INVESTMENT VEHICLES: TAXABLE ACCOUNTS

In part 3 of the investing basics series we will discuss the last major type of investing account, the taxable brokerage account. In the previous articles, we discussed the 401(k) and the IRA accounts, these are government sponsored accounts that use tax incentives to try and get Americans to invest. On the other hand, a taxable brokerage account is as simple as the name implies, it is taxable.

Taxable Accounts

From my experience, I have noticed that many individuals choose to invest in a taxable brokerage account before investing in a tax advantaged account. In my opinion, I think this is short term thinking and a behavioral fallacy that your money is more liquid then if it were in a tax advantaged account. Taxes can be a huge drag on overall returns if you are an excessive trader. Let’s look at an example of the difference between investing in a Roth IRA or a taxable brokerage account to make more sense of this.

Example:

Let’s say you are as good of an investor as you think you are, most likely you are not, but neither am I or 99.9% of others you talk to so no sweat. Let’s use Tesla (TSLA) as our example as it is a “hot stock” these days with the modern-day Tony Stark running the company. Let’s say you had the gut call last winter to invest $5,500 (the maximum amount allowed annually to contribute to an IRA) and made a buy on 12/1/16. You are like most traders constantly checking in on your position and monitoring the stock, and good news, it heads on a tear upwards! In March, the stock starts to pull back and you get a bit nervous about your position and the overall economy, but you understand the ups and downs so you keep your money invested. Soon after you hear on the news Trump has the possibility of getting impeached! This makes you uncertain of how the market will react and you’ve already made money so you are ready to lock in your gains. You sell on 5/18/17 and lock in a gain of 72% in less than half a year!

The only issue is the investment is only half the battle, the other half is what account you made the investment in because the IRS wants their share. If you had this money in a Roth IRA you are covered, you owe no taxes and the original money you invested can be liquid the day you take it out of the market. So, although it is not the best idea to pull out your earnings instead of reinvesting you are much more liquid then you think if you need the money.

What if you had the same exact investment but in a taxable account? All the transaction costs and your gains are the same and your before tax return is 72%. The big catch is that you must pay capital gains taxes on the sale of your investment. Additionally, you only held the stock for 168 days which makes it a short-term investment. You understand taxes and that you will be taxed at your income rate for these gains. In the example below it assumes your highest rate is 25% after you pay your taxes this lowers your overall return to 54%!

Tesla Trade Example

The example is also only analyzing capital gains. There is another piece to the taxable account puzzle income taxes must be paid on any distributions from holdings as well. This means if a fund pays a dividend you must pay taxes on the distribution in the taxable year it was paid (even if you do not take it out of the account). This means you would want to avoid funds and stocks that have large dividend yields because this works against you lowering your overall returns. Even worse than stocks are owning bonds or other types of debt that have higher monthly distributions this is extremely tax inefficient and these positions should be held in your tax advantaged accounts. It is important to understand this plays a major role in your long-term gains and can’t be overlooked. You will not feel the pain right away but come tax season it will sting. If you usually get a refund your refund will be lowered or you will even end up paying when you file.

Not all is bad.

There are benefits of having a taxable account and if you are maxing out your tax advantaged accounts it can be a great tool to save and invest. Although I would not recommend investing in a taxable account until you have maxed out your other options here are some pros of using a taxable account.

  • Can access funds whenever you need them.
  • Plan for retirement by having another “bucket” to draw from, this can help with tax planning down the road as your accounts grow.
  • No required minimum distributions when you reach a certain age.
  • Inheritance planning benefits. If you pass the money on the beneficiary will not have to pay taxes on any of the gains you created in your lifetime. Instead the cost resets to the price of the shares the day you pass as the new basis for them!
  • Tax Loss Harvesting

So, as you can see there are some great benefits if you are able to do a mix of everything you will come out way ahead and have flexibility over the years to conquer anything that comes up in life.

The vehicle you put your investments in is just as important as the investments you choose, so make sure you think it through before you decide.

What are your thoughts?

  1. Do you invest in a taxable account?
  2. Do you trade stocks in the short term?
  3. Why do you invest in a taxable account if you do?

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