Investing in a Taxable Account
I get a lot of questions at social events from friends and family about their personal finance situation. That is one of the fun parts of working in the personal finance world. They trust me to affirm, or sometimes deny, that they are on the right track. Most questions are related to paying off debt or how much they should be putting in a 401k. However, I am always intrigued when I get questions about investments held in taxable accounts or with an advisor.
Taxable accounts are generally used for three main reasons. The first is for people who want to play in the stock market. I use the world play intentionally. These people are usually investing in individual stocks and think they can pick the next hot stocks. It is fun to invest as long as they are aware they can lose money very easily. The next reason is for those saving for a purchase in the next 3-10 years and are trying to earn more than a savings account. Finally, taxable accounts are used when retirement account contributions have been maxed out. Taxable accounts can add investments to retirement or other long-term goals.
I am going to ignore the people using these accounts to play in the market and focus on how you can maximize the benefit of investments held your taxable account.
There are a couple of advantages when investing in a taxable account. First, you have the opportunity for long term capital gain tax treatment. Investments that are held for longer than one year are taxed at lower rates than ordinary income. Second, you can contribute and withdraw from these accounts without any tax consequences. Retirement accounts have contribution limits each year. You are also required to pay ordinary income taxes on (Non-Roth) retirement accounts when you withdraw money from them. Withdrawing from these accounts early may also cause you to pay penalties in addition to taxes.
Because investment activity in these accounts is taxed, investors must manage their tax efficiency. There are a couple things that everyone should do if you have investments in both taxable and retirement accounts. First, you should use Exchange Traded Funds (ETFs) instead of Mutual Funds. Mutual Funds distribute capital gains to their shareholders each year. ETFs only make dividend distributions. This allows the investor to take advantage of lower tax rates on distributions. Most mutual funds have an ETF with the same investment strategy, so it will not impact your investment options.
Another tax issue that people often miss is Asset Location. Many people set the same asset allocation in every account. The better option is to keep all tax advantaged assets (stocks, municipal bonds, and ETFs) in taxable accounts. Other assets (taxable bonds, mutual funds, REITS) should be kept in retirement accounts. This will allow you to minimize your tax liability each year while maintaining the proper asset allocation for your plan.
Another thing to keep in mind is your beneficiaries. Retirement accounts require beneficiaries when the account is opened, but taxable accounts usually do not. Check to make sure that you have beneficiaries set up to avoid having the account sent to probate. Upon death of the investor, the assets will receive a step-up basis which means that the recipient can sell the investments with no tax consequences.
Always make sure to keep your overall plan in mind. Try to max out your retirement contributions before investing in a taxable account if you are planning to use these funds for retirement. Taxable accounts can help save extra. These investments should complement your retirement accounts. However, if you have a plan that you will need to pull money out before age 59.5, these accounts should be used. Just be aware of the risks of your investments and when you need the money. Investments in stocks could drop 30% or more in a year. You don’t want that to happen the year before you need to withdraw the money.
Of course, if you just want to play around in the stock market, you can ignore this post. But feel free to call me and I can give you my “Money invested in individual stocks could be completely lost” speech.
Mike Zeiter, CPA/PFS