Smart Ways to Use Taxable Accounts for Retirement and More

How significant are a few additional steps?

For an elite marathoner, a few inspired steps can be the difference between a respectable time and a first-place medal. For a politician, a few more hands to shake and babies to kiss can be the difference between elected official and also-ran. For an architect, a few more feet can be the difference between tall and tallest in the world.

In your own life, there are accomplishments you can attribute to taking those extra steps. These experiences can be an important source of motivation. But, also a reminder to ask yourself occasionally, am I doing all that I can?

If you regularly contribute to a retirement account, have built an emergency fund, live below your means and carry no high-interest debt, then you’re likely doing enough to enjoy a comfortable financial life.

Still, there may be additional steps available to you that can help accelerate progress toward your financial goals. One such step is to take advantage of a taxable account.

Often overshadowed by the benefits of retirement accounts – perhaps, it’s the name – taxable accounts have their own benefits that make them worth considering as part of your overall financial plan.

What is a taxable account?

First, let’s quickly review how taxable accounts work.

A taxable account is essentially a regular investment account that you open through a brokerage firm or with the help of a financial adviser. With a taxable account, you can buy stocks, bonds, mutual funds and various other investments. Unlike a 401(k) or traditional IRA, contributions to a taxable account are made with after-tax dollars.

Now comes the taxable part.

You are subject to capital gains taxes when you sell an investment for more than you originally paid (the cost basis) and when you receive a dividend or interest income. Gains on assets you owned for more than a year are taxed at the long-term capital gains rate, which is 0-20%, depending on your income. Any gains from assets held for less than a year are considered short-term capital gains, which are taxed as ordinary income.

The advantages taxable accounts have over tax-advantage accounts

Retirement accounts certainly offer valuable tax advantages. You can contribute to a 401(k) and traditional IRA with pre-tax dollars, which may be tax deductible. Money in retirement accounts also grow tax-deferred (tax-free in a Roth), meaning you don’t pay taxes until you withdraw the money.

However, tax-advantaged retirement accounts also have limitations.

For one, you are restricted as to when you can access your money. If you make a withdrawal from a retirement account before the age of 59 ½, you may be subject to a 10% early withdrawal penalty on top of the income tax you will have to pay on the distribution. (In a Roth IRA, only earnings are subjected to the penalty.) A similar 10% tax penalty applies to 529 plans when money is used for nonqualified expenses.

With a taxable account, you can withdraw that money whenever you want and for whatever you want. Further, there are no annual maximum contribution limits or income limits. You can invest as much as you want in a taxable account, and anyone, no matter how much money you earn, can contribute to one.

At age 70 ½, the IRS mandates that you withdraw annual required minimum distributions (RMDs) from employer-sponsored plans and traditional IRAs. Failing to take your RMDs can result in a hefty tax penalty. Taxable accounts, like Roth IRAs, are not subject to RMDs.

Altogether, the benefits of a taxable account give you greater flexibility. You can use a taxable account in several to ways to help you save for retirement or other financial goals and manage your tax burden.

Boost your retirement savings

If you’re fortunate enough to have more money to save than is allowed in a 401(k) ($19,500; $26,000 if 50 or older in 2020) or IRA ($6,000; $7,000 if 50 or older in 2020), or earn more than the Roth IRA income limits ($124,000 for singles; $196,000 for couples in 2020), then investing in a taxable account is a good option for further building your retirement savings.

Over time, your additional retirement savings can compound at ever-increasing rates. Those extra funds can help you live some of your larger retirement goals, such as traveling the world or starting a business.

However, make sure you’re already maximizing your retirement account before considering using a taxable to save for retirement.

You also need to be mindful of how you invest. The sooner you anticipate using funds in your account, the more conservative you should be, with a lower percentage of equities. The right mix, however, will depend on your personal situation.

Control your taxes in retirement

A taxable account can play a role in how you manage taxes in retirement. Withdrawals from 401(k)s and traditional IRAs are considered taxable income. So, if you withdraw too much, you could find yourself bumped into a higher tax bracket. Take those funds from a taxable account instead and it’s unlikely your tax bracket will change because it is not taxable income.

Having both taxable and retirement accounts allows you to moderate your tax costs. Since the long-term capital gains rate is likely substantially lower than your ordinary income tax rate, you may be able to withdraw no more than the RMD amount from your retirement accounts and any more you need from your taxable account.

Save for big financial goals before retirement

Without the threat of an early withdrawal penalty, a taxable account is an attractive option for saving for large preretirement financial goals – a home down payment, college expenses, a long vacation, a new car, etc.

These days, traditional bank savings accounts offer low interest rates. So, if you have some time and can afford to take some risk, a taxable account is worth considering for the higher return potential.

Harvest your losses

Tax-loss harvesting is a way to sell your losing investments to help minimize your taxes. When properly done, you can sell investments that have lost value to offset up to $3,000 in ordinary income. But don’t look to your retirement accounts to harvest any losses. Because the IRS does not tax growth on investments in retirement accounts, they can’t be used to minimize your gains. There are a variety of rules to navigate, so this is best done with the guidance of a tax or financial professional to avoid triggering any unnecessary taxes.

Create a home for your tax-efficient investments

Some investments are inherently more tax-efficient, while others are subject to higher tax rates. Generally, your tax-efficient investments can go into your taxable accounts and your tax-laden investments in your tax-advantaged accounts. A primary example is holding municipal bonds, which generally have tax-free income, in your taxable accounts. This can help reduce your overall investment tax burden.

The bottom line

As with diversifying your investments, there are potential benefits to diversifying your investment accounts. A mix of retirement accounts and taxable investment accounts can give you some wiggle room around taxes and more. It’s one extra step to help you get a little closer to your big life goals – not just your retirement targets. Regardless, with all the rules involved, be sure to work with your financial adviser to determine what mix of accounts is right for you.