While most retirement savers are (rightly) concerned with optimizing their 401(k)s and IRAs, taxable brokerage accounts often go under-appreciated. Though you won't receive tax deductions for contributions, and you'll be taxed as you receive interest, dividends, and capital gains distributions, taxable accounts offer different benefits that may appeal to investors on all levels of the investing spectrum.
Here, we'll discuss the advantages of taxable brokerage accounts and how they can even help you retire a millionaire.
More investment options and (possibly) lower costs
Unlike 401(k) plans, which generally offer a fixed menu of mutual funds and company stock funds, taxable brokerage accounts offer access to the wider universe of investment options. This includes single stocks, bonds, exchange-traded funds, options, and at certain providers, even cryptocurrency and real estate. Depending on your preferences, access to more investment options can make a big difference in the process of creating a bespoke portfolio.
On top of that, many legacy 401(k) plans can be on the expensive side -- even after accounting for their tax-deferred status. A 401(k) plan charging high administrative fees or offering only high-expense mutual funds can make it difficult for savers to accumulate as much money as they otherwise could in a low-fee plan. Many taxable brokerage accounts, like those found at the major online brokers, are accessible at low or no cost. Simply not paying high fees is one way to supercharge your investment returns.
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No contribution limits or age limitations
In contrast to 401(k) plans and IRAs, taxable accounts come with no contribution limits attached. This allows higher-income taxpayers to invest at levels far beyond those of their workplace retirement plans. IRAs offer even lower contribution limits than do 401(k)s, making them even less effective for those with higher income and/or asset levels.
Also unlike 401(k)s and IRAs, taxable accounts don't come with a minimum age for withdrawal, or a penalty for withdrawing money before a certain time. Both 401(k)s and IRAs will levy a 10% penalty on the grand majority of withdrawals before age 59.5, in addition to the normal ordinary income tax you'll pay on the amount of the entire withdrawal.
One of the big criticisms of 401(k) plans is that you can't easily access the money in the event you want to make a large purchase, like a primary residence. Taxable brokerage accounts, on the other hand, offer immediate access whenever you need the money -- no questions asked. Making use of a taxable account in this instance allows for a great deal of withdrawal flexibility in the event you want to make other asset purchases.
Potential for attractive capital gains tax rates
With pre-tax 401(k)s and IRAs, you're eligible to receive a tax deduction when you contribute money, but then are hit with ordinary income tax when you take the money out -- even if you wait until after you've retired. Depending on where you live and how much other income you have, pre-tax retirement account withdrawals can be especially costly, and can even drive you into a higher tax bracket.
The rules are a bit different within the taxable account world. Gains on stocks and other securities held longer than one year are taxed at long-term capital gains rates, which are usually substantially lower than ordinary income tax rates. For certain earners on the lower end of the income scale, long-term capital gains tax can be as low as 0% -- a valuable benefit you won't see in the normal course of 401(k) or IRA withdrawals.
Furthermore, when a taxable accountholder passes away, all positions are "stepped-up" to their market values on the date of death. This effectively eliminates all capital gains and effectively transitions the taxable account to its beneficiary (or beneficiaries) tax-free. This step-up in basis is a game-changer relative to how 401(k)s are dealt with at death, and make the taxable account attractive from yet another angle.
Consider adding a taxable account
A taxable account is best used as a complement to, rather than a replacement for, most workplace and independent retirement plans. You can use a taxable account for any purpose, but you'll get the most out of one by buying and holding your positions for the long term. When you need to withdraw money, you won't face any restrictions -- and depending on how long you've held your positions, you can even lock in a lower tax rate on your sales.
No matter how you choose to address your asset allocation, make sure it considers all your accounts from a bird's-eye view. In most cases, adding a taxable account is sensible. Investments in synchrony are much better aligned for success in the long run, so be sure to take the time to engage in sound financial planning.
