There are a few different ways to build wealth in your 20s, 30s and beyond. Funneling money into tax-advantaged accounts such as 401(k)s and IRAs is a start, but you can only contribute so much every year. Once you hit the contribution limit, you could begin investing in a taxable brokerage account. Before you open one of these accounts, here are a few things to keep in mind.
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1. Contributions Aren’t Deductible
Unlike the money you save in an IRA or a health savings account, your contributions to a taxable investment account can’t be deducted at tax time. If you’re in a higher income bracket, it’s a good idea to completely max out all of your tax-advantaged options before investing through a brokerage account.
2. Tax Loss Harvesting Is Your Friend
When you sell an investment held in a taxable account for a profit, the sale counts as a capital gain. The short-term capital gains rate, which is your regular income tax rate, applies to investments held for a year or less. The more favorable long-term capital gains tax rate applies when you hold an investment for more than one year.
Investors with taxable accounts can harvest their losses to offset their gains. Essentially, this means that you can sell off an investment that’s underperforming and replace it with a similar (but not substantially identical) holding. At tax time, you can deduct your losses and minimize any taxes you owe on capital gains. That’s something you can’t do with a tax-deferred retirement account.
Related Article:4 Ways to Minimize Capital Gains Taxes on Investments
3. Charitable Donations Aren’t Subject to Capital Gains Tax
When you donate an investment from a taxable account to charity, you pay no capital gains tax on any profits that are realized at the sale. Then, you can turn around and deduct the value of the gift on your taxes. As of tax year 2015, the IRS generally lets you deduct charitable giftsup to 50% of your adjusted gross income for the year. That’s a definite plus if your investments have performed well but you need to minimize your tax bite.
4. There Are No Early Withdrawal Penalties
Pulling money out of your 401(k) or IRA ahead of schedule is a bad idea for two reasons. First, if you’re under age 59 1/2, you’ll have to pay a 10% early withdrawal penalty on any money you withdraw unless an exception applies. Second, the distribution may also be subject to regular income tax if it’s coming out of a tax-deferred account. With a regular brokerage account, you can sell off investments at any time without paying an early withdrawal penalty.
5. Some Investments Are Tax-Efficient
Certain investments are better suited for managing your tax strategy than others. Those are the ones you might want to incorporate into your investment portfolio. For example, exchange-traded funds typically have lower turnover rates than actively managed mutual funds. That means that the assets held in the fund aren’t swapped as often, resulting in fewer taxable events.
By regularly harvesting your losses and using tax-efficient investments, you can keep your tax bill as low as possible.
Related Article:What Are Exchange-Traded Funds (ETFs)?
6. Fees Can Eat Into Your Returns
When you invest through a brokerage account, you might have to pay for every trade you execute. The fees that discount brokers charge can run between $5 and $15 per transaction so if you’re buying and selling fairly frequently, those costs can easily add up.
As you’re comparing fees, it’s a good idea to keep an eye on the expense ratios of your various investments. That’s the percentage of your assets that goes toward management fees. The higher that ratio, the more of youryou’ll have to hand over.
Final Word
Taxable accounts offer some advantages over traditional retirement accounts, particularly in terms of flexibility and control. Keeping fees in check and having a clearly defined tax strategy are two ways to make the most of your taxable investments. For help with both of those areas, you may consider hiring a financial advisor.A matching tool like SmartAsset’s can help you find a financial advisor to work with to meet your needs. First you’ll answer a series of questions about your financial situation and goals. Then the program will narrow down your options to up to three suitable advisors in your area. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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FAQs
Investments that are tax-efficient should be made in taxable accounts. Investments that aren't tax-efficient are better off in tax-deferred or tax-exempt accounts. Tax-advantaged accounts like IRAs and 401(k)s have annual contribution limits.
Should you buy tips in a taxable account? ›
Investors hoping to avoid possible tax liability of “Phantom Income,” should consider purchasing TIPS in a tax-deferred account. Investors are urged to consult with their own tax advisors with regard to their specific situation prior to making any investment decisions with tax consequences.
