Tax-advantaged accounts are the cornerstone of a solid retirement strategy , but a taxable brokerage account is an opportunity to expand your investment horizons.
Nationwide, an estimated 17 million households own a taxable investment account, according to Deloitte. On average investors held a little more than $500,000 in stocks, bonds and mutual funds in these accounts. “Taxable accounts provide a flexible option for investors to address their short- and long-term cash needs, especially if they’re under age 59½,” says Robert Waskiewicz, a financial advisor at Philadelphia-based Wescott Financial Advisory Group.
[See: 8 Smart Tax Moves for Investors .]
Unlike workplace plans and individual retirement accounts, taxable accounts don't limit annual contributions and aren’t subject to early withdrawal penalties or required minimum distributions. Plus, the accounts are available to high earners, who may be barred from contributing to a Roth IRA.
The accounts, though, are taxed differently. Withdrawals from a 401(k) or traditional IRA are taxed at ordinary income tax rates. In a brokerage account, gains on investments held for a year or more are taxed at the long-term capital gains rate, which can be more favorable, particularly for investors in a high tax bracket. Short-term gains – those from investments held less than one year – are taxed at ordinary income tax rates. “Investors have greater flexibility with taxable accounts because they can influence the amount of taxable income recognized by choosing investments with low or high amounts of appreciation, depending on their goals,” Waskiewicz says.
For example, an investor who’s currently in the 35 percent tax bracket and expects to be in a lower bracket in the future may want to sell investments with little to no appreciation or a loss. The result is less taxable income when the person's tax rate is high. If your investment strategy includes a brokerage account, you'll need to consider how to maximize its tax efficiency.
Stick with growth-oriented stocks. Stocks can help drive growth in your portfolio, and among brokerage account holders, they represent the largest share of holdings. According to Deloitte, investors with taxable accounts had an average of $248,000 in stocks, versus $221,000 in mutual funds.
Not all stocks belong in a brokerage account, however. Non-dividend-paying stocks are better suited for taxable accounts, says Mike Falco, a financial advisor and certified public accountant at Falco Wealth Management in Berwyn, Pennsylvania. “If you choose stocks that pay dividends, you’ll pay taxes on those dividends yearly,” he says. “If your stocks don’t pay dividends, you won’t pay as much in taxes every year.”
[See: 9 of the Market's Best Growth Stocks .]
Because dividends are taxed annually whether they're reinvested or not, you could be paying taxes on money you don't need. Unless you need the income, you’d do better concentrating on growth stocks and leaving the dividend-paying stocks to your tax-advantaged accounts instead. The same goes for other investments that pay out dividends or interest, such as Treasury or corporate bonds .
If you plan to hold dividend stocks in a taxable account, invest in those that pay qualified dividends, says Alan Conner, president of Atlanta-based NovaPoint Capital. “Qualified dividends are taxed at the long-term capital gains rate,” which could soften the blow of any added tax liability they create in a brokerage account. Be careful not to confuse qualified dividends with ordinary dividends, such as those that real estate investment trusts and business development companies pay.
Steer clear of actively managed funds. Some mutual funds also can be a tax drag on a brokerage account. Actively managed funds typically have a higher turnover compared to passive funds, potentially triggering more taxable events. “Passively managed funds tend to generate fewer capital gains distributions than actively managed funds because they’re not buying and selling the underlying holdings as often,” Waskiewicz says.
Index funds or exchange-traded funds are usually better for minimizing taxes in a brokerage account. And there are other advantages. ETFs are structured so they need less frequent rebalancing, and ETFs and index funds can also be cheaper. The average equity index fund expense ratio was just 0.09 percent in 2016, compared to 0.63 percent for actively managed funds, according to the Investment Company Institute. Fewer taxable events and lower expense ratios will leave more of your investment earnings in your portfolio.
Your own investment style also will determine whether to pursue actively or passively managed funds in a taxable account. Do-it-yourself investors may be better off with ETFs or index funds, because “they’re more on auto-drive, leaving less for the individual investor to manage,” Falco says.
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Hone your loss-harvesting abilities. Tax-loss harvesting is unique to taxable accounts, and you should take advantage of it to reduce your tax liability each year. “One benefit of investing in a taxable account is that if you sell a security at a loss, you can use the amount of that loss to offset gains in other investments and even a portion of ordinary income,” says Martin Schamis, vice president and head of wealth planning at Philadelphia-based Janney Montgomery Scott. But that means you have to keep track of the cost basis of any investments you hold in a taxable account.
You must also take care to avoid the wash-sale rule . A wash sale occurs when you sell or trade one security at a loss, then buy a substantially identical stock or security within 30 days of the sale, either before or after it. Under the federal tax code, transactions considered wash sales aren't eligible for tax-loss harvesting.
Another mistake to avoid is to wait until the end of the year to harvest any losses. Cameron Hinds, regional chief investment officer for Wells Fargo Private Bank in Lincoln, Nebraska, says it’s more effective to consider this strategy throughout the year, especially during periods of market weakness.
In recent years, the market downside has been more limited in size and duration, Hinds says. “Many investors have lost opportunities to take advantage of short-term losses within their portfolios as markets have rallied later in the year.”
[See: 8 Times When You Should Sell a Stock .]
Harvesting losses can also be your chance to trade tax-inefficient investments for those that are more tax-friendly. As you structure your brokerage account for optimum tax efficiency, though, keep your investment goals, objectives and risk tolerance firmly in sight.
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