While we may live a fractious society, I bet most of us can agree that hatred of paying taxes is one pastime that binds Americans together. Even if you skew more “great patriotic duty” than “hands off my earnings,” you probably don’t relish the opportunity to pay taxes that you might otherwise skip. But what if there is a reason to pay taxes that you might not have to pay?
Flavors of Retirement Account Taxation
When you sock away dollars in nifty places other than mattresses and floorboards such as IRAs, the TSP, a 401(k), 403(b), or a “standard” brokerage account, Aunt IRS applies different rules to how you’ll pay taxes both on the money you invest and the money your money earns.
The list of different account types is long but distinguished… by a lot alphabet soup such as TSP, 401(k), IRA, SEP, SIMPLE, ISO, NQSO, RSU, CODA, etc., but the tax treatment of most accounts falls into one of three buckets. (We’re skipping stock options here… that’s its own set of buckets.)
Bucket 1: Pre-Tax Retirement Accounts. Pre-tax retirement accounts are usually called “Traditional” (TSP, IRA, 401(k), etc.). The idea is that you skip paying taxes on your employment earnings today as you deposit them into a tax-advantaged account, and instead pay taxes when you start to use those dollars in retirement. Any investment earnings between the time you deposit the money and the time you withdraw it grows “tax-deferred” meaning that you won’t get an annual tax bill on the growth while your dollars compound until retirement. Pre-Tax accounts used to be the only game in town. Today, they’re mostly used by people who don’t know better and people with really high earnings.
Bucket 2: After-Tax Retirement Accounts. After-tax retirement accounts are usually called “Roth” (TSP, IRA, 401(k), etc.). With Roth accounts, the earnings show up on your tax bill for the year you earned the dollars, but now you get to skip paying tax on both the contribution to the account and the money your money earns, even in retirement. Roth accounts are attractive when you think your tax rate will be lower in the future than it is today. For many future military retirees, this is likely to be the case.
Bucket 3: Taxable Accounts. If an investment account isn’t a pre-tax or after-tax account, it’s likely what’s generically called a taxable account. It doesn’t inherently enjoy any tax advantages or “qualified” status. If there’s no special tax advantage, why would you ever invest in such an account?
Taxable Account 101
Taxable accounts get all sorts of confusing names depending on where you open them such as:
- Individual Brokerage
- JTWROS Brokerage
- Individual/TOD or Joint/TOD
Financial professionals often call them taxable accounts versus some version of “brokerage” because it’s not uncommon for IRA accounts to also have the term “brokerage” in the name and frankly, this stuff is confusing enough as it is!
Features of a taxable account include:
Invested dollars don’t have to be from current earnings. You can put gift money, life insurance proceeds, gambling winnings, and pretty much any other funds into a taxable account. With the tax-advantaged accounts, you’re generally limited to earnings from a specific year.
No limits on deposits. While the tax-advantaged accounts have annual limits (e.g. $6,500 for an IRA under age 50 in 2023), you can invest an unlimited amount per year into a taxable account.
Investment Options. Tax-advantaged accounts can have limitations on what you can invest your dollars in. Most of us don’t care, because we want to buy garden variety stocks, bonds, mutual funds and exchange-traded funds (ETFs). Taxable accounts may be able to hold more exotic investments depending on the brokerage firm.
Ownership Options. Tax-advantaged retirement accounts must be owned by the individual that earned the dollars (or inherited the account). Taxable accounts can be owned by couples, groups of people, businesses, and entities like Revocable Living Trusts (which makes them excellent for estate planning).
No limits on withdrawals. One reason that (usually needlessly) scares people away from tax-advantaged retirement accounts is that Congress levies a 10% penalty on accessing your funds prior to age 59.5. This is a fairly toothless bogeyman however as there are many ways to avoid the penalty. There are no such limits on a taxable account. You can deposit the money one day and withdraw it and any earnings the next. No need to count laps around the sun!
