Have you heard the term taxable account before?
If not taxable account, perhaps you’ve heard it referred to as a brokerage account or investment account. Through my client interactions, I’ve learned that this is not a well known investing term but nonetheless an important term to understand. Especially for those of you looking to accumulate wealth over the long term.
But before we get into the specifics of a taxable account, it would be helpful to review the other investment account types out there for investors.
Account Type Breakdown
The world of investing can be overwhelming with all the options available to the end user. It’s more than just being ready to invest. Once you make that decision to become an investor, you will then been faced with a series of choices. The first choice is which type of account to open and the second choice is how to invest the funds to reach the financial goal.
So what is the best account to open? The answer is that it depends, it depends on the purpose of those funds and when you plan to use those funds. There are dozens of account types but to keep things simple, I plan to just cover Traditional IRAs, Roth IRAs and taxable accounts. To learn more about 401(k)s, you can check out my previous post on this employer benefit here.
Traditional IRA
Starting with the traditional Individual Retirement Account (IRA) because this is the type of account most consumers are already familiar with via their employer 401(k).
Yes, that’s right, Traditional 401(k)s have the same tax characteristics as a traditional 401(k) but we will get to that in a minute.
For starters, the purpose of a Traditional IRA is to accumulate funds for retirement. The funds in these accounts are not accessible to the account owner until after age 59.5 without penalty. The penalty should not be cause for concern if the owner is using the account correctly and only contributing and investing dollars intended for long-term retirement expenses.
Now lets talk taxes. You’ll find that the difference between the accounts covered in this post is that tax treatment of each account. The Traditional IRA is funded with pre-tax dollars. This means that come tax time, your taxable income is reduced by the amount contributed to the Traditional IRA. In 2019 and 2020, the contribution limit is $6,000 with a $1,000 catch-up for account owners over age 50. The dollars go into this account pre-tax, grow tax-deferred, meaning the capital gains in the account are not tracked or taxed, but that’s where the tax breaks stop. At distribution, the account owner must pay taxes on every dollar pulled out of the account and is taxed at their marginal income tax rate.
Given the tax characteristics, this is a fantastic account to start saving into for retirement. One thing a Traditional IRA has has working against it is the annual contribution limit. For some folks, only saving $6,000 per year into an IRA account may not be sufficient to meet their retirement goals.
Roth IRA
The Roth IRA is similar to the Traditional IRA in that it is also an account that was created to help folks save for retirement. Like the Traditional IRA, the funds in a Roth IRA are not accessible without penalty until age 59.5. There are some exceptions to this rule if the account owner wants to tap the funds in this account before age 59.5 but rather than confuse you all by covering it here, I will direct you to a helpful article if you want to learn more.
That is where the similarities between a Roth IRA and Traditional IRA stop. The tax treatment is the dollars in and out of Roth is the exact opposite of the Traditional IRA. Contributions into a Roth IRA are after-tax, meaning you are taxed on these dollars (think after-tax income) but the taxes stop there.
The beauty of a Roth IRA is that once contributed, under today’s rules, those dollars will grow tax-free. That’s right, tax-free and for the rest of your life! This means at distribution, zero taxes are owed to the government. Given the tax treatment of this account, there are many planning opportunities that owners can take advantage of to improve their lifetime tax efficiency. One of these strategies is called a Backdoor Roth Contribution but I’ll be sure to write more on that at a future date, stay tuned.
Again, a Roth IRA is a great account to support retirement goals but that downside is the annual funding limit. Similar to a Traditional IRA, account owners are limited to contributing $6,000 with a $1,000 catch-up contribution for 2019 and 2020. And this contribution limit applies to Traditional and Roth IRAs collectively. Said another way, you cannot contribution $6,000 to a Traditional IRA and $6,000 to a Roth IRA. You must pick on to contribute the full $6,000 into one account or split the $6,000 contribution between the Traditional and Roth accounts.
Taxable Account
Last but certainly not least, is the taxable account. As I mentioned, I find that the folks I meet with are less familiar with this type of account. My personal diagnosis of this problem is that people think of investing for retirement only and that is not true. The beauty of a taxable account is that there are no age restrictions or penalties when making distributions from the account which allows this account to be very flexible. Taxable accounts can be used to invest funds earmarked for a home purchase, a major expense like a new car or toy and also retirement. The possibilities are endless!
From a tax perspective, this account is treated differently than the previous accounts. Funds are contributed after tax (think after-tax income) and are then taxed along the way. Don’t worry it isn’t as bad as it seems!
When you look at investment returns there are two sources of that return, the interest and dividends generated by the underlying investments and capital appreciation. Each source of return is taxed separately and at different times. The income and dividends are taxed each year as paid to the investor and are taxed at the investor’s marginal tax rate, unless they are qualified.
The capital gains are not taxed until they go from being an unrealized gain (still invested) to a realized gain after the underlying investments are sold to support the financial goal. Capital gains are taxed based on how long the investment has been held. Short-term gains, held less than one year, are taxed at the investor’s marginal tax rate. Long-term gains, held over one year, are taxed a preferred rate of either 0%, 15% or 20% depending on the investor’s taxable income. This preferred tax treatment is the good news if you are a long-term investor.
If all this sounds confusing and hard to track, don’t worry. The investment custodian is responsible for tracking all these factors of return and provide a tax document around tax-time to ensure these items are reported properly for taxes.
While the tax treatment of taxable accounts can be confusing, taxable accounts are great because there are no restrictions as it relates to contributions and distributions like the IRAs. In simple terms, a taxable account is a savings account that can be invested in the stock market. The account has the ultimate flexibility and can be used for any financial goal.
What Account Should You Fund?
Now that you have a better understanding of the investment account landscape, what is the best account to use? I’ve created the chart below to help you navigate this decision based on the purpose of the funds and the timing of the goal.
Once you’ve identified the type of account you need to open, you are on your way to investing! The next step is to find a custodian, if you don’t already have one, and implement the investment strategy that matches your goal(s).
As always, if you have any questions on anything discussed or navigating the account opening and investment implementation process, feel free to reach out.
Happy Investing!
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