Saturday Selection: The Taxable Investing Account
This classic post from Dr. Jim Dahle originally appeared on The White Coat Investor.
A “taxable” account or non-qualified brokerage account is often viewed in a poor light, but it really deserves a much better name. More than half of my retirement assets now reside in our taxable account and I pay little in the way of taxes on it.
cash-value life insurance (whole life, universal life, variable life etc) or variable annuities in order to protect themselves from those awful taxes. But the truth of the matter is that accounts like that cost you so much that the costs outweigh the tax benefits.
Most doctors would be far better using a good old taxable account. Now, nobody actually calls it a “taxable account”, and you can see why. Who would want a taxable account? But that’s what any brokerage or mutual fund account is that isn’t in some type of retirement plan. It is “fully taxable.” But what does that mean?
It turns out there are a lot of advantages of a taxable account, including tax advantages. They definitely should not be ruled out as a good way to invest for retirement and other expenses, especially once you’ve maxed out IRAs, 401(k)s, etc… for the year. Let’s look at the advantages:
Advantages of a Taxable Investing Account
You can get at the money anytime you choose and spend it on anything you want, with no restrictions. You don’t have to wait until you’re 59 1/2, you don’t have to spend it only on education, and you don’t have to borrow from it to access the funds. If you change your mind about saving it, and decide you just want to blow it on a boat, you can!
2) Low cost.
You can buy stock/ETFs at many brokerages for basically no commission. If you go directly to a mutual fund company, particularly a low cost one like Vanguard, you can buy their lowest expense index funds. Your investment expenses could be as low as 0.04% of your stash, or $4 for every $10,000 invested. That’s pretty darn cheap. Remember, in investing, you get what you DON’T pay for.
You probably shouldn’t, but if you wanted to you can get a “margin” account, which allows you to use leverage to magnify the upswings (and, unfortunately, the downswings) of your investments.
4) Reduced Dividend Tax Rate.
When your investments pay you qualified dividends (most stock and stock mutual fund dividends), you get to pay taxes on it at a lower rate than usual. In fact, if you are in a federal tax bracket lower than the 25% bracket (think resident or military doctor) your tax rate on dividends is 0%. Can’t beat that with a stick. For the rest of us, the rate is 15%. Far better than the 28-35% bracket most of us are in.
5) Reduced Long-Term Capital Gains Tax Rate.
When you sell an investment that has appreciated in value, you have to pay taxes on the increase in value. But if you held the investment for at least a year, you get a reduced tax rate on them. Again, if you are in the 10% or 15% bracket, your rate is 0%. If in the 25-35% brackets, your rate is 15%. Of course, if you sell in less time than a year, you have a short-term capital gain, which is taxed at your regular tax rate.
6) Tax-efficient investments are available.
At a mutual fund company such as Vanguard, you can buy investments that are naturally tax-efficient such as tax-managed funds and index (especially total market index) stock funds. These funds pay out relatively low amounts of capital gains and dividends each year, instead using those funds to increase the value of your shares — which you don’t pay taxes on until you sell.
Stocks that don’t pay dividends are also extremely tax-efficient. Microsoft, for instance, didn’t pay out dividends for years. Warren Buffett’s company, Berkshire-Hathaway, also doesn’t pay a dividend. So you don’t pay taxes until you sell. You can defer your taxes until you are in lower brackets in retirement.
That sounds a bit like an IRA. Of course, an IRA gives you a tax break up front (which a taxable account obviously doesn’t.) However, the IRA also makes you pay taxes at your regular income tax rates, rather than the lower capital gains rates when you cash out. You can also buy “munis” or bonds issued by municipal governments. The interest on these bonds isn’t taxed by the federal government or by the state they are issued in. These bonds generally pay a lower rate of interest than regular bonds, but if you’re in a high tax bracket, the after-tax rate is usually higher for the municipal bonds. Even bonds issued by the US Treasury offer a tax break when held in a taxable account — you don’t have to pay state taxes on their interest.
7) Tax-Loss Harvesting.
This concept takes a bit to wrap your head around the first time you hear of it. But if you persist, it will be worth your while. We already mentioned how Uncle Sam will tax you if you make money investing. But Sam is also generous, in that he will share in your investment losses, at least within a taxable account.
If you lose money on an investment, you can deduct your losses on your taxes. Each year you can deduct up to $3,000 of your investment losses from your regular income. If you’re in the 33% bracket or so like most docs, that’s an extra $1000 in your pocket. Sure, you lost $3,000 to get $1,000, but at least you get something, right?
Now, here’s the fun part. Nobody likes to sell a good investment just because it is down. With tax-loss harvesting, you exchange one investment in which you have a loss, for another which is similar, but not identical.
So you didn’t sell low, and you still get the tax deduction. Each year you can use capital losses to cancel out all your capital gains, plus $3000 of regular income. If you can’t use all your losses in one year, you can roll them over to the next until you use them all up. Just be careful to avoid violating the wash sale rule, which says that if you buy a stock (or fund) again within 30 days of selling it that you don’t get to deduct the loss.
8) Step-Up in Basis At Death.
Stocks and stock mutual funds in a taxable account are awesome estate planning tools. Here’s how it works. You buy a stock when you are young. You hold onto it your whole life and it appreciates and appreciates in value. If you sold it the day before you died, you would pay a huge capital gains tax. If your heirs sell it the day after you die, no taxes are owed.
Pretty cool trick, huh? Their basis, or as far as the IRS is concerned, the amount they “bought it” for, is reset on the day of your death. So even if you bought it at $10 a share, if it is $500 a share the day you die, that’s what the IRS thinks your heirs bought it for.
This is another cool trick, especially if you regularly give to charity. When you give an investment directly to a charity (most large charities are set up to do this), three interesting tax benefits show up. First, you don’t have to pay taxes on the gains. Second, neither does the charity. And third, you get to deduct the entire gift on your taxes. So instead of increasing your taxes, your taxes actually went down.
It is far better for you to give appreciated stock to a charity than cash. So, if you’re really slick, you buy investments in a taxable account, and if the value goes down you tax loss harvest it. Then, when the value goes back up, you give it to charity. You were planning to give the money anyway, so no loss there, but you get to donate not only the loss, but also the entire value of the donation. This allows you to either keep more money, or give more money to charity. Who says Uncle Sam never does anything nice?
10) Foreign Tax Credit.
If you hold an investment in a foreign country, such as an international stock fund, the fund has to pay taxes to the foreign country on some of its gains. You can deduct these taxes on YOUR taxes, but only if you hold the investment in a taxable account. If you hold it in a 401K or IRA you’re just out the money used to pay those taxes.
So before you let some financial “adviser” talk you into some rotten investment to save you some taxes, remember that even a plain old taxable account has a lot of tax advantages. (Caveat: You should still max out your IRAs and 401(k) before investing in a taxable account, most of the time.)
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PoF: I take advantage of nearly all of these in my now 7-figure taxable account. I don’t use margin and I haven’t died yet, but I can check the rest of the boxes.
Last year, I was able to tax loss harvest to the tune of about $40,000 or 13 years worth of $3,000 deductions.
Editor’s note: I changed the TLH section from the original post which talked about selling one company’s total stock market fund and buying a different broker’s total stock market fund. If they are tracking the same index, such an exchange could qualify as substantially identical. It may be a gray area, but I feel it’s best to avoid those when you easily can by buying a fund that correlates extremely well, like the S&P 500 index.