If you’re winning the game, then at some point you will start to max out your tax-protected retirement space. For a typical married filing jointly couple, each with a W-2 job, this would be $36,000 (401k x 2) + $11,000 (Roth IRA x 2) = $47,000 per year in tax-protected space. If you are able to save nearly 50K per year starting in your early 20s, you will be well on your way to becoming a millionaire by age 40.
However, if you’re like myself, who didn’t get out of debt and start saving for
retirement financial freedom until age 34, then you need to step it up. 50K per year may not be enough. In such a case, instead of lamenting that there isn’t more tax-protected retirement space available, embrace the benefits of the taxable investment account.
Benefits of a Taxable Investment Account
A taxable investment sounds really bad. Why would I want to put money in an account that is subject to taxes? Well, if you have maxed out your tax-advantaged accounts, there really isn’t any other choice. When it comes down to it, the taxable account really isn’t that bad. It actually has quite a few benefits, including:
- You can invest in anything you like. There are no limitations like there is with an employer-sponsored 401k plan.
- You can take money out at any time without penalty. In a 401k, you will be required to pay a 10% penalty if you withdraw funds prior to age 59 1/2. In a Roth IRA, although you are able to withdraw contributions at any time without penalty, you will pay a penalty if you withdraw earnings prior to age 59 1/2.
- There is no limit to the amount you can place in a taxable account. In comparison, there are strict limits on contributions to 401k’s and IRA’s.
- You can Tax-Loss Harvest: Basically, if a fund in your taxable account loses value, you can sell it and use the loss (up to $3000 per year) to reduce your taxable income. We’ll cover more about tax loss harvesting in future posts, but for now you can read more about it in the bogleheads wiki.
How a Taxable Account is Taxed
The money that you place in a taxable account is post-tax money, meaning that you have already been taxed on it. This money (the contributions to the taxable account) will never be taxed again. However, you will be taxed on:
- Dividends and
- Earnings (Capital Gains)
I. Dividends are basically payments (income) that your stocks, bonds, or savings account will give you throughout the year. This is money that you get without doing anything. If you have never experienced the power of having your money make money, then you need to start investing TODAY. We’ll cover more about the power of passive income in future posts. For now, it’s important to understand that there are two types of dividends:
- Ordinary Dividends: These are taxed at your ordinary marginal tax rate (bad). This includes interest from CDs (certificates of deposit) and savings accounts, as well as dividends from bonds.
- Qualified Dividends: These are dividends that meet specific criteria to be taxed at the lower long-term capital gains rate (good). Stocks often produce primarily qualified dividends. It is important to understand that all dividends are ordinary, but not all ordinary dividends are qualified.
II. Earnings occur when a stock or bond increases in value. You will not owe any taxes until you sell, at which point, there will be realized capital gains. However, if you own a stock mutual fund, even if you don’t sell shares of the fund, the fund manager may be buying and selling shares, which may generate capital gains that you will owe taxes on at the end of the year. Like dividends, there are two types of capital gains:
- Short-term Capital Gains: apply if an investment (like a stock) is held less than 1 year. These are taxed at your ordinary marginal tax rate (bad).
- Long-term Capital Gains: apply if an investment is held longer than 1 year. These are taxed at the lower long-term capital gains rate (good).
Minimizing Taxes on the Taxable Account
As you can see, taxation of funds in your taxable account can get complicated. However, we’ll try to simplify it for you. Basically, to minimize your taxes in a taxable account, you want to pick funds that are taxed at the lower long-term capital gains and qualified dividends rate.
This essentially narrows it down to buying and holding individual stocks and total stock market index funds. Turnover (frequent buying and selling) is low, which reduces or eliminates short-term capital gains, and most of the dividends are qualified dividends.
Bond funds (including TIPS), high-yield savings accounts, CDs, and REITs (real estate investment trusts) are out because they generate interest income and ordinary dividends, which are taxed at the ordinary income marginal tax rate. Actively managed mutual funds are out because they generate high amounts of short-term capital gains.
What you should put in your taxable account
In general, the only thing you should put in your taxable account is a total stock market index fund. If you prefer more international exposure, then you may add a total international stock index fund. If you absolutely need bonds in your taxable account to maintain your chosen stock:bond allocation, then you can either take the tax hit, or if you are in a high tax bracket, you can use municipal bond funds, which are exempt from federal taxes.
My Taxable Account
Here’s what I have in my taxable account (my chosen asset allocation is 75% stocks and 25% bonds):
- 55% Vanguard Total Stock Market Index
- 20% Vanguard Total International Stock Market Index
- 25% Vanguard Intermediate Term Tax Exempt Bond Fund
How my taxable account is taxed
Vanguard Total Stock Market Index Fund: As you can see from the chart below, this fund does not produce any realized capital gains throughout the year (either short or long-term) and ALL of the dividends are qualified dividends. Therefore, you only pay taxes on the approximate 2% dividend disbursement. So, if you owned $100,000 of Vanguard Total Stock Market Index, you would receive $2000 in dividends, and even if you were in the top tax bracket, you would “only” pay a tax rate of 23.8% (20% + the ACA Medicare surcharge of 3.8%), or around $500. In comparison, if you had earned $2000 from a CD or savings account, assuming the highest tax bracket, you would owe around 43.4% or $900 in taxes, nearly twice as much. Of course, when it comes time to sell the shares of your Vanguard Total Stock Market Index Fund in “retirement”, there WILL be long-term capital gains, but that is quite a few years into the future.
Vanguard Total International Stock Market Index Fund: Like the Total Stock Market Index fund (as you can see from the chart below), there are no realized short or long-term capital gains to pay taxes on. However, unlike the Total Stock Market Index fund, not all of the dividends are qualified. In 2015, the dividend rate is 2.8%, so if you owned $100,000 worth of Total International, there would be $2800 in dividends. Only 70% or around $2000 is considered qualified dividends, taxed at the lower tax rate, and $800 is considered ordinary dividends, taxed at the higher tax rate. You’ll also notice from this table that there is a column for foreign tax credit. This represents the amount you paid in foreign taxes by holding an international fund, and you can deduct this from your taxes owed. You can read more about the foreign tax credit here.
Vanguard Intermediate Term Tax Exempt Bond Fund: This fund is fantastic because the income generated is exempt from all federal taxes. Note, however, that if you live in a state with a state income tax, you will pay state taxes on this income. I am fortunate to live in Alaska, which has no state income taxes (for now). The Vanguard Intermediate Term Tax Exempt Bond Funds pays out dividends monthly, currently at a rate of approximately 2.8% per year (this has varied over the last 10 years from around 1.5% to 4%). So, if you own $100,000 worth of this fund, you would have received approximately $2800 in dividends last year, which would be around $230 per month. This is not a large amount of income, but it IS tax-free. The closest thing to a free lunch you can get.
The taxable account is not your enemy. In fact, the taxable account has several benefits, including the ability to take distributions whenever you want, which is particularly helpful to the early retiree. After you fill up all your tax-advantaged accounts (Roth IRA, 401k), don’t be afraid to start investing in a taxable account. If you understand the basics of how this account is taxed, you can select tax-efficient investments to minimize tax drag and eventually earn your freedom.
What do you think? Are you in the fortunate situation of being able to fill up all your tax-advantaged space and begin contributing to a taxable account? What investments do you have in your taxable account? Comment below!