How a Taxable Brokerage Account Can Be as Good or Better Than a Roth IRA

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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.

 

How a Taxable Brokerage Account Can Be as Good or Better Than a Roth IRA

 

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.

Roth IRA money is not subject to Required Minimum Distributions (RMDs), although an inherited Roth IRA will be.

 

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.

 

 

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 (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.

 

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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 $78,750 (if married filing jointly in 2019) or $39,375 (for single filers in 2019).

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 are to own funds that don’t distribute gains or dividends.

Note that does not mean you need to own assets that don’t appreciate. 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 $78,750 (if married filing jointly in 2019) or $39,375 (for single filers in 2019), 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 – $24,400 standard deduction in 2019 = taxable income of $75,400. That puts them in the 0% capital gains bracket with no taxes owed on the year.

Outside income could foul this up, of course, but the bottom line is that your total taxable income should be under that magic number.

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 $12,200 2019 standard deduction and she’s got taxable income of $37,800. That’s in 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 passive 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 then and age 70.5 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, 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.

 

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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 – $24,400 standard deduction = $35,600.

That leaves you $78,750 – $35,600 = $43,150 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 – $43,150) = $17,650 for initially. Those are assets that have more than tripled.

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 $78,751 dollars in taxable income for the year, and you realized $42,750 in long-term capital gains, you DO NOT owe 15% capital gains taxes on all $42,750 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 2019. 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 often left out of capital gains tax discussions.

 

The Not-So-Taxable Account

 

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.

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.

 

 

Do you invest in a taxable brokerage account? Is tax-efficiency a priority when you invest?

30 thoughts on “How a Taxable Brokerage Account Can Be as Good or Better Than a Roth IRA”

  1. I was literally having this conversation with Wealthy Doc on my site yesterday in the comments of one of my recent posts. (Minus the math in this post, which was well done!)

    If you are smart, you can keep your taxable income low in retirement and this is a great example of that.

    TPP

    Reply
    • TPP,
      I don’t disagree with this.
      I have more outside of retirement funds than within them. That will be true for many doctors who efficiently grow wealth.

      My comment on your post was more about problem doctors (and others) have. People think their retirement money is all theirs. It isn’t. Uncle Sam needs to be paid.

      Right or wrong, most doctors have a lot of money in traditional IRAs and 401K. $3M in a 401K does not equal $3M in a Roth IRA. Doctors’ eyes glaze over when talking about this but the distinction is critical.

      The best option depends on your future income and your future marginal tax rate. Your guess is as good as mine.

      A case for hedging (tax diversification) can be made.

      Reply
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  3. Great work! Tax treatment of capital gains takes forever to wrap your head around.

    For the ultra nerdy, there are 4 capital gain tax brackets:

    • 0% if all of your income keeps you below the 12% (or 15%) tax bracket
    • 15% until NIIT
    • 18.8% between NIIT and 20% Capital Gain Bracket
    • 23.8% above the 20% Capital Gain Bracket

    If you want to see how to actually calculate capital gains (but the NIIT is added later!), then see page 40 of the following link: Line 11a– Qualified Dividends and Capital Gains Tax Worksheet https://www.irs.gov/pub/irs-pdf/i1040gi.pdf

    Reply
    • So much fun!

      And the 0% cap gains bracket is no longer coupled to a federal income tax bracket — it was tied to the 15% bracket, but now the 12% bracket (up to $78,950 MFJ) and 0% cap gains (up to $78,750) are slightly different and can drift more over time.

      And most Americans will pay state income tax and some will pay county or city income taxes on capital gains, as well.

      Cheers!
      -PoF

      Reply
    • Excellent point — that’s a featured that adds tremendous value to the taxable account. It’s been worth abou $1,400 a year in my working years.

      I’ve added a line to the content above. Thank you for the contribution, Big ERN.

      Cheers!
      -PoF

      Reply
    • Also remember step up in basis on death; especially beneficial to community property spouses.

      And state specific Muni bonds have a place in these accounts as well, although capital gains would still be s/t tax.

      Reply
  4. The 0% capital gains tax bracket would be ideal to shoot for but this is where creating a passive income machine during your working years can actually bump you out of it in a hurry (first world problems).

    I was not aware that if you bump out of the 0% capital gains bracket that your entire gains would not be taxed at the next level. I had assumed the opposite (ie if you were in the top tax bracket, all your capital gains would be taxed at 23.8%).

