Overview: A taxable brokerage account is often maligned because it doesn’t offer the same tax protections of accounts like 401(k)’s or IRA’s. However, there are lots of great reasons to have a brokerage account. Excellent for long term savings goals and piggy backing on to retirement accounts, they are a great addition to have for your overall retirement and savings goals.
People often think brokerage accounts are just for buying and selling stocks. They can be, but I don’t recommend buying individual securities because of uncompensated risk. Passive index funds however, are a great way to invest in taxable accounts for their tax efficiency. But why use a taxable account? They offer lots of benefits regular retirement accounts can’t. Also, if you have a 401(k) or IRA, you really should be using a brokerage account!
Like the name implies, taxable accounts have tax consequences when you sell the investments you’ve purchased. This is unlike retirement accounts where you can buy and sell without worry of paying taxes on any gains. Because of this, you need to be selective in what you buy because you may hold that investment for a long time before selling it and realizing a gain.
Benefits
One of the best benefits of the taxable account is the lower capital gains rates on any earnings that you’ve held for longer than a year. Depending on your tax bracket, these are 0%, 15%, or 20% for long term capital gains (LTCG). This is in contrast to retirement accounts like a 401(k) or IRA, where withdrawals are taxed at income rates. For example, earning less than $89,450 [2023] filing jointly, enjoys the 0% LTCG tax rate. This can be a great place to earn extra tax free income by selling appreciated shares.
Tax loss harvesting is a great way to use a brokerage account. When you lose money in an investment, the government lets you take up to $3,000 off your taxes each year. At the next dip, I plan on selling what I have in my account, realizing the loss, then buying a similar fund so I can keep my money in the market. If I realize a $9,000 loss, I can deduct $3,000 for three years. If the market falls but I don’t sell (don’t tax loss harvest), I’d still be down in my accounts, but I wouldn’t have a deduction at the end of the year. TLH sounds complicated, and sometimes it feels like it can be, but there are lots of tutorials online that help make sense of it.
Traditional versions of 401(k)’s and IRA’s have RMD’s, or ‘required minimum distributions’ when you reach 72 years old. These aren’t terrible because if you don’t need the money, you can simply reinvest them. However, taxable accounts never have RMD’s tied to them. Taxable accounts are also great to leave to heirs because they get a step up in basis upon your death. This means your heirs get the funds, but pay tax on the gains from the day they receive them, not the day you bought the funds. There are also a lot of low-cost investment options you can choose from in a taxable account, unlike many 401(k)’s.
Taxable accounts are also a great way to give to charity. Instead of writing a check to our church or favorite charity each month, I put that money in our brokerage account. Then, if it grows, the charity gets the money plus the gains, tax free. I also don’t pay taxes on the gains of donated shares. If the market plummets and I lose money, I’ll tax loss harvest and either donate other shares, or donate cash. It’s a real win-win. Shares to charity are a great way to flush out capital gains, especially on money you were going to donate anyway. A donor advised fund is a good vehicle for this as well.
With short investing horizons like saving up for a car or house down payment, savings accounts or CD’s (Certificates of Depression) are best. Money for goals that mature within five years or less should probably be out of the market. But if you want to save up for a child’s first car, first house, wedding, round the world vacation, etc., taxable accounts can give you more leverage with market gains and compounding. I’m currently saving for all the expenses my four young daughters will cost me one day.
Save the tax break
Finally, it’s all about the tax savings. Everyone should have either a 401(k), IRA, or both. If you have a traditional 401(k) or traditional IRA, you need a brokerage account. Let me explain. Traditional IRA’s and 401(k)’s are tax deferred meaning you are currently getting a tax break to put money in those accounts. You’ll have to pay taxes on that money and any gains upon withdrawal in retirement. But for now, contributing to a 401(k) means you are paying less in taxes. You have two choices with that tax break: spend it or save it.
Take your marginal tax rate (your tax bracket rate) and multiply it by the amount you put into the traditional IRA or 401(k) each month. Then, invest that difference instead of spending it on yet another Starbucks coffee. If you put $1,000 a month into your 401(k) and you are in the 24% tax bracket, then you are saving about $250 a month in taxes. Again, you can spend that money, or you can save it. I choose to save it. Send that $250 to your brokerage account, and buy something simple like VTSAX, a passive total US stock market fund. Set that transfer to run automatically each month and you’ll be all set, with it being out of sight and out of mind.
Remember, if you have $1 million in a 401(k), you don’t really own all of it, the government owns about 25% of it. You really own about $750,000, depending on tax rates. But what if there was a way to own all of it? There is! If you have been diligently “saving the tax break” into a brokerage account, along with your 401(k) deferrals, you’ll also have a healthy amount of money in your brokerage account. If you have $200,000 in your taxable account, you’ll have enough to offset a lot of the taxes you’ll owe on your 401(k) withdrawals. The numbers and percentages can differ, but the principle is the same: save your tax deductions in a brokerage account. It will help you save more for retirement, and it’s a hidden way of saving without spending that money willy-nilly without a purpose.
Roth Accounts
One note, the point of saving the tax break only works with traditional pre-tax accounts. If you have a Roth 401(k) or Roth IRA, this doesn’t apply. Why? Because you’ve already paid the taxes to get that money in the account. There is no tax break. Roth accounts “pre-pay” the taxes now but then are tax free in retirement. $1,000,000 in a Roth 401(k) really is 1 million bucks because the government doesn’t own any part of it.
I’m still a big believer in the saying “a tax deferred is a tax not paid.” That means that future tax law is unknowable, so defer the taxes as long as you can to avoid dealing with them. I put money into my traditional tax deferred accounts while “saving the tax break” to get the tax cut now, and I’ll deal with future tax rates in the future.