One of the biggest and most common investing and financial planning mistakes people make is failing to leverage the advantages of taxable brokerage accounts.
Just the utterance of the word “taxable” evokes fear and loathing of taxes and the Internal Revenue Service and has people embracing the idea of saving in tax-deferred accounts, such as 401(k)s and IRAs.
But it’s not just the fear of taxes or hatred of the IRS that makes people ignore taxable brokerage accounts. Financial media and most investment advisers have largely oversold the idea of tax-deferred savings vehicles and have all but completely ignored the advantages of taxable brokerage accounts.
So what’s wrong with stuffing all or most of your savings in 401(k)s and IRAs? Here are three reasons you should be taking advantage of taxable brokerage accounts.
Taxable Brokerage Account Benefits: Tax Diversification
Most investors are well versed in the idea of diversification — reducing market risk by spreading assets among investments that are not highly correlated. But they often overlook the benefits of allocating assets among different account types for the purpose of tax diversification.
As I said in a recent article on why I believe the traditional IRA is dead, the whole idea of tax deferral in accounts like 401(k)s and traditional IRAs is to “defer” current taxes until retirement, when the individual will presumably be in a lower tax bracket. But this advice ignores the worst enemy of the long-term investor — inflation.
Not only does the cost of living increase significantly over a person’s saving years, inflation continues to creep up through the retirement years, making it highly possible for the individual to remain in the same tax bracket (or even move into a higher tax bracket) over the many decades that transpire during the span of the tax-deferred account’s usage.
Also, who knows whether or not federal tax brackets will change in their lifetime? With income tax rates at historic lows, tax brackets seem likely to stay the same or even go higher in the decades ahead.
The best advice in the conventional realm with regard to saving in various accounts is to limit 401(k) contributions to only the amount needed to get the full employer match, then maximize contributions to a Roth IRA, which is funded with after-tax dollars. If the saver is fortunate enough to put away money above and beyond those two account types, or if they do not qualify for Roth contributions, an individual or joint brokerage account is the next account to fund.
Taxable Brokerage Account Benefits: Early Retirement
Having money set aside in a taxable brokerage account can be an advantage for people wanting to retire early or delay Social Security benefits.
For those people fortunate enough to be in a position to retire or semi-retire prior to the age of 62, when reduced Social Security benefits can be elected, brokerage accounts can be a crucial financial planning tool.
If retirement or semi-retirement begins before 59-1/2, withdrawing from a 401(k) or IRA generally triggers a 10% early withdrawal penalty. With savings in brokerage accounts to draw from first, the penalty can be avoided.
Also, keeping tax-deferred money untouched for as long as possible is a crucial financial planning strategy with growing life expectancies. With people expected to draw from retirement savings for 15, 20 or even 30 years, withdrawing from brokerage accounts first will enable the tax-deferred accounts to continue compounding, taking full advantage of that growth.
Taxable Brokerage Account Benefits: Emergency Savings and Unforeseen Expenses
Taxable brokerage accounts are flexible tools: They can be used for short-, intermediate- or long-term savings, whereas tax-deferred accounts are tools that are almost exclusively reserved for retirement savings.
With a balance of cash, bonds and stocks, brokerage accounts can be used as tools to cover the financial needs other than retirement. The cash, hopefully in a money market fund that earns more than a savings account at a bank, can be reserved for short-term needs.
The bonds or bond mutual funds, which rarely lose value over periods of more than one year, can grow faster than cash and be available for larger, unforeseen needs further down the road. Money you don’t expect to need for at least 3 years, and hopefully not for at least 10, will be best allocated to stocks and stock mutual funds in the brokerage account.
All withdrawals from the cash portion of a brokerage account are completely tax-free. The principal amount of withdrawals from bonds, stocks and mutual funds are also free of tax, while withdrawals above that initial amount invested (the gains) are taxed at the prevailing capital gains tax rate, which is currently 15% on long-term gains.
Bottom Line: If the investments in brokerage accounts are tax-efficient, in combination with periodic tax-loss harvesting on the part of the investor to keep a lid on capital gains taxes, a taxable brokerage account is an indispensable tool to have in the financial planning toolkit.
Kent Thune runs an investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent tax advice or a recommendation to buy or sell securities.