    Reply
  5. I’m wondering how you know exactly what your taxable income will end up being in any given year so that you exactly (closely) march up to, but don’t cross, that next bracket? Do you wait to make conversions (from tax deferred IRA to Roth) or sale of taxable funds until after you get your W2 but before April 15? TIA!

    Reply
    • If you have ordinary income from investments you don’t know exactly but it tends to track +- 10% each year so you can make a reasonable plan. I Roth converted at 5K under my maximum conversion goal exactly for this reason.

      Reply
    • You should have a pretty good idea based on the dividends you receive, any tax-deferred money you withdraw, and any other taxable income sources. If you work with a CPA or financial advisor, they can help you model this based on previous years and any changes, but you can also do it yourself.

      If you’re well under the limit in taxable income, it would be smart to either do Roth conversions or tax gain harvesting (taking gains and reinvesting to increase your cost basis) to put yourself closer to the top of the 0% tax bracket.

      Cheers!
      -PoF

      Reply
  6. Excellent points.
    Small point: Brokerage accounts are low hanging fruit when it comes to asset protection.
    A little bit of self employment income in “retirement” goes a long way. The 199A deduction gives you more LTCG “headroom” by reducing taxable income. Couple that with the ability to deduct business expenses (and pay no FICA) and you can enjoy very low tax income.
    Recent tax law changes make paying down your mortgage (especially with realized 0% tax LTCG) an excellent investment.
    Remember you can still fund a TIRA and/or HSA and not reduce your QBD,

    https://www.financial-planning.com/news/michael-kitces-managing-long-term-capital-gains-tax
    https://www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/

    https://www.kitces.com/blog/199a-qbi-deduction-production-taxable-income-limit-increase/

    Reply
    • All true. I ended the article with a mention of the asset protection benefits of a Roth IRA over a taxable account, but it probably belongs in the “limitations” section, as well.

      I am glad to have this other thing (the blog) in retirement. It will allow me to fund an individual 401(k) — which I’ll probably start making Roth contributions to next year so as not to lose some of that QBI deduction (as you will with tax-deferred 401(k) contributions). I will also have a health plan with HSA. I won’t actually enact my retirement drawdown plan until I move on from this website.

      And then, who knows what life (and the tax code) will look like?

      Cheers!
      -PoF

      Reply
  7. U mention investing in stocks/funds that dont pay dividends in taxable accounts – surprised you didn’t mention using DRIP’s and that many companies you can simply reinvest any dividend in their stock directly and since u set this up with the company themselves u skip the commission – Am I missing something?

    And not taking advantage of multiple streams of passive income just to stay under 78,750 as a tax play seems shortsided

    Reply
    • You pay tax on the dividend as ordinary income regardless of who’s doing the re-investing. The tax code is quite progressive once you get out of the 12% bracket. The government considers 12% middle class and above 12% rich from a tax perspective and they actually DO soak the rich despite the “fair share” rhetoric. If you have multiple streams and have been maxing out your pretax, once you RMD you will be paying a ton in taxes and RMD itself is progressive so you will be in a progressive tax bracket and a progressive RMD bracket that’s progressive squared, and being in that progressive bracket will kick up your cap gains further increasing your tax bill. That’s how it works. Have a nice retirement paying your taxes.

      There are things you can do to mitigate that reality but you have to plan and begin to implement the plan a decade or two before you retire. If you’re going o retire a tycoon get a good tax lawyer, the boggleheads ain’t gonna save you

      Reply
    • If you’re interested in retirement income, the last thing you want to do is reinvest the dividends. You’ll pay taxes regardless of what you do, so you might as well take that as a portion of your spending money.

      Also, note that we’re not eschewing passive income in this article. It’s quite the opposite. A taxable account can give you plenty of passive income and put you in charge of the tax consequences.

      Would you prefer an asset that paid a 5% dividend and appreciated 4% annually or an asset that pays no dividend and appreciates 10% annually? I’d take the latter 10 times out of 9 and decide how much passive income I want from it each year. I’ve said it before, selling shares beats collecting dividends.

