Would you believe that a non-qualified brokerage account, a.k.a. taxable account could mimic the benefits of a Roth IRA? Or be as good or better than a Roth 401(k)?
If you answered “no,” then I’ve got news for you, and if you answered “yes,” then I probably don’t have much to teach you and you’re welcome to move on over to Bogleheads and answer everyone’s questions over there.
A certain number of conditions must be met, of course, and it may not be ideal to attempt to meet all of the criteria, but the fact is that a taxable account can behave pretty much exactly like a Roth IRA, but without some of the Roth IRA’s limitations, particularly after retirement.
What is a Roth IRA?
First, we need to identify what a Roth IRA is and how it’s beneficial.
A Roth IRA is an Individual Retirement Arrangement that is funded with post-tax money. That is, you’re investing in the account with money that has already been taxed or you’re paying tax on the money when you convert it from tax-deferred to Roth.
Growth in your Roth account is not subject to tax. Neither are withdrawals.
Dividends are not taxed. Earnings are tax-free. Quite simply, once your money is in a Roth account, it will never be taxed again. Sure, the tax laws could change, but any proposal that resulted in double taxation of Roth money would be extremely unpopular and unlikely to gain real traction.
Limitations of a Roth IRA
Roth money is so valuable that most people, including me, recommend not touching it unless you have no other money sources available. Generally, taxable dollars and tax-deferred dollars should be spent first in retirement, and it can be smart to convert tax-deferred dollars to Roth, depending on your marginal income tax bracket.
However, there are some limitations. Any growth in the Roth account cannot be accessed without a 10% penalty before the age of 59.5.
If you do need to access a Roth account, Roth contributions are available for penalty-free withdrawals at any age, and Roth conversions are available without penalty in the fifth year after the conversion.
A Roth IRA does not give you the opportunity to tax loss harvest, a simple exchange of similar funds that can give you a $3,000 tax deduction every single year. In your working years, that can easily be worth $1,000 to $1,400 a year in income tax and another $100 or so if you pay the NIIT.
What is a Taxable Account?
When you buy mutual funds, ETFs, or individual stocks or bonds outside of your tax-advantaged retirement accounts with your own hard-earned after-tax dollars, they will reside in a plain old brokerage account.
This type of non-qualified (non-tax-advantaged account) is commonly referred to as a taxable account, which sounds like a terrible place to invest.
Limitations of a Taxable Account
The limitations are all about the taxes.
Short-term capital gains and ordinary, non-qualified dividends are taxed at your marginal income tax rate. Long-term (assets held > one year) capital gains and qualified dividends are typically taxed, as well, but at a preferential capital gains rate.
When you sell assets to spend the money invested in a taxable account, you’ll generally pay taxes on the difference between what you paid (your cost basis) and the value at which you sell. These are realized gains and the taxation depends upon how long you’ve owned the asset. You’ll get the preferential rate when you’ve held the fund, stock, or bond for more than a year.
Unlike a Roth IRA, you don’t have to reach any particular age to access any or all of the money. There is no 10% penalty or 5-year seasoning period. It’s yours and available to you at any time.
How a Taxable Account Can Behave Like a Roth IRA
So you want your taxable account to resemble a Roth IRA?
The following criteria must be met:
- No tax on the growth
- No tax on withdrawals
That’s pretty much it. How do we magically make these taxes disappear?
No sleight of hand is required, but you do need to understand how dividends and capital gains are taxed at various income levels.
No Tax on the Growth of a Taxable Account
If you’re investing in a taxable account, I’m going to assume you’re already maxing out all tax-advantaged investing opportunities. If you’re able to afford to do so, there’s a very good chance your taxable income is above $80,000 (if married filing jointly in 2020) or $40,000 (for single filers in 2020).
These figures are important, and will come up again — it’s the taxable income above which you’ll owe federal income tax on long-term capital gains and qualified dividends.
Since we’re assuming you’re making more than that, the only way to avoid taxes on the realized gains and dividends is to own funds that don’t distribute gains or dividends.
Note that does not mean you need to own assets that don’t appreciate in value. The stock price or net asset value can go up and up and up, but as long as you’re not selling and no dividends are forced upon you, no tax will be due on your unrealized gains.
One way to accomplish this is by owning growth stocks that distribute no dividends. Berkshire Hathaway is an excellent example of a diversified individual stock that does not pay out dividends, and I love them for it.
There is, of course, the “danger” that a company will change course one day and start paying dividends, but that’s a risk you’re going to have to live with.
Other well-known companies that have not paid out dividends include Facebook, Amazon, Netflix, and Google (Alphabet). I’ve never been into individual stock investing, but it wouldn’t be difficult to build a basket of 30+ no-dividend stocks across numerous sectors with M1 Finance, which is something I might actually do if I find the time. If you know of a “pie” like that, let me know in the comments!
If you’re okay with a taxable account that doesn’t 100% mimic the taxation of a Roth account but is still very tax-efficient, consider investing in Growth stocks and funds in your taxable account. You can offset the growth-tilt by investing more in Value assets in your tax-advantaged accounts if you wish.
Growth companies tend to invest most of their profits back into their growing businesses while giving little or no cash back to investors in the form of dividends. Conversely, value companies are more likely to distribute regular dividends from a portion of their profits.
