In a previous chapter, we spent time on the concept of tax-advantaged investing. The idea with tax-advantaged investing is that there are special investment accounts that enjoy tax advantages, such as tax-deferred growth, deductible contributions, or tax-free distributions. These accounts are popular for retirement savers because of these advantages; however, they all have one major disadvantage: contribution limits.
What Are Taxable Accounts?
This is where taxable accounts come in. Taxable accounts can also be referred to as “non-qualified” accounts, but it’s a technical term that’s much broader in scope. For simplicity, we will discuss only taxable accounts here.
Taxable accounts are any basic account that doesn’t qualify for special tax advantages. For example, plain old checking and savings accounts are taxable, an investment brokerage account is taxable, and even money under your mattress is considered taxable. (Just don’t tell anyone who knows your address that you do that.)
Pros and Cons of Taxable Accounts
There are two key advantages with taxable accounts: no contribution limits and no withdrawal limits.
As I implied above, taxable accounts aren’t subject to contribution limits, so they can be a great place to invest retirement money that exceeds what can be put in a 401(k), IRA, or other traditional retirement vehicles.
One of the other big advantages of non-qualified accounts is the ability to access the money without government tax penalties prior to retirement. While qualified accounts often have tax penalties designed to encourage people to leave the money alone for retirement, taxable accounts don’t have these restrictions. This attribute makes these accounts good for intermediate goals. If I want to save money for a vacation home, a boat, a car, or any other big-ticket item, the non-qualified account is probably the way to go.
The downsides of taxable accounts are that they don’t qualify for tax-deductions on contributions, are subject to creditors, and taxes may have to be paid on growth (more on this below).
Here’s a chart to help compare some of the key differences between the most common accounts:
|IRA/401(k)||Yes||Tax deductible||Taxable|| |
Contributions limited, early withdrawal penalty before 59 1/2, income limits
|Roth||Yes||After-tax||Tax-free||Contributions limited, early withdrawal penalty before 59 1/2, income limits|
|Taxable||No||After-tax||Taxed at capital gains rates||None|
In a taxable account, the interest earned on the money in the account is taxed—in most cases—in the year that it’s earned. Exceptions include accounts with imputed interest and some insurance products. If I have an investment account that holds government bonds, corporate bonds, money market accounts, or other investments that pay out interest, then I have to pay taxes on that interest even if the proceeds are reinvested back into the account. Those taxes are paid at the highest marginal rate to which I am subject.
For this reason, these accounts are often called “pay as you go” accounts. You’re paying taxes on the account each year, as opposed to having tax-deferred growth like in retirement accounts and other special accounts. These taxes slow the growth of the account, making them less tax-efficient.
Here’s how it works. All the money you put into the account is considered your basis, and you can always withdraw the basis tax-free, because you put it in after-tax. Then, your basis increases over time because the interest, dividends, and capital gains (from sales of securities) that the account generates each year are taxable in the year they are created. As you pay taxes on these, the basis of the account increases.
Then, when you want to withdraw the money, you only pay capital gains tax on earnings above the basis. For example, if the basis is $100,000, the account value is $200,000, and you withdraw $10,000, you’ll only pay capital gains on the portion of that $10,000 that isn’t counted as your basis. There are different ways to account for this, but most people just use the average cost basis method, which divides the basis by the account value and applies it to each withdrawal. So, in the example above, the average basis is ½ (100,000/200,000), so for a $10,000 withdrawal $5,000 would be considered gains and subject to capital gains tax rates.
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Differences in Tax Treatment
Before talking about how we can minimize the taxes in a taxable account, I need to explain two factors that can affect the level of taxes created each year. The first is how the dividends are treated. When the leadership of the company decides to pay part of the profits of that company back as a dividend, that dividend becomes taxable income. Some dividends are categorized as “non-qualified dividends.” (As if this wasn’t confusing enough already.) That would make the dividend taxable at regular marginal tax rates like any other ordinary income. Qualified dividends can be subject to more favorable capital gains rates. The different treatment of dividends comes down to holding periods of the investments.
Another possible difference in how taxation is applied comes down to the holding period of the stocks themselves. If a stock is held in a mutual fund, ETF, or by itself and has a gain over the course of time, there can be different tax treatments. To start off simply, let’s say I own a single stock and it goes up in value. For example, maybe I bought it for $50 and sold it for $60 a share. If that sale took place in less than one year, then I would be subject to a “short-term” capital gain. In this case, I would pay taxes at the same rates at which I pay taxes on ordinary income—my highest marginal rate. If, however, I hold the stock for more than a calendar year, I can get away with paying taxes at “long-term” capital gains rates. In most periods of history, these rates have been lower.
This means that, in general, accounts with more frequent trading will create more taxes each year inside of a taxable account.
What can be done to minimize some of these unnecessary taxes? One strategy is to reduce the number of trading that occurs within the account. In addition to the costs incurred when stocks are bought and sold, these trades can create unnecessary taxation.
One way to keep trading down is to use funds with a low “turnover” rate. Turnover is a measure of the transactions that take place inside a mutual fund or ETF. A turnover rate of 100% would mean that all of the holdings were replaced in the last year. It is not unusual to see fund turnover rates exceeding 60% (or even much higher) in a year in many mutual funds. As you can imagine, this can have significant tax ramifications.
A high turnover rate means that the fund manager believes they can beat the market through stock-picking and market-timing. One of the best ways of determining whether a manager is engaging in this behavior is by reading the fund’s prospectus. I will often read the fund objectives section and look for tell-tale phrases that show the fund manager’s philosophy of investing. If the manager says they are looking for undervalued stocks, selling overvalued stocks, searching for overlooked markets, or using tactical asset allocation, then I am wary about the amount of trading that may take place. I will often see fund prospectuses telling me that the manager takes a “flexible” approach to investing or they are on the lookout for “opportunities.”
If you see those words, run. The evidence is overwhelming that trying to beat the market has been counterproductive for investors. It is possible to get lucky and beat the market over the short run, but long-run outperformance is rare. The fact that it can be detrimental from a tax standpoint is just another good reason to avoid this behavior.
While it’s important to have low turnover in your funds, exactly how low depends on the area of the market the fund invests in, which is beyond the scope of this book. The amount of trading that might be acceptable and the reasons for it are covered in my book Confident Investing. But it is important to note that zero trades can also cause issues.
A portfolio that is never traded can change drastically in risk since historically higher performing asset categories (like small and value stocks) can come to dominate the portfolio. The risk is that these market segments can fall in value without warning and that can be painful if they’ve grown to be a large part of the account value. The other issue is that small companies and value companies often grow to become large or growth companies. When this happens, the overall return expectation of the portfolio can change. If we expect greater returns out of these asset classes and they become a smaller part of the portfolio, then it stands to reason that future returns could be jeopardized.
Taxable accounts can be creatively used to boost income in retirement and even allow for advanced tax strategies, such as Roth conversions, with the help of a qualified financial planner. If you want to give yourself every advantage in building a secure financial future, be sure to investigate the wide array of options of non-qualified accounts. They can be a great addition to a solid financial plan.
By Paul Winkler
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase or sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.