My friend’s experience purchasing life insurance really struck a nerve with me. It seems very deceptive to 1) compare the returns of a taxable account with a tax-deferred account when there are other low-cost, tax-deferred vehicles available, and 2) inflate the tax rates and capital gains each year to make your discrepancy even bigger.
These situations prove why you must understand the fundamentals of personal finance. If you do, you won’t get suckered into purchasing something that will hurt you in the long run. Along those lines, today I will cover the need-to-know fundamentals of taxable accounts.
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.
The advantages of using a taxable account
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 like.
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. This lower tax rate may come in handy if you find yourself with a lot of taxable income in retirement.
A word of caution
I would like to make one thing clear: I still prefer tax-advantaged accounts over taxable accounts. In other words, I see much more benefit in maxing out a 401k or company retirement plan and a traditional or Roth IRA before investing in a taxable account.
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.
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.