I often see this question posed on social media, “I max out my work retirement accounts and still have some money I could save for the future. What do I do with it?” Or,
“I‘ve just finished paying off my student loans… woohoo!! What do I do with the couple of thousand dollars I’ll have left each month now that they’re not going towards the loans?” Or,
“My grandma passed away and left me $100,000. I don’t have any debt apart from $435,000 on my mortgage at 3.25% Where do I put this money?” Or,
“My husband and I have been out of training a few years now. We have been maxing out our work retirement accounts and Backdoor Roth IRA. We finally did some reading on finance basics and feel ready to invest. How do we go about this?”
You get the idea. There’s some money lying around. You don’t need it right away and can sock it away for the future. You do not have any more tax-advantaged space left. What do you do?
The answer is, you open a taxable account and invest it in there.
Before you Invest
Well, before you do that, make sure you don’t have better use for it:
- All your insurance needs are in place (life, disability and umbrella insurances)
- Your Emergency Fund is adequately plush
- You have no moderate to high-interest debt that you should pay off first
- You have enough put aside for all taxes due- your annual tax bill come tax time, estimated taxes if you are required to pay those, property taxes if you don’t escrow.
- You’ve fully funded all tax-advantaged retirement space available to you: work-related accounts- such as 401(k) or 403(b), governmental 457(b), etc; Roth IRA- either direct or via the Backdoor; and an HSA- if one is available to you.
If you’ve checked all these boxes, it’s time you opened a regular brokerage account, also known as a taxable account. This puts you at #10 on the Milestones along the road to Financial Independence. That’s progress!
Downsides of a Taxable Account
It’s all in the name.
A brokerage account is often referred to as a taxable account because, unlike retirement accounts, which have tax advantages, these accounts do not. Or not as much.
- You put in post-tax money into it- so you do not get an upfront tax deduction.
- You pay taxes annually on any capital gains distributions or dividends a stock or mutual fund throws out. So the growth of your money has a tax-drag. In other words, it is not growing tax-free. But qualified dividends are taxed at the lower capital gains rate. And investments such as Index funds, do not spit out too many of these, thereby making them tax efficient enough to put in a taxable account.
- You pay taxes when you sell a holding in these account, depending on how long you’ve held that particular investment. There are ways around this- such as with charitable donations, the stepped-up basis in death and by tax loss harvesting- as we discuss below.
Upsides of a Taxable Account
The upsides outweigh the downsides.
- Flexibility. You can open your account at the brokerage house of your choice. You can hold whichever funds you like in it.
- You can keep costs extremely low by index investing at brokerages such as Vanguard and Fidelity.
- And take out any amount, anytime you need to, without penalty.
- There are no income limits- on the high or low side.
- There are no contribution limits. You can put in as little or as much as your situation allows.
- There are no required distributions. Like the RMDs mandated for IRAs.
- Even the tax on it is not so bad. Especially if you’re a buy and hold investor. For all investments held for greater than a year, you pay taxes at the lower long-term capital gains tax. The long-term capital gains tax rates are 0%, 15% or 20%- depending on your income and tax filing status. Even if you make enough to get hit with the 3.8% Net Investment Income Tax (NIIT)- it is still significantly less than your marginal tax bracket. If you’ve held an investment for less than a year though, you pay short-term capital gains tax, which is the same as your marginal tax bracket.
- And you can choose tax efficient investments to reduce that tax burden. Index funds are very tax efficient. Their ETF versions even more so, outside of Vanguard. Municipal or other tax-advantaged bond funds are another good option.
- You can tax loss harvest and reduce some of that pesky tax burden.
- Step-up in basis for your heirs. When you pass on and leave your account to your heirs, the cost basis of the investments goes up to what it is on the day of your passing- not what you originally bought it for. This is huge for investments held over long periods of time or those that have risen meteorically.
- Planning withdrawals during retirement. Since withdrawals from the brokerage account does not count towards your taxable income for the year, it helps you stay in a lower tax bracket than you would by withdrawing the same amount from your pre-tax retirement account.
- It helps to have taxable money to help pay for Roth conversions from your pre-tax accounts when you’re easing into retirement and the first few years thereafter. You might want to do this to reduce the size of your pre-tax accounts and therefore the RMDs you are obligated to take.
- You can use appreciated shares to donate to charity- instead of donating cash. You do not pay capital gains taxes on it. Neither does the charity. Win win.
Do I Need A Taxable Account?
I suspect the answer is yes. Here’s why I say so.
Say you need $100k in annual retirement income. Figure out your own number here. At 4% Safe Withdrawal Rate, that amounts to a $2.5Million retirement stash you will need.
If you want to get there in 20 years, you will need to plow in $84k annually into accounts earmarked for retirement. If you consider 25 years, it’s about $60k you’ll need to save every year. Stretch it out to 30 years, you’ll need $44.5k a year (and that means you’re working into your 60’s). I’ve played around with these calculations here.
Most of us, particularly employed physicians, do not have $84k in tax-advantaged space per year. Here is how much an employed physician, under 50 years, might have access to:
- $19,500 in a 401(k) or 403(b) + some employer match
- $6000 in Backdoor Roth IRA
- $7100 in HSA for a family
About $32.6k. Nowhere close to $44k or $60k or $84k.
A self-employed doc does better:
- $57,000 for a maxed-out contribution to a 401(k) as an employer
- $6000 in Backdoor Roth IRA
- $7100 in HSA for a family
This brings up the total to $70k. Not bad. These physicians are often higher income, and if they’re not inflating their lifestyle too much, usually have extra cash to invest.
This necessitates most of us will use a regular taxable account to save for retirement once us’ve maxed out our other accounts.
Tax Efficient Fund Placement
Reams have been written about this subject and no one agrees fully with each other.
The basic premise is that you put in your least tax-efficient investments into your tax-advantaged accounts. Everything else goes wherever there’s room- tax-advantaged space as long as it’s available and then in the taxable account.
This also changes with time. As you progress through the years, your taxable account becomes a bigger and bigger portion of your portfolio. At that point, more and more of your asset allocation spills into the taxable account, in part or whole.
Without diving too deep into the weeds,
- Broad index funds are very tax-efficient and perfect candidates for the taxable account. This is a good thing since for most of us, this is also the biggest chunk of our portfolio.
- International Index Funds, such as Total International Stock Market Fund or International Small Cap Funds or Emerging Market Funds also get you a Foreign Tax Credit- which you cannot avail of if they are placed in a tax-advantaged account.
- The volatile small cap funds- whether domestic or international- also allow good Tax Loss Harvesting opportunities.
- REITS, if they are part of your portfolio, do best in a Roth account, being notoriously tax-inefficient.
- Municipal and other Tax Exempt Bond funds are good candidates for the taxable account. Other bonds usually do better in tax-sheltered accounts since their interest payouts are taxed at ordinary income tax rates.
This is a brief overview of the taxable investment account. Next time, we will see how to open one and what to do with it.
I look forward to your questions and comments!