The Overlooked Account
The “preferred” accounts
When talking with clients about savings and retirement, I spend a great deal of time talking about different types of accounts. Accounts for retirement, accounts for emergencies, accounts for health savings, education, different types of spending, and even for individual purchases. YES, within these accounts we typically look at different types of portfolios to help reach our goals, but the design of the account itself (what I like to call “the wrapper”) is the first decision.
When considering account type, one of the most important characteristics we choose is tax treatment. That is, how are the assets in the account taxed when deposited, when they grow, and ultimately when they are withdrawn. Along with these tax treatments we also consider rules regarding when and why withdrawals can be taken. There are other considerations, but these tax treatments and rules are usually the most important part of the discussion. It makes sense when you think about it. How our money is taxed and when we can access it is a large part of meeting our desired goals.
When it comes to the accounts with preferential tax treatment (tax-deferred), they all fall within one of three categories: pre-tax, after-tax, and the unicorn of the crew: triple-tax-advantaged. Feel free to skip ahead, but here’s a brief explanation of each:
Pre-tax: These types of accounts are funded with pre-tax money. That is, you get a tax deduction for every dollar you deposit. Growth within the account is tax-deferred, and all withdrawals are taxed as regular income. 401(k), 403(b), traditional TSP, and traditional IRA accounts are the most popular type of this account, but there are others.
After-tax: Just like pre-tax, but in reverse. You don’t receive a tax deduction for deposits; all accounts are funded with after-tax money. The growth is still tax-deferred, but all withdrawals are tax-free so long as you abide by specific rules. Any tax-deferred account named “Roth” is this type of account. 529 accounts also behave this way as long as rules are followed.
Triple-tax advantaged: Of all the tax-deferred accounts, one stands alone. The Health Savings Account or HSA. Again, rules apply, but if you do it correctly, funds are tax-free when deposited, growth is tax-deferred, and withdrawals are tax-free when used for certain health expenses.
You may be wondering, ‘if there are three basic types of tax-deferred accounts, why are there so many versions?’ The answer lies in the differing rules and intended purposes for each type. Each account is limited in use and treatment depending on that specific purpose. Accounts intended for retirement have limitations on when you can begin taking funds (i.e., retirement age), whereas 529, HSA, and FSA accounts are intended for specific types of expenses. The rule around those accounts are focused on what they can be used for. As you can probably guess, stacking these accounts can get pretty complicated!
The overlooked account
When searching for the right account to use, I don’t mind that complication so much. After all, the complication is partly why my business exists. That said, there is an often overlooked account that gets lost in the wash. This account gets overlooked because it doesn’t enjoy the same deferment of taxes as those mentioned above. However, when it comes to rules and limitations, it blows them all away. That overlooked account is a standard brokerage (aka “taxable”) account.
A brokerage account is similar to other types of investment savings accounts in that you can own a nearly unlimited type of investments within it. Money is invested after-tax (similar to a Roth), but taxation on growth happens a few different ways. Taxation on any interest or dividends is charged in the year they occur, and any growth in the stock price itself is taxed as capital gains when you sell it (more on this later). However, when it comes to listing limitations of a brokerage account, the lack of tax deferment is pretty much the only drawback worth mentioning.
The benefits, on the other hand, are considerable:
1. Unlimited liquidity: Of all the reasons, I believe this is the most important reason to consider a brokerage account. For every tax-advantaged account listed above, there are certain rules that apply for when you can withdraw your funds. For most of them, withdrawing money outside of these rules includes additional penalties and taxes. These limits can be related to age, time invested in the account, or the purpose of the money being withdrawn. These rules ensure that the accounts are used in the way they were intended (and incentivized) to be used.
Since brokerage accounts enjoy no such incentives, there are no rules or limits to the amount of money you can withdraw at any time or throughout the year. It’s like a savings or checking account, only with investment options. Speaking of…
2. Millions of investment options: Once you fund a brokerage account, you can own almost any kind of investment within it. Most common are stocks, bonds, cash, mutual funds, and ETFs, but the list also includes options, futures, REITs, and precious metals and other commodities. (Other types of investments like direct ownership of art, vehicles, collectibles, life insurance, and real estate are not allowed, but instead are typically held in trusts.)
3. Unlimited contributions: Unlike most tax-deferred accounts, there is no limit to the amount you can contribute to a taxable brokerage account. Some brokerage houses require a minimum amount to open the account or to set up monthly transactions, but the sky is the limit after that.
4. No income restrictions: Many types of tax-deferred accounts have eligibility phase-outs relative to your annual income. For example, if you’re married and your workplace provides a 401(k) or other retirement plan, your eligibility to contribute to an IRA begins to phase out at $109,000. Brokerage accounts, on the other hand, have no such limitation or phase-out. As you can probably guess, between this benefit and the mentioned unlimited contributions, brokerage accounts are very popular for wealthy folks and high earners.
