Taxable brokerage accounts: the best investment option for control freaks

While taxable brokerage accounts don’t provide tax-deferred growth or immediate tax savings like retirement accounts, they’re one of the most versatile tools in an investor’s toolbox. You can build a portfolio as conservative or adventurous as you desire and use gains to improve your income and losses to offset your tax bill.

“When it comes to tax planning, you want control,” says Patrick McDonald, a certified financial planner and managing director at Manhattan West. That control is exactly what you get from a taxable brokerage account.

What is a taxable brokerage account?

A taxable brokerage account is an investment account that doesn’t receive favorable tax treatment like IRAs or 401(k)s. With retirement accounts, your investments grow tax-deferred, and you’ll only pay taxes when you make withdrawals during retirement. If you have a Roth IRA, your retirement withdrawals are tax-free. 

But with a taxable investment account, your realized earnings are subject to taxes. Earnings are realized when you:

• Sell a stock, exchange-traded fund, or mutual fund at a profit
• Receive interest payments from taxable bonds
• Receive dividend payments

When you file your taxes for the year, these gains are subject to capital gains taxes instead of ordinary income taxes.

Taxable brokerage accounts are one of an advisor’s favorite accounts because they provide greater flexibility than a retirement account and more investment options than a savings account, says Patrick Bobbins, vice president and financial advisor at Wealth Enhancement Group. You can trade stocks, bonds, exchange-traded funds (ETFs), or any other security you’d like.

Unlike tax-advantaged retirement accounts such as your 401(k) or IRA, there are no contribution limits or income restrictions on how much you can put into a taxable brokerage account each year.

The other distinction between taxable brokerage accounts and retirement accounts is, of course, taxation. You don’t get to take a tax deduction for money you put into a taxable brokerage account as you do with a traditional IRA or 401(k), but you also don’t have to pay taxes when you withdraw. Instead, the money in a taxable brokerage account is taxed in the year in which it is earned.

For example, if you sell a stock for a $100 gain in 2023, you’ll pay taxes on that profit when you file your 2023 income taxes. Likewise, for any dividend or interest income earned during the year.

The rates at which these capital gains and income are taxed can vary. The IRS divides capital gains into short-term and long-term buckets. Short-term gains are those earned on investments you held for less than 365 days. If you hold it for 365 days or longer, it is long-term.

Long-term gains qualify for the more favorable capital gains tax rates of 0%, 15%, or 20%, depending on your taxable income for the year. Short-term capital gains are taxed at your ordinary income tax rate for the year.

That said, Nayan Ranchhod, private wealth advisor at Ameriprise Financial, recommends checking with your tax advisor on these rates “as there are many nuances.”

Since earnings are taxed as they occur, the IRS does not impose requirements or restrictions on withdrawals. You can take money out of a taxable brokerage account at any time or can leave it in the account indefinitely since there are no required minimum distributions (RMDs).

When should you invest using a taxable brokerage account?

Given the flexibility taxable brokerage accounts provide, many advisors say you should always be using one for part of your savings. However, there are certain situations which better lend themselves to using a taxable brokerage account.

You have a lot of cash in a savings account.

A key benefit to a taxable brokerage account is the plethora of investment options available, most of which can provide far greater long-term returns than a savings account.

This doesn’t mean you have to invest aggressively inside a taxable brokerage account. You can tailor the risk and return level of the investments inside your taxable brokerage account to the goal you’re saving for, Bobbins says. For example, a long-term saver may choose to use primarily stocks while someone saving for a down payment on a house could use short- to intermediate-term bonds, which may pay a higher interest rate than a savings account or certificate of deposit (CD).

This also doesn’t mean you should have no money in a savings account. You should first build an emergency fund of three to six months’ worth of living expenses that you keep in a cash-like position, then start building your after-tax savings in a taxable brokerage account, Ranchhod says.

You’ve maxed out your retirement accounts.

A taxable brokerage account is a great place for surplus savings if you’ve already saved as much as the IRS will let you into your tax-advantaged retirement accounts. You may even start putting money into your taxable brokerage before you max out your retirement savings.

You should always contribute at least enough to your employer-sponsored 401(k) to get the full employer match–it’s free money!–but after that the benefit of pre-tax accounts wanes, McDonald says.

While he loves a Roth 401(k) because all future growth is tax-free, pre-tax retirement savings can leave retirees with hefty tax bills.

“There’s this theory that you’ll be in a lower tax bracket in retirement, but… in practice that’s not correct,” he says. If you have a large traditional 401(k) when you reach RMD age (73 if you turn 72 after Dec. 31, 2022), you could be required to take a huge taxable distribution which may push you into a tax bracket that’s above the capital gains tax rates.

This could in turn increase your medicare premiums. “I don’t care how wealthy you are,” McDonald says, “no one likes paying more for Medicare.”

You want more liquidity.

You want to avoid accessing money in an IRA or 401(k) until at least age 59.5 because any earlier than this could result in a 10% penalty. There are exceptions to this rule, but it still only provides limited access.

