limits on what you can contribute. That’s part of the arrangement you make with the IRS in exchange for a tax break. You can generally put up to $20,500 in a 401(k) and $6,000 in a Roth IRA under most circumstances. Taxable accounts have no limits on what you can contribute. If you max out all tax-advantaged accounts available to you and still want to invest more, you can use a taxable account.

These features make taxable accounts a great tool for retiring early. Because of the withdrawal restrictions on retirement accounts, it can be difficult to use them before 59.5 when the IRS says you can officially withdraw money without penalty. And unlimited contributions mean high-income earners can front-load their investments. If your goal is to retire early, a taxable account may be the way to go.

Taxable accounts are also ideal for non-retirement goals that are 10 to 20 years out, or if you don’t know what the money is for. A lot of investors might get nervous about locking up their money for longer periods. Taxable accounts ensure you can always change your mind about where you put your money after you invest it.

Taxable accounts can be used in conjunction with your emergency fund to build a personal safety net in case of a major life event. Having extra money invested in addition to a cash emergency fund ensures not too much of your money is stuck in a low-yielding savings account but that it’s also there in case you need it.

You can also think of your taxable account as an opportunity fund. For example, if you decide to invest in a rental property and you find a good deal, you can move money from a taxable brokerage account for a down payment.

How to Think About Taxes

Naturally, everyone using a taxable account should be thinking about taxes. This means being aware of what investments you put in a taxable account, because not all investments or investment activities will result in the same tax consequences. And while different from a tax-advantaged account, a taxable account can be surprisingly tax-efficient if you know how to optimize it. You may even end up paying 0% in capital gains taxes if you fall under a lower income threshold.

Total market ETFs or mutual funds are ideal for tax-aware investors. Some investments are tax-inefficient, like bonds, small-cap stocks and some international stocks, although international funds offer the benefit of the foreign tax credit to offset dividends that are taxed as regular income.

While you can buy and sell to your heart’s content inside a tax-advantaged account without worrying about taxes, trading in a taxable account incurs costs. Every time you sell shares of a stock or fund for a gain, you may owe taxes. You can reduce your tax burden through a buy-and-hold strategy, only subjecting your gains to long-term capital gains rates.

By buying and holding your investments in a taxable account, you’re still essentially deferring your gains until you sell your assets. Dividends are the exception to this. Depending on the type, you’ll either pay taxes on dividends at short-term rates or long-term rates for the year you receive them. Tax-efficient investments like total market funds pay mostly qualified dividends that are taxed at lower rates.

One unique feature of a taxable account is tax-loss harvesting. This is where you use some of your losses to offset gains. For example, if in one tax year you realize $500 of gains on one investment and $500 of losses on another investment, you can claim the loss against your gain, canceling out your tax bill. And if you happen to fall in the 0% long-term capital gains bracket, you can even tax-gain harvest, realizing gains when you have a lower income to take advantage of the 0% tax rate. This will reset your cost basis, or basically what you paid for an asset, to reduce your taxes later.

Speaking of cost basis, taxable accounts also come with tax benefits when you die. Due to the step-up in basis rule, your cost basis is reset upon your death, meaning that when your heirs sell inherited assets, their cost basis will be calculated based on the price of the assets at your death rather than what you paid for them. That means you could theoretically buy assets and never sell them, passing them onto your heirs who can then sell them at a low (or $0) cost basis, incurring almost no tax bill.

Embrace Taxable Accounts for Flexibility

So taxable accounts come with a lot of unique selling points, and despite their name, actually have a lot of tax advantages. Almost anyone can find some way to fit them into their investment plan.

A lot of people try to optimize their investments, but optimization shouldn’t come at the expense of flexibility. A smart investment plan ideally involves both tax-advantaged accounts and taxable accounts to cover all your bases. This is sometimes referred to as the tax triangle; tax-deferred accounts, after-tax accounts and taxable accounts each form the points on the triangle.

Keeping your options open when investing, especially when you have an unclear time horizon or your goals are more general, will help you invest for the future while remaining flexible.