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The Importance of a Taxable Account for Early Retirees

When it comes to retirement planning (especially early retirement planning), it’s tempting to focus on retirement accounts. But it’s equally important to think about taxable accounts.

Tax-advantaged retirement accounts are a vital part of your long-term plan, but you also need easy access to funds before you hit age 59 ½, the age at which you can easily withdraw money from retirement accounts without a 10% penalty. There are numerous ways to avoid that penalty, but the simplest is to have money invested outside of tax-advantaged retirement accounts.

An after-tax investment account allows you to access funds when needed. With careful planning, these accounts can help you minimize your taxes over your lifetime.

In some cases, an after-tax investment account can be more beneficial than a Roth IRA.

 

Understanding After-Tax Investment Accounts

After-tax investment accounts (also known as non-qualified brokerage accounts or taxable investment accounts) are accounts where you put after-tax money. Since you’ve already paid taxes on these funds, you may not pay taxes when you withdraw funds from the account. If your assets have appreciated, you will pay taxes on any realized capital gains.

These accounts differ from Roth IRAs since there are no limits on the contributions you can make each year. Roth IRAs also require you to leave the funds in your account for five years before the earnings can be withdrawn tax-free.

In an after-tax account, you pay taxes on investment income, such as dividends and realized capital gains generated by funds you own,  even if you don’t withdraw the funds from your account. But long-term capital gains and qualified dividends benefit from lower tax rates.

This is the opposite of a pre-tax account. In a pre-tax account, you are not taxed on your investment income as long as the funds stay in your account. You are, however, taxed on any withdrawals you take from the account.

Let’s take a look at an example:

After-Tax Account: John has an after-tax investment account worth $100,000 at the beginning of the year. During the year, he sells a stock with $10,000 of long-term capital gains and reinvests $6,000 of the profit in a different stock. He withdraws $4,000 of the gain to spend. He’ll owe taxes on the $10,000 of capital gains at the end of the year. John will pay taxes at the long-term capital gains rate, which will typically be lower than his ordinary income tax rate.

Pre-Tax Account: John’s pre-tax account is worth $100,000, and he sells a stock with $10,000 of capital gains. He decides to reinvest $6,000 and withdraw the remaining $4,000 of profit. He will pay taxes on the $4,000 withdrawn from the account, which will be taxed at his ordinary income tax rate, but he will not be taxed on the $6,000 that remains in his account.

 

 

Types of Investments

After-tax accounts can hold a variety of different types of investments, including:

  • Stocks
  • Bonds
  • Mutual funds
  • Exchange-traded funds
  • Real estate investment trusts (REITs)
  • Options and futures
  • Certificates of deposits (CDs)
  • Publicly traded partnerships (PTPs)

Many employer-sponsored pre-tax retirement accounts have limited investment options. Your investment choices in employer accounts usually include mutual funds, bonds, and exchange-traded funds.

 

The Role of After-Tax Investment Accounts in Early Retirement

When planning for early retirement, having a mix of after-tax and tax-deferred accounts is essential to minimizing your taxes. Diversification of your accounts gives you more options when deciding which funds to use.

After-tax investment accounts allow you to access your funds anytime without penalties. After-tax accounts do not have required minimum distributions (RMDs) either, so you are never forced to withdraw your assets.

An after-tax account is helpful before you reach age 59 ½ if you want to avoid the early withdrawal penalties pre-tax accounts can incur.

During the initial years of early retirement, your income will be lower since you do not need to take RMDs. You also will not be receiving Social Security income. You can use this time to take advantage of your lower income and lower capital gains tax rates to realize long-term capital gains.

Your capital gains tax rate is determined by your total income. The 2023 capital gains tax brackets are listed below.

 

Tax-filing status0% tax rate15% tax rate20% tax rate
Single$0 to $44,625$44,626 to $492,300$492,301 or more
Married, filing jointly$0 to $89,250$89,251 to $553,850$553,851 or more
Married, filing separately$0 to $44,625$44,626 to $276,900$276,901 or more
Head of household$0 to $59,750$59,751 to $523,050$523,051 or more

 

Because withdrawals from after-tax accounts do not carry restrictions and long-term capital gains are usually taxed at a lower rate, they can provide income to cover living expenses in early retirement. You’ll want to maximize the capital gains to utilize the entire 0% bracket before RMDs and Social Security payments start. Strategic capital gain harvesting in early retirement can help you fully utilize the 0% long-term capital gains tax bracket.

Strategic withdrawals from after-tax accounts can help manage your tax bracket in retirement.

 

The Tax Benefits of After-Tax Investment Accounts for Early Retirees

After-tax investment accounts offer several significant tax benefits that can contribute to a more financially secure retirement.

 

Tax Implications of After-Tax Investment Accounts

Investments in after-tax accounts are made with money that has already been taxed. You will only incur further taxes when you receive dividends, your holdings generate capital gains, or you sell assets that have appreciated, realizing capital gains. This is a key difference between an after-tax and a pre-tax account, such as a traditional 401(k) or IRA.

