Most investors focus initially on tax-advantaged retirement accounts, such as IRAs and 401(k)s—and rightfully so, because these accounts provide substantial tax benefits. Most SMI readers also have a taxable emergency savings account. But between an IRA/401(k) and a savings account lies the world of taxable investment accounts.
Why use a taxable account?
One of the biggest benefits of a taxable investing account is the flexibility it provides. Below are a number of reasons people choose to utilize these accounts. And because there are no restrictions on them, a single taxable account can potentially serve multiple of these goals at the same time.
While a taxable account shouldn’t be your first choice for retirement savings, it can be a viable way to save more after making full use of tax-advantaged accounts. If you’re in the enviable position of having maxed out your contributions to a 401(k) and/or IRA, a taxable account offers an unrestricted opportunity to invest additional dollars. There are no eligibility rules, contribution limits, penalties for early withdrawals, limits on how long you can add to the account, or deadlines for when you must start making withdrawals. Plus, your investment options are unlimited.
For Non-retirement Goals
One of the most common reasons for investing in a taxable account is to save for a non-retirement goal. Examples include saving for a down payment on a house, a daughter’s future wedding, a home remodeling project, or the replacement of a vehicle. For shorter-term goals, it’s best to invest conservatively (bonds and saving vehicles) while longer-term goals (minimum of five years away) may also include stock market investments.
Here, too, a taxable account shouldn’t be the first choice for most people. A 529 plan account is usually better, as some states offer a tax credit or deduction for contributions, and as long as the money ends up being used for college, earnings are tax-free.
However, there may be some upside in using a taxable account in addition to a 529 plan. For example, what if your child decides not to go to college? Money from a 529 plan used for a non-educational purpose will incur tax on the earnings plus a 10% penalty. Of course, you could shift the 529 money to use for another child’s education (or your own), but money in a taxable account could be used for any purpose with no strings attached.
The investment options within 529 plans also tend to be limited whereas taxable accounts have no such limits.
For More Income
Another reason why some people use a taxable account is to generate additional current income by buying dividend-paying stocks or income-oriented mutual funds.
For Tax-advantaged Giving
If you give a taxable asset that has appreciated in value, such as shares of a stock or mutual fund, neither you nor the charity will owe tax on the gains and you get a deduction for the current value.
For Your Heirs
When you die, your heirs receive all of the money in a taxable account tax-free. That’s because the cost basis of your investments “steps up” on the date of your death. For example, let’s say you invest $10,000 in a taxable account that grows to $100,000 by the time you pass away. The cost basis for your heirs would be $100,000, making the inheritance essentially tax-free (unless estate taxes factor in).
If the money had been in a traditional IRA instead, non-spouse heirs would be required to take taxable distributions, either by the end of the fifth year after your death or over their expected lifetime. (While Congress is now considering eliminating the “stretch” IRA, here’s how this powerful tax-advantaged idea works). If your spouse were the beneficiary, distributions would be taxable as well. (A surviving spouse, however, has the option of becoming the IRA account owner and thus continuing the tax-deferral.)
Of course, taxes are the most significant drawback of taxable accounts! While your heirs may enjoy generous tax benefits when inheriting your account, you can derive a few tax benefits while you’re still alive. Such benefits are based primarily on the specific types of investments you make and how long you hold them.
If you sell an individual stock for a profit within a year of buying it, you’ll owe short-term capital gains taxes. The short-term rate is the same as your ordinary income tax rate (ranging from 0%-37%). On the other hand, if you sell the stock after holding it for more than a year, you will owe tax at the more favorable long-term capital gains rate (0%-20%).
If you sell a stock that has declined in value, the loss can be used to offset gains you’ve earned on other stocks. If your losses exceed your gains, up to $3,000 per year can be deducted, with additional losses carried forward to future tax years.
If you have dividend-paying stocks, how the dividends are taxed depends on whether they are “non-qualified” or “qualified.” Non-qualified dividend income is taxed at ordinary income tax rates. Qualified dividend income is taxed at the more favorable long-term capital gains rates.
To qualify for the lower tax, a dividend has to have been paid by a company (U.S. or foreign) listed on a major U.S. stock exchange. In addition, you have to have owned the stock for more than 60 days within a 121-day holding period that extends from 60 days before the ex-dividend date (i.e., the day a stock starts trading without the value of its next dividend payment) to 60 days after the ex-dividend date.
The holding periods that apply to stocks apply here too, but there’s another factor as well. Mutual funds incur capital gains and losses on the investments they make and also earn dividend and interest income. All of these earnings are paid out to shareholders in the form of distributions. You can elect to receive the distributions in cash or have them reinvested in more shares. But either way, a distribution is a taxable event to an investor using a taxable account. In other words, it isn’t only when you sell a mutual fund that you will owe tax. Just holding a mutual fund will generate a tax bill.
Index funds (and most exchange-traded funds) are more tax efficient than actively managed funds. Index funds and ETFs replace very few holdings each year (i.e., their “turn-over ratio” is low), which means they generate lower distributions than actively managed funds. Index funds often sport turn-over ratios of just 1-2%, whereas actively managed funds can have turnover ratios of 20-100% or more. Generally speaking, the lower the turn-over ratio, the lower the tax bill.
Income generated by municipal bonds is exempt from federal tax, and in some cases, state tax as well. If your asset allocation calls for bonds, this feature makes municipal bonds an especially good choice for a taxable account.
Beware the wealth tax
For wealthier households, taxable investment income may trigger an additional 3.8% net investment income tax. This tax hits single people with modified adjusted gross income (MAGI) of $200,000 or more and married couples filing jointly with MAGI of $250,000 or more. At those income levels, taxpayers with investment income owe an additional 3.8% of the lesser of their taxable investment income or the portion of their MAGI that exceeds the before-mentioned thresholds.
Using SMI in a taxable account
If you plan to use a taxable account for a portion of your investing, the SMI strategy best suited to the job is Just-the-Basics. Its reliance on index funds makes it very tax-efficient. Because the holdings don’t change, a taxable JtB account becomes similar to an IRA in terms of its ability to defer tax indefinitely until the investments are sold.