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Why You Need a Taxable Brokerage Account in Addition to an IRA & 401(k)


Using a 401(k) or IRA is one of the best ways to save, but these accounts aren’t sufficient for all of your investing needs. While they’re perfect for retirement savings, you likely have things you want to do before you reach your golden years.

Retirement accounts have some significant drawbacks you can run into if you try to use the money in them for anything other than retirement. You could wind up paying massive penalties and incurring substantial tax bills.

By contrast, taxable brokerage accounts don’t offer all of the tax incentives retirement accounts do, but they’re far more flexible. If you expect to need any significant chunk of money before you retire, that makes them an essential part of your savings plans.

Why 401(k)s and IRAs Aren’t Enough

401(k)s and IRAs are two great tools to use when you’re saving for retirement, but they’re not great for other purposes. If you want to invest your money for goals like buying a house or paying for college, you’ll need to use a different account.

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Drawbacks of 401(k)s

401(k)s are the retirement account the average American is probably most familiar with. They can be powerful tools, but some drawbacks stop them from being the ultimate investment account.

1. You Can Only Get Them Through Your Employer

The most significant issue with 401(k)s is that you can only get them through an employer. You can’t just walk into a bank or investment management company and ask to open a 401(k). You have to work for an employer that offers 401(k)s as a benefit, and you must meet the eligibility requirements to sign up.

There are 401(k)s for self-employed workers, but that doesn’t cover people who don’t work for themselves or an employer that offers a 401(k). That leaves a large group of Americans unable to access the country’s hallmark retirement account.

2. They Have Contribution Limits

As with most retirement accounts, you’re limited in the amount you can contribute to a 401(k). These limits come from a few places.

The most commonly known is the IRS’ hard contribution limit, which is $20,500 for contributions made in 2022. You cannot contribute more than this amount unless you’re 50 or older. If you are, you’re allowed to add $6,500 for a total of $27,000.

Your employer may impose other limits. For example, some company’s payroll systems won’t allow employees to contribute more than a certain percentage of their salary. While you can usually get around these limits by talking to HR or the payroll department, it adds extra complications to the process.

The third limit applies to highly compensated employees (HCEs). An HCE is anyone who earns more than $135,000 in compensation or owns over 5% of the business that employs them.

Highly compensated employees cannot contribute a percentage of their salary that’s more than 2% higher than the percentage non-HCEs contribute. At the end of the year, if HCEs contributed too much, the company will refund their contributions, which increases their tax bills.

Companies can avoid HCE issues by providing a safe harbor 401(k) plan. Any plan that meets one of these requirements qualifies as a safe harbor plan:

  • Minimum employer match of 100% of the first 3% of salary contributed and 50% on the next 2%
  • Minimum employer match of 100% of the first 4% of salary contributed
  • Employer automatically contributes at least 3% of eligible employees’ salaries

Not all employers offer safe harbor plans, so if you’re a highly compensated employee, you could be heavily limited in the amount you contribute.

3. Investment Options Are Limited

Because you can only get a 401(k) through your employer, your investment options are highly limited. You can only choose from the options your employer’s 401(k) provider offers. Most 401(k) plans won’t let you go outside of the standard offerings.

Many 401(k) plans offer basic mutual funds and target-date retirement funds. These are excellent choices for many purposes, but they can make it difficult to execute more complex investing strategies. Most 401(k)s won’t let you hedge your investments by buying and selling options or give you the opportunity to buy individual securities.

4. They Can Carry Significant Fees

Some 401(k)s impose hefty fees, reducing your ability to grow your savings over time. These fees can come in the form of account maintenance fees or administration fees, but they can also come in forms that are harder to spot.

Most 401(k)s offer mutual funds as an investment option. Mutual funds charge a fee called an expense ratio. It’s the percentage of your money you pay each year to keep your money in the mutual fund. Expense ratios can be as high as 1% or more, which can have a significant impact on your money’s long-term growth.

For example, if you invest $500 every month in your 401(k) and it earns 7% returns each year, you’ll have $566,764 after 30 years. Reduce your returns by 1% each year, and you’ll have just $474,349. A 1% difference in the rate of growth will cost you more than $90,000 over time.

5. Early Withdrawals Incur Penalties

You’re supposed to use retirement accounts like 401(k)s for retirement. You’re not meant to take advantage of the tax benefits, then turn around and use the money for any reason at all. If you make a withdrawal before you turn 59 ½, you’ll incur a penalty based on the amount you withdraw.

The early withdrawal penalty is 10% of the amount you withdraw. On top of that penalty, the money you withdraw is treated as income and taxed. If your tax rate is 25% and you withdraw $10,000, you’ll pay a $1,000 penalty plus $2,500 in taxes, leaving you with just $6,500 of the $10,000 you withdrew.