Taxation. It wouldn’t be called a taxable account if taxation weren’t a player, so let’s look at some of the taxes and tax impacts that your taxable account may have:
Capital Gains Tax. When assets you own in the account gain value and are sold after being owned for over a year, you’ll pay one of three tax rates on those gains: 0%, 15%, or 20%. The rate you pay depends on how much income you earned overall that year. Clearly 0% is attractive, but 15% and 20% are lower than most Ordinary Income tax rates, so Capital Gains Tax is generally considered a favorable tax structure.
Beware that you don’t have to sell assets in your account each year to incur Capital Gains taxation. If you own mutual funds that internally sell stocks or bonds for a gain, you’ll get your pro-rata share of those gains inside your fund holding. You’ll pay tax on those earnings for that year even if you reinvest those earnings to buy more shares.
Tax on Dividends. When you own stocks or funds that pay dividends, you’ll be taxed on those dividends each year either at Capital Gains rates (0%, 15%, 20%) or at your Ordinary Income rate (e.g., 22%, 24%, etc.) depending on how long you owned the stock or fund that produced the dividend.
Net Investment Income Tax. If your total income is above a certain threshold (e.g., $250K for married, $200K single), and you have investment income, you’ll pay an extra 3.8% tax on those earnings over that threshold.
Shadow Taxes. You’ll find no listing for Shadow Taxes in the Internal Revenue Code, but many taxes phase in and many tax deductions/credits phase out base based on your total income, which includes income from your taxable account. The Medicare IRMAA tax and the Child Tax Credit are two examples. The IRMAA tax kicks in above $194K for married couples in 2023. The Child Tax Credit starts to phase out at $400K in 2023.
Charitable Deductions. Not all taxable account actions add to your tax bill. You can donate investments directly from your taxable account to a qualified charity and potentially deduct that from your income. You may also lower your future tax exposure by donating highly-appreciated assets.
In Defense of Taxable Accounts
After reading the myriad ways Aunt IRS can scrape the earnings of your taxable account, why on earth would one invest in such a beast? Two words: flexibility.
Setting aside that you may need to invest more than the annual limits for IRAs and employer accounts (TSP, 401(k), etc.) in order to sustain your standard of living in retirement such that taxable account might be your least-worst option, a taxable account provides excellent flexibility.
Flexibility of Purpose. Prior to retirement, you probably know that you’ll have future needs for money, but damned if you know what those needs are and when they’ll happen. If they happen before age 59.5, you’ve got at least a modest amount of friction standing between you and your tax-advantaged retirement accounts. Your taxable account welcomes your need and your timing. Taxable accounts can help fund:
- College / education
- Homes
- Other investments such as real estate
- Toys (things that fly and float and such)
- … and the granddaddy of them all retirement expenses prior to age 59.5!
Flexibility of Timing. You can start and stop contributions to and withdrawals from your taxable account at anytime until you die. There are no IRS handcuffs on when you can access your money based on age or work status.
Flexibility of Taxation. Despite the Begats of taxation above, it may be possible to signature-manage the tax man with your investment choices in your taxable account. What’s more, a common technique for retirees is to sprinkle certain amounts out of the taxable and tax-advantaged accounts each year to optimize their tax bill.
Flexibility of Preference. This is really about a combination of purpose and timing, but none of us is who we’re going to become. You may think you want to work until the undertaker knocks, but your 55 year-old self might decide it’s time to hang up the spurs. S/he will appreciate an easy-to-access pile of dollars for retiring a bit early. Whatever the reason or season, a taxable account helps your future self to retain decision space both for life experiences and tax timing.
Taxable Account Tax Tactics
Say that five times really fast… If you’re going to have a taxable account by choice or inheritance, you might as well signature-manage the tax man. These tactics can help:
ETFs over Mutual Funds. Exchange-Traded Funds are usually more tax-efficient than their cousin Mutual Funds. While they may pay the same amount of dividends, they generally don’t distribute much in the way of internal capital gains.