5. Beneficial tax treatment: While it’s important to remember there is no tax deferment or deductions when it comes to brokerage accounts, it’s also important to understand how taxation is treated. Believe it or not, brokerage accounts DO enjoy some tax benefits. Let’s break it down by type:
* Interest: Any interest paid on an investment in a brokerage account is taxed as regular income (it is included along with your other income for the year). This is most common with bonds and money market funds.
* Unqualified dividends: Any unqualified dividends are also taxed as normal income for the year. The criteria are complicated, but REITs and some foreign dividends fall into this category. Your holding period of the investment can also trigger unqualified treatment of dividends.
* Qualified dividends: Here’s where the beneficial treatment begins! If you invest in a US company or fund, a certified foreign company and hold the investment for long enough (60 days or so), the dividend is taxed at 0%, 15%, and 20% depending on your income level; far below normal income tax rates.
* Capital gains: Capital gains tax is levied on any increase in value between when you buy an investment and when you sell it. It’s important to know how long you’ve held the investment to determine what type you should expect to pay. For any investment held for a year or less, you will pay short-term capital gains tax. This is treated as normal income. However, if you hold any investment for longer than a year, then you will enjoy the much lower long-term capital gains tax. Long-term capital gains tax is the same as qualified dividends: 0%, 15%, and 20% depending on your level of income.
6. Tax on return and growth ONLY: It’s important to remember that, with a taxable brokerage account, you are only taxed on any return you experience. In other words, you have to be paid a dividend, interest, or sell the investment at a gain to be taxed.
For instance, if you invest $100 in a brokerage account, hold it for some period of time, experience no interest or dividends, and sell it at $100, you have no taxable event. In fact, if you sell it for $98, you actually have a loss you can claim against income! (limits apply)
Also, it’s important to know that any tax you pay on reinvested funds raises your tax basis. That is, if you buy $100 worth of stock and you receive a $5 dividend, yes you will pay some form of tax on the dividend, but your basis in the account is now $105 if you chose to reinvest the dividend. Should you then sell the investment for $105, you won’t pay any further taxes.
Since compound growth is the magic of investing, the cost basis tends to grow along with the overall balance in a brokerage account. Yes, you pay taxes along the way, but the end result is a large account that can be withdrawn with taxes due on only a small amount of unrealized gains.
7. Stepped-up basis for inheritance: One often ignored tax advantage of brokerage accounts is stepped-up basis on inherited stock. I know that sounds complicated, but it’s actually pretty simple and very powerful. Let’s say you buy a stock for $10 and hold on to it. After holding it for dozens of years, the stock is worth $250. If you choose to sell the stock, you will be liable for long-term capital gains tax on the $240 worth of growth. However, should you pass away and inherit the stock to your heirs, they will receive the stock at the stepped-up basis of $250. That means they could sell the stock with no capital gains tax whatsoever. And by the way, pre-tax accounts like 401(k)s and IRAs do not enjoy the same benefit.
Two more for the road
Bringing together all the benefits above, I especially like brokerage accounts for a few different reasons. In a recent article, I talked about the idea of a “goal window” in which an investor defines a range of time and money needed for a goal, thus allowing for greater flexibility and increased risk. Read more about that idea here. If your goal window involves a flexible goal that you hope to achieve before age 59, a brokerage account can be a fantastic tool to use. Read about using one to pay off your mortgage.
Finally, I simply love the flexibility and liquidity of a brokerage account. Add in strategies to control how you’re taxed (within reason), and the benefits are well worth the cost (done right). Don’t look at the taxes paid as a penalty; look at them as the premium paid for complete freedom and flexibility to achieve your goals.
Keep things in perspective
Just a reminder, don’t EVER shy away from making money to avoid taxes. Yes, by all means, take every tax advantage you can find, but avoiding making a dollar (or regretting making a dollar) because you have to pay taxes on it is the financial version of cutting off your nose. Sure, the tax man won’t get his, but ultimately at your expense. We go through great lengths to avoid excess taxes (such as tax-deferred accounts above), but don’t ever shy away from returns and income to avoid them. Remember, taxes are an annoying side effect of a good thing.
The right tool for the task
As you can see, brokerage accounts hold all the cards when it comes to avoiding rules and limits. They even have a few tax benefits that make them somewhat competitive with completely tax-deferred accounts.
So when choosing the right account for you, remember you have options. First, make sure to keep the main purpose in mind. Retirement? Yes, use 401(k)s and IRAs by all means. Education? 529s are really great. However, as you peruse your choices, just remember you have a “Swiss Army knife” option at your disposal. One that can be used for any goal at any time for any reason.
Don’t be afraid to be flexible, don’t be afraid of a few taxes along the way, and don’t overlook the brokerage account.
