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Taxable Accounts Make Sense For Investors

We all know the famous saying, “there are two certainties in life: death and taxes.” To that end, investors spend countless hours strategizing to avoid paying Uncle Sam. And it’s been drilled into our heads that we should first maximize our tax-free and tax-deferred accounts, like IRAs and 401(k)s, first before saving money anywhere else.

However, investors may want to flip that conventional thinking upside down.

The truth is, a taxable account should be one of the first places you place your hard-earned savings. There’s plenty of tax efficiency and flexibility when it comes to using a regular brokerage account.
In the end, a taxable account makes sense for many investors and it should be part of your overall investment menu.

Learn more about portfolio management on our Retirement Channel.

Brokerage Accounts Grow

It may shock many investors and the financial community, but the humble taxable brokerage account is quickly becoming a main avenue for savers. A surprising survey from FINRA Investor Education Foundation and the University of Chicago showed that investors have continued to open brokerage accounts at a rapid pace over the last few years and through the pandemic. According to the survey, 57% of total respondents opened a new brokerage account in 2020. Of those, more than 66% had never had a taxable brokerage account before. This follows previous surveys by FINRA and other organizations that have shown that taxable brokerage account ownership is on the rise.

So, why the rise in ownership rates? This comes down to one word: liquidity.

The great thing about accounts like 401(k)s and IRAs is their tax-deferred/free status. However, in order to gain that benefit, investors are locked into their money for the long haul. It’s nearly impossible to take out money from a 401(k) plan while you’re still working at the company sponsoring the plan. Meanwhile, IRAs are loaded with penalties and fees if you withdraw your money early. Then there’s age to consider. If you make a withdrawal from a retirement account before the age of 59 ½, you may be subject to a 10% early withdrawal penalty on top of the income tax that you’ll owe.

This all is not true with taxable accounts.

With a taxable account, you can withdraw money at any time for any purpose. You can use it for retirement, education, buying a new motorcycle or a prolonged hospital stay – it doesn’t matter when or how you tap into it. With the pandemic and economic uncertainty raging, this flexibility is key for many savers.

Low or No Tax From a Taxable Brokerage Account

The problem is that taxable accounts are, well, taxable. That means that investors need to address what happens in the account – dividends, capital gains, etc. – each year. However, these days, investors can run a taxable account in a very tax-efficient manner and address all of those concerns. In fact, taxable accounts can be more tax efficient than 401(k)s and traditional IRAs in some instances.

For example, investors only pay capital gains tax when they sell a security. That means buying a non-dividend-paying stock like Google and holding it means a portfolio is able to defer taxes the entire length of holding. Investors are also rewarded for holding stocks over the long term. Hold GOOG stock for at least a year and the capital gains taxes drop to just 15%, which could be much less than ordinary income rates from a 401(k). Meanwhile, if Google starts paying a dividend, that income is taxed favorably as well. Most investors will pay just 15% on those dividends. Again, much lower than ordinary income rates for most savers.

At the same time, low-cost index ETFs have leveled the playing field further. Their creation/redemption mechanism eliminates the internal capital gains that mutual funds generate. Mutual fund managers must rebalance their holdings by buying and selling securities to manage shareholder redemptions or to re-allocate assets. This is true for even index mutual funds. That’s not the case with index ETFs like the iShares Core S&P Total U.S. Stock Market ETF (ITOT).

Bond’s interest is taxed at higher ordinary rates. So, typically, they should be held in tax-deferred accounts. However, municipal bonds and muni money market funds are unique in that they are free from federal taxes and, in many instances, state and local taxes as well. Here, you can get tax-free ballast and income from their portfolio that only makes sense in a taxable account.

But there’s ways to reduce tax burden even further.

Taxable accounts can take advantage of tax-loss harvesting. In a nutshell, tax-loss harvesting involves selling stocks, funds or assets that are currently showing a paper loss in your portfolio. With this, the IRS will let you use those losses to offset realized gains in other securities. Better still is that you can carry forward some of those losses to reduce future gains or reduce your ordinary income.

Finally, a taxable brokerage may be completely tax free for some investors. Those single savers with taxable incomes of $40,400 or less and those married couples with incomes of $80,800 or less will pay a 0% dividend tax rate and 0% capital gains on their investments. This fact makes a taxable account a top pick for low-income savers.

Some Caveats

Now, not all assets are suitable for a taxable account. Commodities funds, real estate investment trusts (REITs) and some other security types come with some weird tax treatments. This includes the ETFs and funds that hold them. For example, gold and silver are taxed as collectibles and come with high 28% tax rates. Placing these sorts of assets in a taxable account can significantly reduce the account’s ability to be a low tax vehicle.

The Bottom Line

While we tend to fill up our 401(k)s, IRAs and other tax-deferred/tax-free accounts first, we really should be focusing on our taxable accounts as well. For many investors, running a taxable account can be very efficient and provides flexibility not found in the other account forms. Using a taxable account makes sense in this day and age.

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Feb 26, 2021