Non-dividend paying stocks. While I’m not a fan of loading up on single stocks in lieu of more diversified investments it is possible to choose stocks that don’t pay (currently) dividends. This defers taxation until you actually sell an investment.
Stocks over funds. Again, I’m not a fan of single stocks over diversified funds, but with single stocks, you retain complete control over when to sell. Neither a fund manager nor change in an index can create capital gains without your consent.
Mind the Bonds and Real Estate. Dividends from bond and real estate funds are taxed at higher Ordinary Income tax rates. While they provide diversification in a taxable account, they do add tax drag, so it’s important to consider the tradeoff.
Municipal Bonds. Returns from municipal bonds/bond funds are exempt from federal income taxes (but not necessarily state income taxes). They generally pay lower returns, so the benefit really accrues to the highest income earners.
Passive versus Active Strategies. Frequent selling inside a taxable account often drives capital gains. If you invest in mutual funds or ETFs, passive funds that track an index tend to sell infrequently since the stocks/bonds in the index don’t change as often as the whims of an active fund manager.
Tax-loss Harvesting (TLH). I’ve written on this quite a bit, but this strategy involves selling investments that have lost value in order to net the losses against other gains or up to $3K of ordinary income. This also allows you to free up cash to re-shape your portfolio.
Tax-gain Harvesting. As mentioned above, retirees (and pre-retirees) might choose to forecast when low-income years will occur, then purposefully sell from their taxable account to enjoy a lower rate. The holy grail is the 0% Capital Gains rate, but 15% is still 25% better than 20%!.
Maximizing Deferral. By spending out of a taxable account early in retirement, dollars in a pre-tax tax-advantaged account get to keep compounding without getting taxed (Uncle Sam eventually forces us to start taking funds out of pre-tax accounts so he can tax them.) . Since inflation makes the value of a dollar today worth more than the value of the same dollar tomorrow, it’s usually makes sense to pay taxes with tomorrow’s dollars than today’s. By that logic, the longer we wait to pay taxes on a pre-tax account, the more compounding we get in the pre-tax account and the lower the value of the dollars that we pay taxes with.
What’s more, a common retirement withdrawal strategy is to deplete taxable accounts first to let pre-tax accounts compound, then deplete pre-tax accounts to let Roth accounts compound the longest. Ultimately, it’s worth doing professional tax planning to determine how to best sequence your withdrawals. The game is to lower the lifetime tax bill, not just this year’s tax bill.
Surgical Sales. As discussed in the tax-loss harvesting article, if you invest in a taxable account over the decades, you’ll likely buy shares of assets at various prices. Some will be relatively higher prices than others. The price you paid is your basis. You only pay tax on the gain above the basis. When you sell shares in a taxable account, you can choose the shares with the basis that best fits your tax strategy. E.g., sell high basis shares to reduce taxable gain and low basis shares to maximize a tax-loss harvest.
Step-up in Basis. The final tactic for taxable accounts is to avoid selling assets until you die. Under current tax law, the basis in your taxable assets resets to the fair market value on the day you die. If you bought company stock for $1 per share in 1999 and it’s worth $100 per share when you die in 2069, your heirs inherit it with a basis of $100. The taxable gain that you sat on evaporates and they can sell with little or no tax due.
Taxes and Dogs. One of the great investing maxims is, “Don’t let the tax tail wag the investment dog.” If you’re paying taxes on your investments, it’s because you made money. A high tax bill from an obese taxable account is an ultra-first-world problem. It’s folly to skip a taxable account just because of taxes.
Cleared to Rejoin
Death and taxes—yeah, yeah, yeah… but if we are going to invest we’re going to pay some taxes. Taxable accounts are the extra flexible financial firepower that our future selves are going to want. While it’s rare to completely zero out the tax bill from taxable account investing, there’s no shortage of tactics to suppress the tax man. Don’t let the tax tail wag that investment dog!
Fight’s On!
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