You can access money inside a taxable brokerage account at any time. This means if your car breaks down or your roof needs a repair, you can pull from your brokerage account at any time without penalty. 

You want more control over taxes.

A huge benefit of taxable brokerage accounts is the control they offer both today and in the future in terms of how you pay taxes. When you withdraw from a pre-tax retirement account, you have to pay ordinary income tax rates but you only pay capital gains tax rates on investments you’ve held for one year or more in a taxable brokerage account.

In other words: you can get the money you need while sending only what is necessary to the government, Bobbins says.

You can also use tax-loss harvesting, where you use losses incurred on the sale of one asset to offset the gains on another for tax purposes. For example, if you know you’ll incur a $5,000 gain on one stock sale this year, you can sell another stock at a $3,000 loss and then only need to pay taxes on the net gain of $2,000.

You want to leave a legacy.

Taxable brokerage accounts can be a more tax-efficient means of leaving assets for your heirs than retirement accounts

“Traditionally, if you inherit a taxable brokerage account you can get a step-up in cost basis at the date of death,” which can result in significant tax savings, Ranchhod says. 

This means that if you die today and leave your adult daughter 100 shares of Microsoft stock you bought in 1991 for $2 per share, she gets to treat it as if it was purchased for today’s price. So when she sells those shares, she only has to pay taxes on the difference between that sale price and the price it was on the day you died.

Alternatively, she could hold onto those shares for as long as she’d like whereas the IRS requires her to liquidate the account within a 10 year period, paying taxes along the way. Spousal beneficiaries of retirement assets are not required to liquidate the account, but can instead treat the retirement assets as if they were their own.

Pros and cons of taxable investment accounts

“The taxable brokerage account becomes really helpful because there are so many pros and very limited cons,” McDonald says. But there are still some downsides to taxable brokerage accounts so weigh the pros and cons carefully before choosing what type of account to open.

Taxes and taxable investment accounts

It’s hard to avoid taxes in a taxable brokerage account. “That’s why the IRS code is more black or white than it is gray,” McDonald says, but there are ways to mitigate the tax bite if you plan.

While you must pay taxes on your earnings each year, you can also generate losses to offset both current and future taxes through tax-loss harvesting. The IRS lets you carry forward up to $3,000 ($1,500 if you’re married filing separately) of net losses each year.

Those losses carry forward indefinitely, McDonald says. So if you sell a bunch of stock in 2040 at a profit, you can use losses from 2022 to offset the taxes you’ll owe.

In practice it might look something like this: Apple stock takes a plunge so you sell some shares at a loss, but you don’t really want to stop owning Apple. The IRS has a wash sale rule which states that if you repurchase Apple within 30 days of this sale, you cannot claim the loss. 

So, you have to wait 30 days to repurchase your shares, but in the meantime you use the proceeds from your sale of Apple to buy an S&P 500 index, which holds predominately Apple. After 30 days, you sell your S&P 500 index and repurchase Apple.

You can also manage capital gains taxes in a taxable brokerage account through giving. You can find friends or family members who are in lower tax brackets and gift appreciated shares to them, McDonad says. This gets the appreciated stock off your balance sheet and lets them benefit from the gain.

You can gift up to $17,000 to each individual recipient in 2023 without incurring the gift tax. 

If you’re charitably inclined, you can also use a donor-advised fund to gift appreciated shares to a qualified charity. You get to take an immediate tax deduction for your donation and then make grants from your account to the charities of your choice.

How to open a taxable brokerage account

If a taxable brokerage account sounds like the right savings strategy for you, follow these steps to open an account today.

1. Choose a provider. You can open a taxable brokerage account at any broker. When choosing a provider, consider the investment selection, account minimum, and any fees.
2. Open the account. Most firms let you open a taxable brokerage account online by completing a short form.
3. Fund the account. Once your account is open, it’s time to fund it.The easiest way to do this is through an electronic transfer from your bank account – again wait out for fees as some firms charge for bank wires while electronic funds transfer (EFT) is often free, albeit slower.
4. Choose your investments. The hardest part of opening a taxable brokerage account is often choosing investments. If you’re unsure, a broad-based index ETF, like an S&P 500 or Nasdaq composite index fund, is a great starting option.
5. Rebalance regularly. Don’t forget to revisit your investments at least once per year to ensure they’re still inline with your target allocation.

You can open as many taxable brokerage accounts as you’d like. Some people enjoy having separate accounts for each of their savings goals, just remember to view your accounts holistically to ensure you’re not over-concentrated in certain positions.

The takeaway 

Taxable brokerage accounts are great additions to any savings strategy. They allow for ultimate flexibility in terms of investment selection and tax management while giving you easy access to your funds.

When it comes to investing, it’s always prudent to speak with a financial advisor to ensure you’re making the best choices for your situation, but chances are they’ll tell you what Ranchhod says: “Start as early and often as possible.”