In fact, in the first episode of Rick Ferri’s Bogleheads podcast, John Bogle explained that he separated the two and created Vanguard index funds for both growth and value for that exact reason.
He wanted investors to be able to invest in the growth companies in a taxable brokerage account and the value stocks in their tax-advantaged accounts to be invested more tax-efficiently.
No Tax on Withdrawals from a Taxable Account
When you’re working and earning a good income, your spending money should come from your paychecks. You should have no need to sell your taxable holdings to fund your lifestyle.
If you do face a situation where selling from taxable is your best option (I’ve done so to purchase a home), that’s quite alright, but understand that your taxable account will not mimic a Roth account if you do this while still earning a good living.
The time that tax-free withdrawals become possible is in retirement, particularly in early retirement.
As long as your taxable income is below $83,350 (if married filing jointly in 2022) or $41,675 (for single filers in 2022), you will pay no tax on long-term capital gains and qualified dividends.
How might this work in real life?
Let’s say you’re retired with a paid-off mortgage and want to live on $120,000 a year.
A married couple could sell $120,000 worth of taxable assets purchased long ago that have appreciated 600% and not owe any tax, as long as the assets have been held for over a year. Their capital gains when selling would be $120,000 (value when sold) – $20,000 (cost basis) = $100,000 long-term capital gains.
A simple tax calculation would be $100,000 long-term capital gains – $25,900 standard deduction in 2022 = taxable income of $74,100. That puts them in the 0% capital gains bracket with no taxes owed on the year. They could have another $5,900 in income from other sources and still owe zero capital gains taxes.
Additional outside income could foul this up, of course, but the bottom line is that your total taxable income should be under that magic number of $83,350 if married filing jointly and half that for single filers.
A single filer wanting tax-free withdrawals and a $120,000 budget would want to sell assets that have not seen such massive price appreciation. She could sell $120,000 worth of BRK-B that she purchased about five years ago for $70,000 for a $50,000 long-term capital gain.
Subtract her $12,950 2022 standard deduction and she’s got taxable income of $37,050. That’s well within the 0% long-term capital gains bracket, and she owes no federal income tax that year.
The 0% Capital Gains Bracket
If you do have other sources of taxable income, whether from IRA withdrawals later in retirement, Roth conversions, real estate investments, or other income sources, the number to keep in mind is your taxable income for the year.
Depending on when you retire, you may have a lot of time between that day and age 72 where RMDs make withdrawals mandatory. If you find yourself in great financial shape and are feeling generous (and I hope both are true for you), you also have the option of donating your RMD as a qualified charitable distribution (up to $100,000 of it), which avoids an increase in taxable income (and benefits the charity of your choice).
If you want your taxable account to mimic a Roth IRA in retirement, remaining in the 0% long-term capital gains (and qualified dividend) bracket is key.
Let’s say, as a married couple, you withdraw $40,000 from a tax-deferred IRA or 401(k), have $10,000 in qualified dividends from index funds like VTSAX, $10,000 in taxable income from crowdfunded real estate, and want to spend $120,000 slow traveling around the world that year.
So far, you’ve got $60,000 to spend and a taxable income of $60,000 – $24,800 standard deduction = $35,200.
That leaves you $80,000 – $35,200 = $44,800 that you can realize in long-term capital gains without owing any money on the withdrawals from your taxable account.
To cover the remaining $60,000 in your $120,000 spending budget, you can sell funds that you paid as little as ($60,000 – $44,8000) = $15,400 for initially. Those are assets that have nearly quadrupled.
Also, keep in mind that actual Roth dollars that you’ve accumulated can also be spent to meet your proposed budget without altering your taxable income. I don’t necessarily recommend it, but it might make sense to tap those funds in certain circumstances.
It’s also important to note that the 0% bracket is not a cliff. If you end up with $80,001 dollars in taxable income for the year, and you realized $44,801 in long-term capital gains, you DO NOT owe 15% capital gains taxes on all $44,800 in realized gains. Only one of those dollars was bumped into the next bracket, and the mistake will cost you 15 cents (which will probably be rounded down to $0).
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Don’t Forget About State Income Tax
The final piece of the Roth-like taxable account is understanding how your particular state taxes capital gains and dividends. The only sure way to avoid paying taxes on them is to live in a state with no income tax levied on capital gains.
Alaska, Florida, Nevada, Tennessee, Texas, Washington, South Dakota, and Wyoming, fit the bill in 2020. New Hampshire does not tax ordinary income but does tax capital gains.
Some states do give long-term capital gains preferential tax treatment — Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont, and Wisconsin according to the CBPP.
Is it worth moving to avoid maybe a few thousand dollars in capital gains taxes? Probably not. But I think it’s worth mentioning, as state taxes are so frequently left out of capital gains tax discussions despite the fact that most states treat capital gains no different than ordinary or earned income.
The Not-So-Taxable Account
While a taxable account is more flexible than a Roth account, there are asset protection benefits offered by an IRA that the taxable account does not have.
That’s alright; you’re not choosing either / or here. I encourage you to maximize all tax-advantage space, including annual contributions to a backdoor Roth.
I hope I’ve convinced you that a “taxable” account can be a great investment account, and it’s not difficult to make it a very low-tax account. And it’s entirely possible, particularly for early retirees with budgets at or below a low six-figure number, to have a tax-free taxable account.
Do you invest in a taxable brokerage account? Is tax-efficiency a priority when you invest?