      Cheers!
      -PoF

      Reply
  8. Such a good article. My portfolio consists of 5 accounts in retirement cash TIRA Roth Brokerage and TLH. Brokerage and TLH allowed me to generate cash to live on tax free while I Roth converted allowing for maximized tax efficiency in conversion. I’m leaving a small TIRA to go to RMD which will be mostly in 80% bonds and 20% stocks, very stable and reliable income and the increasing RMD will act like an inflator so I will get a slightly larger payout each year pretty close to inflation, so that account will act as an inflation adjusted annuity. SS taken at 70 is my second source of ordinary income. My brokerage will act as the source that completes my yearly budget and will require about a 2% WR to get the job done. Between SS and the small RMD I will be in the 12% bracket for 15-20 years before I grow into the next bracket and higher taxes. 15-20 years is pretty much my life expectancy. SS + TIRA + Brokereage = my retirement money machine. My Roth is available for self insurance and will get tapped if we get a bad diagnosis like cancer or NDD. If you are married you have 2 end of life scenarios to fund. Roth also protects against high inflation (and SORR to some extent) If I want a new car or a trip to Europe, I just go see Mr Roth it is open to an occasional purchase as well. Tax planning is paramount in retirement and a nice large brokerage + some TLH is just the ticket. You can’t generate TLH unless you own a brokerage account.

    Reply
    • Thanks, Gasem!

      It is important to understand the tax code well in advance of retirement and have a plan to actually access that money. In the early years of my career, I was focused simply on earning good money and investing “for the future.” The latter half of my short career, I’ve put a lot of thought into the logistics of turning my invested dollars and the dollars they generate into an income that I can actually spend.

      I’m happy with the way things turned out, and especially glad that I built my taxable account into the largest account I own — it’s worth more than all tax-advantaged accounts (which I did max out) combined.

      Cheers!
      -PoF

      Reply
      • U da Man PoF for sure. I maxed out my pretax slightly longer than you, to age 50. I already had a brokerage which I started in the 70’s and was able to TLH for many decades resulting in a massive Harvest. At 50 I started investing heavily in the brokerage so I could use it as a source of income to Roth convert. So our plans are similar but the scope of our time frames different. I would have retired a 58 but a business opportunity popped up which I decided to pursue till I retired. It paid well and had benefits including health care that covered out of state children and I had 2 kids in college so what the hell. Your plan is going to fly just fine

        Reply
        • Much appreciated. You’re setting a great example.

          I see a lot of focus on “income” and people don’t seem to realize that with a well-set-up portfolio, you can create the income you need and be in control of how it’s taxed.

          The ACA subsidies also come into play here.

          Cheers!
          -PoF

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  10. This is a great look at an important concept. It seems the way most people talk, if you don’t have a Roth IRA you will never be able to retire. I retired from medicine in 2017 and I don’t have a single Roth product. The Roth products were not available when I started my retirement savings plan. It seems there are more than one way to skin the retirement cat. I’m putting this into my Fawcett’s Favorites this week.

    Dr. Cory S. Fawcett
    Prescription for Financial Success

    Reply
  11. ACA subsidies — yes you may end up with tax free capital gains and dividends. However, in calculating the subsidy, those items are present in the 4X poverty calculation. We file as a married couple and have to keep our income below 67K, otherwise the whole subsidy is gone. For us in California, we’re talking about 20K we’d have to pay back. So, people need to be very careful.

    Reply
  12. You really walked through this very simply and clearly, Thanks! Because of income most of our investments are in taxable brokerage accounts and this is something I’ve been reading as much as I can on. Really well written!
    Also, one of the perks of vanguard is their tax advantaged funds. I use VTCLX in my taxable account. Still some dividends and minimal capital gains but great exposure to the large/mid cap sectors of the market with less tax inefficiency. And I keep my high dividend payers in the Roth.

    Reply
  13. Great Info. Between a pension and social security we will be about $75K or could be more. While most money is in a taxable acct. we do have a TIRA (about $300K between both of us) that will have RMD and boost our income. Was planning to convert some to a ROTH and just curious, if you know, does inheriting money (parents TIRA) count as income? I do know I will have to pay taxes on it. I have not looked into it as this in the future but asking as others may be interested as well. So if I am converting TIRA to ROTH at the time I have this inheritance, that could put be in the next tax bracket or is there a away around that since it is inherited.? (just another reason why I am glad to have more in a taxable vs TIRA or 401. We do have ROTHs) thanks

    Reply
  14. The first married couple example of not paying tax on long term gains ($100,000 – $24,400 standard deduction) gets messed up if they’re retired & getting Social Security. That income means that a % of their SS is added to their taxable income. Maybe 35% of it, maybe more. That means that they’ll owe 15% federal tax on those LT gains. That’s still better than the 22% they’d otherwise have to pay for regular income.

    Reply
    • True. That falls under the “Outside income could foul this up” category. Adjust accordingly.

      The same is obviously true of RMDs, which may be taken at about the same time (ag 70) although the SECURE Act would push RMDs back 18 months to age 72.

      Best,
      -PoF

      Reply

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