I was hanging out in my hospital physician lounge during lunch recently and was chatting with a few colleagues. As the conversation steered towards our economy and personal finances, one of the older docs brought up the question on how to best invest his money left in his bank account at the end of the year after maxing out his 401k and IRA. To which I immediately responded, “open a taxable account and invest in index funds!” When I was met with a blank stare, I came to realize that he had no idea what a taxable account is. Then it occured to me that most people probably don’t know what a taxable account is even though some of my readers may already invest in one.
A taxable account is also known as a brokerage account or a post tax investment account. As the name would suggest, the investment in this account uses post tax dollars (i.e. your paycheck) to invest in the market. For vast majority of people who are investing his/her money, if the investment is not pre-tax (e.g. 401k or IRA), it’s probably in a taxable account.
So what do you need to know about a taxable account investment? First, the growth from this money you invest in will be taxed when you take it out and only when you take it out. All the growth is tax free as long as you leave the investment alone. Second, If you invest longer than a year, the tax rate is called long term capital gains tax rate which is different (and lower) than your federal income tax rate. Third, your initial investment amount (i.e. contribution) is not to be taxed again at withdrawal because it’s already taxed prior to your investment.
So why are people using taxable accounts? Let me name 2 serious advantages in using a taxable account over a retirement account.
- 100% liquidity: I rank this as the most advantageous characteristic of a taxable investment account. Since this money is invested post tax, the government can’t touch the investing principal or even tell you what to do with it or when to get to withdraw it (unlike your retirement accounts), etc. It is a good account to use to bridge the gap between your early retirement and age 59 ½ when you get to withdraw from your retirement accounts. It’s also super useful if you need money urgently.
- Tax rate arbitrage on the compound interest accumulated: Unlike your traditional 401k or traditional IRA where the growth (and the initial investing principal) are taxed at the rate of federal income tax rate, your investment growth in a taxable account is taxed at long term capital gains tax rate and principal is tax free on withdraw. Why is this important? Let me outline a scenario for you. Remember our teacher Jenny in my previous posts? Let’s say Jenny invested in a taxable account all her life and is ready to retire. Table below lists her total assets after 20 and 40 years of investment.
|Taxable account||total contribution||capital gains|
|Jenny’s nest egg after 20 years||$520,926.66||$240,000.00||$280,926.66|
|Jenny’s nest egg after 40 years||$2,624,813.40||$480,000.00||$2,144,813.40|
As you can see that majority of Jenny’s post tax investment account is going to be capital gains after 20 or 40 years of investment. All that capital gains will be taxed at withdrawal at long term capital gains rate.
|Long-Term Capital Gains Rate||Single Taxpayers||Married Filing Jointly||Head of Household||Married Filing Separately|
|0%||Up to $38,600||Up to $77,200||Up to $51,700||Up to $38,600|
|20%||Over $425,800||Over $479,000||Over $452,400||Over $239,500|
Data source: Tax Cuts and Jobs Act of 2017
As you can see from the table above, even if Jenny decided to withdraw $1million dollars one year (the highest income tax bracket), she will only be taxed at 20%. That’s equivalent in effective tax rate to someone earning $80,000 a year! In other words, that’s $1,000,000 and $80,000 taxed at the same rate!
With all that said, Jenny, our financially shrewd high school teacher will know better than withdrawing a million dollars in a year. It is still better to contribute to her 401k for someone who is likely to spend 30-40k a year in retirement.
What do you think? Do you have a large taxable investment account? Want to learn a little more about the advantages of a taxable account? Keep following me on my next post: 5 more reasons to invest in a taxable account.
Do you find personal financial management stuff boring? Are you sending a paycheck to your financial advisor and let someone else “taking care” of you? Perhaps you should read my previous article on why that’s a bad idea and why it’s important that you should have basic personal financial literacy.
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