The best way to plan for your future is to open an investment account. You have options, including tax-advantaged and taxable account investments. Taxable accounts don’t have the same tax advantages as tax-deferred accounts, such as retirement accounts, but they have their benefits.
Here’s everything you should know about taxable account investments and how they can help your financial goals.
What Is a Taxable Investment Account?
A taxable investment account is an account anyone can open and use for any purpose. You’ll pay applicable taxes if you buy or sell assets from a taxable investment account. There typically aren’t any rules regarding how much you can invest or what you can trade because you’ll pay taxes as you go, unlike tax-advantaged accounts, such as a 401K or IRA.
Taxable accounts are easy to open with minimal requirements, and you can own most assets in them, including the following:
- Mutual funds
When you trade assets in a taxable investment account, you must report the trade on that year’s tax return, paying the appropriate capital gains or taking a write-off for the loss.
The good news is that there are still ways to get around the taxes or at least minimize them. The key is to have a tax-efficient investing strategy that starts with understanding capital gains, dividends, and income tax brackets.
What Is a Capital Gain?
Capital gains are profits made on an investment. The goal for most investors is to buy low and sell high, the difference of which is the capital gains. The type of capital gains determines your income tax rate.
- Short-Term Capital Gain: Short-term capital gains are gains earned on investments you held for less than one year. So if you bought a stock on February 1, 2022, and sold it on September 15, 2022, you’d pay your short-term capital gains tax bracket on the earnings. Short-term capital gains tax rates are between 10 and 24%. The percentage you pay depends on your tax filing status and the amount earned.
- Long-Term Capital Gain: Long-term capital gains are gains earned on investments you held for over one year. The tax rate is between 0 – 20%, and like short-term capital gains, the percentage you pay depends on your tax filing status and the earnings amount.
5 Best Investments for Taxable Accounts
No two investors will use the same tax-efficient investments because each investor has different goals and risk tolerances.
Remember, Uncle Sam always wants his portion of the cut. So you’ll pay taxes if you earn dividends from a stock, interest from an investment account, or other distributions from an investment. You’ll also pay taxes each time you sell a stock or other asset for a profit.
Tax-efficient investments are those you’ll hold for more than a year to get the long-term capital gains tax rate that you won’t trade often. The longer you buy and hold investments, the less money you’ll lose to taxes.
Here are some of the most tax-efficient investments to minimize your tax liabilities:
Stocks can be a great option in a tax-efficient investing strategy if you use them correctly.
First, try investing in stocks you’ll hold for at least one year. This ensures you’ll pay long-term capital gains taxes, a lower percentage than short-term capital gains. You only pay taxes on the stocks you own when you sell them and when there’s a profit.
If you prefer to buy and sell stocks often, it’s best to do it in a tax-deferred account, such as an IRA. You won’t pay taxes on any capital gains in this account until you withdraw the funds. This allows you to invest how you want but not get hit with tax burdens immediately. The goal is to pay a lower tax bracket during retirement, so you keep more of your earnings.
Another option to lower your tax liabilities when buying and selling stocks is to time when you trade them.
Examples of When You Should Sell Stocks with Large Capital Gains:
- In a year when you have lower tax liabilities, the taxes on capital gains won’t make your tax burden seem so high
- In a year when you had capital losses (lost money on stocks) as they can offset the taxes owed on the capital gains (tax-loss harvesting)
Remember, any dividends, interest, or other income earned from anything other than buying or selling stocks will trigger a tax liability. There’s nothing you can do to put this off, so keep it in mind as you decide when’s the best time to sell stocks for a capital gain.
However, taxes on qualified dividends are friendlier than short-term capital gains. Investors typically pay 0%, 15%, or 20% on dividends, depending on their tax filing status and the amount earned.
Qualified Dividends Meet the Following Requirements:
- A US or qualifying foreign entity pays the dividends
- The IRS considers the payment a dividend (no insurance premium kickbacks or credit union annual dividends)
- You held the asset long enough, usually 60 days in the last 121 days
2. REITs (Real Estate Investment Trusts)
REITs or real estate investment trusts are shares of a real estate company you own. The real estate company buys, manages, and sells commercial real estate. REITs must pass down at least 90% of their profits to shareholders as dividends.
The difference, however, is the distributions or dividends often don’t classify as qualified. So, unfortunately, you’ll likely be taxed at your ordinary tax rate.
