The Hidden Flexibility of Taxable Brokerage Accounts

summary

So often, investors are advised to max out their 401 (k) or 403 (b) retirement plan. Or, investors will read why it’s imperative to contribute to an IRA or Roth IRA. Don’t get me wrong, these are all great accounts, and they will help you save towards retirement. However, there’s an often-overlooked investment account called the taxable brokerage account that can be a powerful tool for investors.

In today’s post, I will discuss the ins and outs of a brokerage account and some high-level investment strategies, should you choose to contribute to this account. Finally, I will review two real-life client situations where having a brokerage account saved my clients thousands of dollars in taxes on their 2024 tax return.

the basics

At its core, a taxable brokerage account is a non-retirement investment account. The non-retirement distinction is important for a few reasons:

1) Taxable brokerage accounts do not carry any age requirements to withdraw money. With 401(k) plans and IRAs, investors have to wait until age 59 1/2 to avoid any “early withdrawal penalty”.

2) Unlike 401(k) plans and IRAs/Roth IRAs, there is no limit on how much money you can contribute to the account in a given year. I’ve had clients deposit $200,000 into their brokerage account due to the sale of their home, or they were the beneficiary of a life insurance policy.

3) 401(k) plans and any IRA allow for ONE account holder only. With a taxable brokerage account, you can either have an individual account or open a jointly-owned account. Often, spouses open a jointly owned account.

In addition to these differences, I’d like to point out a few tax differences between retirement accounts and taxable brokerage accounts:

a) Interest and dividends earned in a specific year are taxed that same year. With retirement accounts, the only taxable event is when you withdraw money from the account.

b) Taxable brokerage accounts are subject to capital gains tax. This type of tax is incurred when investors sell an investment for more than the original purchase price (+/- certain adjustments). However, an investor can sell any fund/investment within a retirement account without worrying about capital gains tax.

Now that we’ve reviewed a few differences between brokerage accounts and retirement accounts, let’s transition into the benefits of using taxable brokerage accounts.

benefits to investors

The financial flexibility that a taxable brokerage account provides to investors is its most significant benefit. As I mentioned earlier, taxable brokerage accounts do not have an age restriction that penalizes an investor for withdrawing money before reaching a certain age. Therefore, taxable brokerage accounts are outstanding for investors in their 30s - 50s who want to withdraw money for a down payment on a house, or to supplement a 529 plan and help cover the remaining costs of a child’s college education.

Beyond financial flexibility, taxable brokerage accounts enable investors to utilize specific tax planning strategies that can save them thousands of dollars in taxes. More specifically, investors can utilize the lower tax rates associated with long-term capital gains and employ the tax-loss harvesting strategy.

Capital Gains are Taxed Differently than Other Income

Long-term capital gains are taxed at 0%, 15%, or 20%, but a majority of investors will fall in the 15% tax bracket.

What’s unique about long-term capital gain tax rates is that almost every investor will pay a lower rate on their capital gain income than the tax rate applied to ordinary income, like the salary you earn from your job.

The Seven Tax Brackets for Ordinary Income

These tax brackets are used to appropriately tax your wages, interest from a bank account, profits from a rental property, and income from a retirement plan.

As an investor, it is essential to understand that the profit generated from selling an investment (held longer than one year) is taxed at lower rates than other types of income. Understanding how tax rates differ can help you strategically sell investments within a brokerage account to minimize your tax bill.

I want to conclude this section by briefly discussing the strategy of tax-loss harvesting. Selling an investment within a taxable brokerage account triggers a taxable event. As previously mentioned, if the investment is worth more than your purchase price (+/- certain adjustments), then you have a capital gain. But what happens if your investment is worth less than the purchase price? In that case, you have a capital loss, and the strategic selling of assets within a brokerage account to generate capital losses is called tax-loss harvesting.

investment strategies

Disclaimer: The following information is for educational purposes only and should not be construed as specific investment advice.

How you invest within a brokerage account should be predominantly driven by your comfort level with investing in riskier assets, such as stocks, and how soon you may need the money held within your brokerage account. However, the fact that you have to report any interest, dividends, and capital gains earned throughout the calendar year means that tax-efficient investments play a role in the investment decision process. So, here are some things to consider when investing money in a taxable brokerage account:

1) Consider a municipal bond fund. If you determine that part of your money should be invested in bonds, then municipal bond funds provide the best tax efficiency. Municipal bond interest is tax-exempt from federal income tax, which is not true about the interest earned from U.S. Government bonds or corporate bonds.

2) Be cognizant of funds that make annual capital gain distributions. Every mutual fund or ETF that you purchase is managed by an individual or a group of individuals. Sometimes, these individuals will sell a stock or bond to manage that particular fund better. If the sale generates a capital gain, the fund is required by law to distribute these gains to its investors. Any gain that is distributed to you is included as income on your tax return. I’ve seen tax returns where the individual had $25,000 of capital gain distributions, which increased their tax bill by $3,750. So, spend some time looking at the potential funds you may use as investments for your brokerage account and consider how any capital gain distributions will impact your taxes.

3) Avoid frequent trading of the same investment. As mentioned earlier, the sale of any asset within a brokerage account is a taxable event (either a gain or a loss). The danger of buying/selling the same investment in a short period of time (less than one year) may not come to light until you file your taxes in the spring. When you sell an investment within one year of purchase, you have what’s called a short-term capital gain. These types of capital gains do not get taxed at the lower capital gain rates, but instead are taxed like the income from your job. Therefore, you should generally avoid frequent trading within your brokerage account, so as to avoid short-term capital gains, or you should understand the tax impact of your trading before actually making those trades.

case study: 40-year old couple purchasing a home

I worked with a married couple in their early 40s who wanted to purchase a larger home, as their growing kids made their current home feel a bit crowded. However, their current home would not provide the necessary funds for their down payment, so we looked at other funding sources. Fortunately, they had a brokerage account with various stock funds and a municipal bond fund. Here’s an outline of what we did:

a) Sold $30,000 of a stock mutual fund, generating $13,000 in capital gains.

b) Sold $20,000 of a municipal bond fund, generating $2,500 in capital losses.

c) Used the $50,000 towards the down payment on their home purchase.

The fact that this couple had a taxable brokerage account meant that they had financial flexibility to add another $50,000 towards the down payment of their home. In addition, we were able to strategically sell some of the bond fund to generate losses that offset some of the gains from selling the stock fund. All in all, the sales added $1,575 in federal taxes, but they will pay thousands less in interest payments by having a lower mortgage.

parting remarks

A taxable brokerage account can be a valuable tool in your financial toolbox, offering financial flexibility when used properly. However, it is often overlooked by investors because many people invest solely in their employer’s retirement plan and/or an IRA or Roth IRA.

If you have questions about a taxable brokerage account and how it could be a part of your financial plan, then feel free to email me (matthew@payitforwardfp.com) or schedule your initial exploration meeting!