Another significant tax advantage of after-tax accounts is that they are not subject to Required Minimum Distributions (RMDs). Traditional, tax-deferred retirement accounts require you to start taking withdrawals and paying taxes on those withdrawals once you reach age 73. After-tax accounts have no such requirements, providing more control over your taxable income in retirement.

 

Lower Taxable Income During Retirement

With after-tax investment accounts, you can create a stream of income in retirement that has a lower tax rate. Since your original contributions to these accounts were already taxed, you only owe taxes on your earnings. By strategically withdrawing from these accounts, you can effectively lower your overall taxable income during retirement.

 

Capital Gains Tax Rates in After-Tax Accounts

One of the most compelling tax benefits of after-tax investment accounts is the favorable long-term capital gains tax rates. If you hold an investment in an after-tax account for more than a year before selling, any profits are considered long-term capital gains. These gains are taxed at a lower rate than ordinary income – 23.8% for the highest earners at the federal level (plus state and local income taxes, where such taxes are levied).

In contrast, withdrawals from traditional retirement accounts are taxed as ordinary income, regardless of whether the profits were from long-term investments.

 

Strategic Management of After-Tax Investment Accounts

Strategic management of your after-tax investment accounts can be an effective way to minimize your taxes. Here are some tax-efficient strategies and asset allocation suggestions to consider.

Regular Review and Rebalancing: The value of your investments will fluctuate along with the market. By regularly reviewing and rebalancing your portfolio, you can make sure it aligns with your risk tolerance and retirement goals over time.

Understand Tax Implications: Stay up to date on tax rule changes and understand the tax implications of your investments. The rules change regularly, but there is usually an advanced warning of changes, giving you time to move funds before the rule changes are implemented.

Utilize Losses: If some investments perform poorly, consider exchanging them for similar assets to realize those capital losses. This strategy, known as tax-loss harvesting, can offset capital gains and reduce your taxable income.

 

Asset Allocation Between Pre-Tax and After-Tax Accounts

Though the initial tax savings of pre-tax accounts often make them worthwhile during your working years, it’s essential to invest in an after-tax account. Here are some suggestions for allocating your resources:

Consider Your Retirement Income Needs: If you plan to retire early, it may be beneficial to allocate more to after-tax accounts since these funds are more accessible and don’t have withdrawal penalties.

Balance Risk: High-growth investments are better in after-tax accounts due to favorable long-term capital gains tax rates. Income-producing assets are better suited for pre-tax accounts where the income generated will be tax-deferred.

Take Into Account Your Current and Future Tax Situation: If you’re in a high tax bracket but expect to be in a lower one in retirement, you should contribute more to pre-tax accounts now. Contributions to after-tax accounts should be prioritized in years when your income is lower.

 

Tax-Efficient Investing Strategies in After-Tax Accounts

Investing tax-efficiently in after-tax accounts can help maximize your returns. Here are a few strategies to consider:

Hold Investments Longer: Since long-term capital gains tax rates are lower than short-term rates, holding onto your investments for over a year can result in significant tax savings.

Tax-Loss Harvesting: This maneuver involves exchanging investments that have lost value for similar (but not substantially identical) investments, locking in a paper loss without significantly altering your asset allocation. You can use these losses to offset $3,000 in ordinary income each year and an unlimited amount of capital gains.

Strategic Withdrawals: A withdrawal strategy is just as important as an investment strategy. Consider selling appreciated stocks in your after-tax accounts over several years to avoid moving into a higher tax bracket.

 

Example of Effective Utilization of After-Tax Accounts

Sarah had a goal to retire by 55 and started investing in an after-tax account in her 30s alongside her employer-sponsored 401(k). By her early 50s, she had accumulated significant investments in her after-tax account. She utilized her after-tax account to fund post-retirement adventures without tapping into her 401(k) before 59 ½. Since she was not working, she was able to realize over $44,625 of long-term capital gains each year and pay $0 in federal taxes.

Note that she could continue this strategy effectively until she reached age 70 and had to start taking Social Security benefits, at which point her income would increase, and her long-term capital gains rate would increase to 15%.

Once she starts receiving Social Security and RMDs, she can stop drawing funds from her after-tax account.

 

Analysis of the Strategies Used and Results Achieved

By building up a significant after-tax account, Sarah was able to fund her early retirement while avoiding penalties. This means that Sarah had a source of funds she could tap into before the standard retirement age without penalties.

Sarah diversified her after-tax portfolio with a mix of stocks, bonds, and ETFs, holding them long-term to take advantage of lower capital gains tax rates. Tax gain harvesting is a technique that can be used to maximize utilization of the 0% capital gains bracket and potentially reduce future capital gains taxes due by increasing the cost basis of current holdings.

Strategic utilization of these accounts can offer the flexibility needed for fulfilling retirement goals, demonstrating the value of after-tax accounts in comprehensive financial planning.

 

Final Thoughts

After-tax investment accounts are an invaluable tool in the arsenal of those planning for early retirement. They offer a unique blend of flexibility, tax efficiency, and strategic advantages that make them well-suited to the needs of early retirees.

Unlike traditional retirement accounts, after-tax investment accounts offer early retirees the ability to access funds without age restrictions or penalties.