There’s a loophole, though. REIT investors can deduct up to 20% of ordinary dividends received from a REIT. This automatically reduces your effective tax rate, decreasing your tax liabilities.
3. Tax-Managed Funds
Tax-managed funds are funds managed with tax-efficient strategies in mind. They are often mutual funds but not actively traded mutual funds. Here’s the difference.
Fund managers actively trade mutual funds to earn capital gains. But, unfortunately, each capital gain triggers a tax liability for investors. So while the earnings might be nice, the tax burden isn’t as nice.
Tax-managed funds offer an alternative if you’re looking for a tax-efficient strategy. While they are mutual funds, the fund manager’s goal is to minimize tax liabilities.
Tax-managed funds hold onto investments long-term to give investors access to the lower tax brackets. They also avoid dividend-paying stocks and focus on tax-loss harvesting techniques.
This means fund managers time the sale of certain profitable assets with the sale of assets with a loss. The loss offsets the gains, lowering your tax liability.
If you’re worried about your tax liabilities, you can also time the sale of your tax-managed funds in a year when your tax burden is lower.
4. Municipal Bonds
Municipal bonds are loans to government entities to fund projects to help the general public. They pay interest throughout the bond’s term, and you receive a return of principal when the bond matures.
Unlike most interest payments, municipal bond interest is tax-exempt at the federal level and may be exempt from state and local taxes depending on where you live.
Municipal bonds don’t pay high yields, but their tax advantages offset the lower interest rates. You’d have to earn a much higher yield on taxable bonds to get the same return.
Municipal bonds are a great way to offset the tax burden on other capital gains. Plus, they give you a conservative investment to balance your portfolio.
5. ETFs (Exchange-Traded Funds)
ETFs are well-diversified investments. They can include investments of all types, including stocks, bonds, and other commodities. You can invest in ETFs by theme or choose an ETF that mimics an index, such as the S&P 500.
ETFs are passively traded investments, so there are fewer capital gains to worry about when filing your taxes. In addition, unlike mutual funds, most ETFs don’t distribute capital gains, so you only pay taxes when you sell your shares.
Like stocks, if you hold the investment for over a year, you’ll pay long-term capital gains taxes, reducing your tax liability.
Tax-advantaged accounts are accounts with tax benefits. If the account is tax-deferred, you get a tax deduction for the year you make the contributions. As a result, your contributions and earnings grow tax-free, but you pay taxes on the profits when you withdraw them.
A common example of tax-advantaged accounts with tax-deferred earnings is a traditional IRA.
You get the deduction for your contributions in the year you contribute, and your earnings grow tax-deferred. Then, when you withdraw the funds during retirement, you pay the tax bracket when you withdraw the funds.
Another tax-advantaged account is the tax-exempt account. The contributions you make to tax-exempt accounts are after-tax. However, the contributions and earnings grow tax-free, and withdrawals may be tax-free. This is only applicable if you use the funds for the intended purpose.
A few tax-exempt accounts include the following:
- Roth IRA – If you withdraw funds after 59 ½, you won’t pay taxes on the contributions or earnings
- 529 Savings Plan – If you use the funds for qualified educational purposes, you won’t pay taxes on the withdrawals
Most tax-advantaged accounts have contribution limits or strict guidelines regarding how to use the funds.
Maximize Your Bottom Line While Minimizing Taxes
When choosing your investments, it’s important to consider the tax liabilities they will incur. With the right strategy, you can maximize your bottom line while minimizing taxes.
Importance of Tax-Efficient Investing
Tax-efficient investing is important to protect your bottom line. Without tax-efficient investing, you decrease your earnings by the amount you pay in taxes, and you lose the potential growth those earnings could have had.
Tax-Efficient Investment Strategies
To minimize your tax liabilities, consider these tax-efficient investment strategies:
- Allocate as much of your investments to tax-advantaged accounts up to the contribution limits
- Invest in passively managed funds, such as ETFs, to limit the amount of capital gains actively earned
- Add bonds to your portfolio because they are tax-exempt at the federal level, and many state and local governments offer tax breaks too
When to Choose a Taxable Investment Account?
Sometimes, a taxable investment account makes more sense than a tax-advantaged one. If you’ve maxed out your contributions for your retirement accounts, you’ll have no choice, but here are a few other reasons to choose a taxable investment account.