Why should no one use brokerage accounts? ›
If the value of your investments drops too far, you might struggle to repay the money you owe the brokerage. Should your account be sent to collections, it could damage your credit score. You can avoid this risk by opening a cash account, which doesn't involve borrowing money.
Is a taxable account better than IRA? ›
Also known as a taxable account, brokerage accounts do not offer the same tax advantages that IRAs and other retirement accounts do. Instead, any capital gains, interest or dividends that an investment generates within a brokerage account will trigger a tax bill that year.
When should I start investing in a taxable account? ›
There are a few different ways to build wealth in your 20s, 30s and beyond. Funneling money into tax-advantaged accounts such as 401(k)s and IRAs is a start, but you can only contribute so much every year. Once you hit the contribution limit, you could begin investing in a taxable brokerage account.
Why are ETFs better for taxable accounts? ›
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.
Is an ETF better than an index fund for taxable accounts? ›
If you're investing in a taxable brokerage account, you may be able to squeeze out a bit more tax efficiency from an ETF than an index fund. However, index funds are still very tax-efficient, so the difference is negligible. Don't sell an index fund just to buy the equivalent ETF.
Should I put dividend stocks in my taxable account? ›
Stocks and Funds That Pay Dividends
Dividends are not a bad thing, but they are considered taxable income in the year you receive them. If you're invested in stocks or funds that generate a lot of dividend income, your current-year tax bills may be high.
Are mutual funds good for taxable accounts? ›
Key Takeaways. Mutual funds with dividend distributions can bring in extra income, but they are also typically taxed at the higher ordinary income tax rate. In certain cases, qualified dividends and mutual funds with government or municipal bond investments can be taxed at lower rates, or even be tax-free.
What is a better investment than I bonds? ›
Bottom line. If inflation and investment safety are your chief concerns — TIPS and I-bonds deliver both. TIPS offer greater liquidity and the higher yearly limit allows you to stash far more cash in TIPS than I-bonds. If you're saving for education, I-bonds may be the way to go.
Millionaires use brokerage accounts for low-cost index funds. “Buying and holding index funds in a brokerage account, it's possible to keep and grow wealth over the long term,” according to Business Insider.
How much money is safe to keep in a brokerage account? ›
Holding cash here is appropriate if you plan to spend the money within a few days or would like to quickly place a trade. Assets in your brokerage account are protected up to $500,000 per investor, including a maximum of $250,000 in cash by SIPC in the event a SIPC-member brokerage fails.
Is money safer in a bank or brokerage account? ›
While bank balances are insured by the FDIC, investments in a brokerage account are covered by the Securities Investor Protection Corporation (SIPC). It protects investors in the unlikely event that their brokerage firm fails. However, certain rules and conditions apply—and investment earnings are not insured.
Is taxable better than 401k? ›
Taking money from a taxable account can benefit you more than a 401(k). Investors making a withdrawal from a taxable account will owe capital gains taxes on the sale of a security. But those pulling money out from a 401(k) will get taxed at a higher rate for ordinary income.
Should I hold dividend stocks in a taxable account? ›
4. Stocks and Funds That Pay Dividends. Dividends are not a bad thing, but they are considered taxable income in the year you receive them. If you're invested in stocks or funds that generate a lot of dividend income, your current-year tax bills may be high.
Should I hold bonds in a taxable account? ›
Certain bond holdings can be a particularly bad idea for taxable accounts. High-yield bond funds, because they tend to generate (relatively) large amounts of current income, are best avoided in taxable accounts.
What is the difference between a 401k and a taxable account? ›
Moreover, because the 401(k) money has never been taxed, investors owe taxes on the entire withdrawal, not just the appreciation; taxable-account investors, by contrast, will only owe tax on their gains. Finally, 401(k) assets are subject to required minimum distributions at age 73.