They also provide the opportunity to leverage lower long-term capital gains tax rates and use strategies like tax-loss harvesting to manage tax liabilities. These accounts can provide a steady income stream until other retirement funds become available.

With changing economic landscapes and tax laws, these accounts offer the adaptability needed to respond effectively to future uncertainties.

 

FAQ

 

What are the advantages of a taxable account?

Taxable accounts have several advantages for early retirement. Taxable accounts allow you to withdraw your funds at any time without penalty, giving you full flexibility over the timing of your withdrawals. You’ll also benefit from the lower tax rate on long-term capital gains and qualified dividends.

 

What is the disadvantage of using a tax-deferred retirement plan?

Tax-deferred accounts have many benefits but also come with drawbacks. Withdrawals from tax-deferred retirement plans are taxed at your ordinary income rate, even if the withdrawals result from long-term capital gains. You’ll also be required to make RMDs once you reach 73 and penalties may apply if you withdraw funds before turning 59 ½.

 

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10 thoughts on “The Importance of a Taxable Account for Early Retirees”

  1. I struggle with figuring out asset location for early retirement. Tax advantaged asset allocation generally recommends holding bonds in pre-tax accounts.

    “Income-producing assets are better suited for pre-tax accounts where the income generated will be tax-deferred.”

    However part of wanting a bonds/fixed income allocation is to be able to use that during early retirement when equity markets are down. If bonds are not in after tax accounts, how to access that? Sell equity in post tax to generate cash, then rebalance in pre-tax buy selling bonds and buy equity? This would effectively reduce the bond allocation.

    Or just hold bonds in post tax accounts?

    Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. I struggle with figuring out asset location for early retirement. Tax advantaged asset allocation generally recommends holding bonds in pre-tax accounts.

    “Income-producing assets are better suited for pre-tax accounts where the income generated will be tax-deferred.”

    However part of wanting a bonds/fixed income allocation is to be able to use that during early retirement when equity markets are down. If bonds are not in after tax accounts, how to access that? Sell equity in post tax to generate cash, then rebalance in pre-tax buy selling bonds and buy equity? This would effectively reduce the bond allocation.

    Or just hold bonds in post tax accounts?

    Reply
  4. I struggle with figuring out asset location for early retirement. Tax advantaged asset allocation generally recommends holding bonds in pre-tax accounts.

    “Income-producing assets are better suited for pre-tax accounts where the income generated will be tax-deferred.”

    However part of wanting a bonds/fixed income allocation is to be able to use that during early retirement when equity markets are down. If bonds are not in after tax accounts, how to access that? Sell equity in post tax to generate cash, then rebalance in pre-tax buy selling bonds and buy equity? This would effectively reduce the bond allocation.

    Or just hold bonds in post tax accounts?

    Reply
  5. Missed one of the great features of a taxable account. The “step up” basis of these funds being passed on to heirs and incurring zero taxes on the new value at time of death.

    Reply
  6. Missed one of the great features of a taxable account. The “step up” basis of these funds being passed on to heirs and incurring zero taxes on the new value at time of death.

    Reply
  7. Missed one of the great features of a taxable account. The “step up” basis of these funds being passed on to heirs and incurring zero taxes on the new value at time of death.

    Reply
  8. Rebalance in your taxable account. Always take capital losses especially when short term. They are “in the bank.” Using the $3000 deduction and defraying short term cap gains is the best use of losses. Don’t take LTCG if you can avoid it. Using up your realized capital losses against LTCG when in the 0% LTCG bracket is a waste. If after Soc Security and RMDs, you still have headroom, maybe take them then. Or donate some or gift some. Remember the max tax rate on Soc Security is 85%. Does your State have Retirement tax credits for taking out Retirement funds?

    Reply
  9. This whole article misses how a 72t distribution or Roth IRA conversion ladder dramatically alters the logic behind prioritizing after tax brokerage money.

    Reply
    • Not really. If you’re holding taxable real estate in a trust account you can use a 1031 to move between “substantially equivalent” assets without incurring taxes, but almost by definition that wouldn’t help with rebalancing.

      Unless you’re significantly changing your strategy/risk tolerance, a rebalance should be a fairly small percentage though, and the taxes should not be significant. Imagine you want to be 50/50 between funds A and B, but you’re currently 55/45. Assume you’re doing this annually (not the ideal for management, but not bad, and better for taxes). You’re going to sell 5% of your account value from A, but only 10% of that is gain. The rest is your original principle (you invested 50, you’re up to 55, so roughly 10% gain). And unless you’re income is very high or very low, you’re only paying 15% on it. So 15% of 10% of 5% of your taxable account, or 0.075% a.k.a. 7.5 basis points. That’s not “nothing,” but it’s relatively cheap to have full access to your funds. Remember you’d pay the same amount if you were withdrawing instead of rebalancing.

      If you need to make a large rebalance because one fund is up and another is down, you might be able to harvest the losses in the down fund to offset the realized gain, but you’d have to switch funds enough to avoid wash sale rules.

      If you’re setting up an income stream you can use munis to make it tax free, but that’s rarely optimal unless you’re both very conservative and very high income. And you’d still pay taxes on a rebalance.

      Reply

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