1. Additional Liquidity
You don’t have to provide reasons to access your funds in a taxable account. If you cash in your assets, you pay the appropriate taxes and can use the funds how you want.
If you invest only in tax-advantaged accounts, you may face age or use restrictions for your funds. For example, you shouldn’t touch the money in an IRA or 401K until age 59 ½. If you do, you’ll pay your current tax rate plus a 10% penalty on the funds withdrawn.
If you withdraw funds from an HSA or 529 Savings Plan and use the funds for something other than medical expenses and education expenses, respectively, you may owe taxes and penalties on the funds.
Taxable investment accounts don’t have these restrictions. You can use the funds for similar reasons, such as retirement or medical purposes, or use them for anything else, such as buying a house or a car.
2. More Saved for Retirement
If you’ve maxed your retirement accounts but want more money saved for retirement, you can invest in a taxable account. You won’t get the same tax benefits, but you’ll have more freedom with the funds.
This works well if you retire early. However, since you can’t access retirement funds early without paying the penalty, it hurts your overall retirement income. With a taxable account, you can do what you want with the funds and not pay any penalties.
3. More Investment Options
Taxable investment accounts allow more freedom in choosing your investments. IRAs and 401Ks restrict your choices to what the brokerage offers. With a taxable investment account, you can invest in the basics, like stocks, bonds, and commodities. But you can also invest in gold, crypto, real estate, or any other assets you want.
There aren’t any restrictions because you control the investments you choose, giving you more opportunities to grow your portfolio.
4. Maximizing Inheritance
New laws require beneficiaries to withdraw all funds from inherited retirement accounts within ten years of receiving them. This could leave your heirs with a significant unexpected tax burden.
Instead of passing on your retirement accounts, you can pass on your taxable accounts. Then, while alive, you can use your retirement funds (after age 59 ½) and easily pass any money left in your taxable accounts to your beneficiaries without the same tax rules.
When you die, your beneficiaries inherit the taxable accounts, and any earnings are wiped away regarding taxes. The only taxes beneficiaries pay on inherited investments is their earnings from the date they inherit the account (the date you pass) to when they sell the assets.
5. Avoid Retirement RMDs
The IRS has Required Minimum Distributions on all retirement accounts except for Roth accounts. Therefore, by age 72, you must take distributions from your retirement accounts in an amount suitable to the IRS.
If you aren’t ready to take the withdrawals, you could incur a larger tax burden than anticipated, leaving you with fewer funds.
Taxable investment accounts don’t require this, so you can leave the funds untouched as long as you want without incurring unplanned tax burdens.
6. Greater College Saving Flexibility
Taxable investment accounts can be a great addition to a 529 Savings Plan. Funds from your 529 Plan may only cover qualified educational expenses. This usually doesn’t cover everything, so your taxable account can cover the costs that don’t fall under the qualified educational expenses.
Money in a 529 will also incur penalties and taxes if you don’t use the funds for qualified educational expenses; taxable accounts don’t have this issue.
Frequently Asked Questions
Taxable investment accounts have their time and place. They are often a good accompaniment to other tax-advantaged accounts, so it’s important to include one in your portfolio.
Exactly how are individual taxable accounts taxed?
Your taxable accounts are taxed at your current tax rate based on the type of earnings. Qualified dividends, regular dividends, and short-term and long-term capital gains each have different tax brackets. You claim your capital gains and losses on your tax return and pay the applicable taxes.
What are the benefits of a taxable brokerage account?
Taxable brokerage accounts have more flexibility than tax-advantaged accounts. You can use the funds; however, you need and control when and how much taxes you pay if you use a tax-efficient investment strategy.
There aren’t restrictions on when you can withdraw the funds or how you use them, and you can invest in a larger number of assets that may not be available in other accounts.
Should I use a robo-advisor or an online discount broker?
If you want a hands-off approach to investing, a robo-advisor is a great option. You answer a few questions when you open the account, fund it, and the robo-advisor does the rest. It chooses your investments, creating a well-diversified portfolio based on your risk tolerance, financial goals, and timeline. Most robo-advisors also automatically rebalance your portfolio as needed.
An online discount broker is a better option if you prefer to be more hands-on or have a DIY investment strategy. You can buy and sell as needed and make your own decisions. However, it requires more effort on your part.
How do you open a taxable investment account?
You can open a taxable investment account online or in person with a brokerage. Today, hundreds of online brokerage options offer discount prices, and many offer zero trading commissions.