Hey all!
Sorry I’ve been away for a little bit. Ben and I were in Germany celebrating my brother’s wedding! I thought I would have been able to get a post out before I left, but getting everything squared away for the trip disrupted those plans.
No need to worry though; I’m back and ready to write again.
Last week, I discussed options for taking advantage of tax-deferred and tax-free retirement accounts, even when you exceed the income limits. I also want to highlight another option for investing excess funds outside of your workplace retirement plans: the taxable account.
Today I will cover the need-to-know fundamentals of taxable accounts. And on Friday, I will discuss how to get the most out of them.
What is a taxable account?
Simply put, a taxable account is an account where you have to pay income tax at the time of a taxable event. Usually a taxable event involves selling an investment, whether a stock, bond, or mutual fund.
Selling causes a taxable event because at the point of sale you have either created a gain or a loss for yourself. You determine the gain or loss by taking the difference between how much you paid for the investment (your basis) and what you sold it for.
If you sold it for more than you paid, you had a gain. If you sold it for less than you purchased it for, you had a loss. Either way, you have to deal with the tax consequence as a soon as this sale happens, hence the name taxable account.
In addition to selling an investment, you can also experience a taxable event by receiving a dividend from a stock, a coupon payment from a bond, interest on a money market account, or a mutual fund simply selling one of its investments (mostly done in actively-managed mutual funds). All of these events create income that must be claimed on your tax return if that income isn’t sheltered within a tax-advantage vehicle, like a 401k or IRA. When you invest in a taxable account, you always have access to your funds. You can buy or sell investments at any time. By contrast, you incur a 10% penalty on any funds you take from a 401k or IRA, unless you’re over 59 ½, or meet one of the exceptions to the rule. With the Roth IRA, you also can’t tap the earnings until you are 59 ½ and have had the account for five years (although with a Roth you can take out your contributions at any time). The lack of restrictions make taxable accounts appealing investment tools because you can do whatever you want with the money, whenever you feel like it.
Taxable accounts can also provide some diversification in your investment portfolio, which will allow you to mix and match the kind of income you get in retirement. For example, a taxable account can provide for lower tax rates for investments held for more than a year. (More on the specifics for this on Friday.) This lower tax rate may come in handy if you find yourself with a lot of taxable income in retirement. I would like to make one thing clear: I still prefer tax-advantaged accounts over taxable accounts. In other words, I think you should max out your 401k or company retirement plan and a traditional or Roth IRA before investing in a taxable account. Even in this introduction, you can see a lot more thought needs to go into investing in a taxable account. However, with the right amount of effort and a good advisor on your side, a taxable account could be a great supplement to your retirement account.The advantages of using a taxable account
A word of caution
I think this mainly because in the investing world, the most important thing you can do after choosing the appropriate asset allocation is to minimize costs.
You can reduce costs by choosing investments with low expenses and avoiding the taxable events in your portfolio. By minimizing these costs, you can keep more of your money in your account and let compound interest do the rest of the work for you.