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.
What should I put in my taxable brokerage account? ›
The Best Investments for Taxable Accounts
- Municipal Bonds, Municipal-Bond Funds, and Money Market Funds.
- I Bonds, Series EE Bonds.
- Individual Stocks.
- Equity Exchange-Traded Funds.
- Equity Index Funds.
- Tax-Managed Funds.
- Master Limited Partnerships.
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.
Should I hold bonds in my taxable account? ›
If you're in a higher tax bracket and are investing in a taxable account, you'll probably want to keep at least part of your bond exposure in municipal bonds, which have interest payments that are generally exempt from federal (and in some cases, state or local) income taxes.
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.
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.
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.
Should I hold REITs in taxable accounts? ›
REITs and REIT Funds
Real estate investment trusts are a poor fit for taxable accounts for the reason that I just mentioned. Their income tends to be high and often composes a big share of the returns that investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year.
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.
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.
Are treasury tips a good investment? ›
Unlike traditional bonds, TIPS adjust principal and interest payments based on consumer price index changes. TIPS may be advantageous for inflation protection, but they historically underperform stocks in the long run. TIPS are generally seen as a wealth protection tool rather than a wealth-building instrument.
What is the best investment for a taxable account? ›
Individual stocks are, as a general rule, relatively tax-advantaged. Equity index mutual funds and ETFs are generally quite tax-advantaged. Tax-managed equity funds (that is, equity funds that name tax management as an explicit goal) tend to be highly tax-advantaged.
Are taxable accounts worth it? ›
With a taxable account, you may benefit from a lower long-term capital gains tax rate. For example, the same single person under age 50 making $170,000 in 2024 cannot contribute to a Roth IRA, and, assuming they are participating in their company plan, they cannot deduct their contributions to a Traditional IRA.
How to rebalance in a taxable account? ›
With taxable accounts, one way to rebalance is by directing new purchases and reinvested distributions into underweighted asset classes.
Should you hold ETFs in a taxable account? ›
ETFs can be more tax efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account. From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same.
Is it smart to invest your tax return? ›
Investing and building wealth. Investing is a key part of building wealth and saving for long-term goals such as retirement, so using your tax refund to invest can be a great choice. Securities such as stocks and bonds can be used to build a diversified portfolio that can grow significantly over time.
Is it better to invest in a tax-free or a taxable mutual fund? ›
Taxable funds generally have higher returns—nominally. But if the tax on those returns effectively wipes out the additional return, the more optimal choice is the tax-free fund.
Is it better to invest in a 401k or brokerage account? ›
Brokerage accounts are taxable, but provide much greater liquidity and investment flexibility. 401(k) accounts offer significant tax advantages at the cost of tying up funds until retirement. Both types of accounts can be useful for helping you reach your ultimate financial goals, retirement or otherwise.