6. You Must Take Mandatory Distributions

On top of penalties for early withdrawals come forced withdrawals when you reach 70 ½. You must start taking required minimum distributions (RMDs) by April 1 of the year after you turn 70 ½.

Your RMD is based on your account balance and life expectancy, so it’s difficult to calculate. The critical thing to know is that you still have to pay taxes on the amount you withdraw from the account, even if you were forced to take the distribution. That makes tax planning crucial for people who have to take RMDs.

Drawbacks of IRAs

Individual Retirement Accounts (IRAs) are more flexible than 401(k)s. But they come with their own disadvantages.

1. There Are Income Requirements for Tax Deductions

If you want to deduct the money you contribute to a traditional IRA from your taxes, you have to meet specific income requirements. If you earn too much, any contributions you make won’t be deductible.

For a single person or a head of household in 2022, you can only deduct the full amount if you make less than $68,000. The deduction starts to phase out when your income is between $68,000 and $78,000. If you make more than $78,000, you can’t deduct any of your contributions to an IRA.

If you’re married and filing jointly, you can deduct the full amount if your joint income is $204,000 or less. The deduction phases out completely at $214,000. If you’re filing separately, you cannot take a full deduction, and the deduction phases out completely at just $10,000 in income.

These income limits only apply if your employer offers a 401(k) plan you can use. If you don’t have access to a 401(k), there is no income limit unless you’re married and your spouse is covered by a 401(k) plan.

2. They Have Contribution Limits

IRAs, like 401(k)s, limit the amount you can contribute each year. In 2022, the contribution limit is $6,000. If you’re at least 50, you can add an extra $1,000.

Remember, you might not be able to deduct the full amount you contribute based on IRA income requirements.

For Roth IRAs, you don’t get to make upfront deductions, so the IRS limits your contributions based on your income. For 2022, single people and heads of household can make a full Roth IRA contribution if they make less than $129,000. The contribution limit begins to decrease when your compensation reaches $129,000. You’re no longer allowed to contribute at an annual income of $144,000.

Married people can contribute the full amount to a Roth IRA if their joint income is $204,000 or less. They can no longer contribute at all once their income reaches $213,000. If you’re married filing separately, you can’t contribute the full amount and can’t make contributions at all if you make $10,000 or more.

3. Early Withdrawals Incur Penalties

Traditional IRAs charge the same early withdrawal penalties as 401(k)s: 10% of the withdrawn amount, plus taxes on the withdrawn amount.

4. You Must Take Mandatory Distributions

Traditional IRAs are also subject to the same mandatory distributions as 401(k)s, which can complicate your tax planning.

Benefits of Taxable Brokerage Accounts

You can set up a taxable brokerage account with low-cost investing platforms like Betterment and M1 Finance. These accounts exist to help people invest for goals other than retirement. While you won’t get a tax incentive for using one, they don’t have all of the rules and regulations retirement accounts have. That flexibility makes them worth using for a lot of situations. Consider the following benefits.

1. There Are No Income Requirements

There are no income requirements related to opening a taxable brokerage account. Also, while some brokerages have minimum deposit requirements, plenty have no minimums. All you need to get started is enough cash to buy your first investment.

2. There Are No Contribution Limits

You can deposit as much as you want to your brokerage account, and you can make your deposits at any time. If you have a lot of extra cash, that makes it easy to invest as much of it as you’d like as quickly as you’d like.

3. Investment Options Are Unlimited

Typically, 401(k)s only offer a small selection of mutual funds. With a brokerage account, you can invest in anything: stocks, bonds, options, ETFs, futures, precious metals, commodities, forex, and more are all fair game for you. If you’re a sophisticated investor or want to play around with some nontraditional securities, a brokerage account lets you do that.

Before investing in exotic instruments, take the time to educate yourself. This list of the top forex trading books is a good start for budding forex investors, for example.

4. There Are No Penalties for Early Withdrawals

Possibly the most crucial benefit of taxable brokerage accounts is that you can make a withdrawal whenever you like. All you have to do is sell enough investments to cover the amount you want to withdraw, then ask your brokerage company to send the funds to your checking account.

You will have to pay capital gains taxes if your investments gain value, but there are no withdrawal penalties to worry about.

5. There Are No Mandatory Distributions

Taxable brokerage accounts don’t have required distributions. That means you can keep your money invested long past the time you turn 70 ½. That makes it easier to plan your taxes and leave your investments to grow for future generations.

When to Use a Taxable Brokerage Account

Taxable brokerage accounts are the right choice for several investing goals and situations.

When You’re Saving for Medium-Term Goals

Taxable brokerage accounts are ideal if you want to save for something but need to access the money before you reach retirement age. Whether you’re saving for a down payment on a house or funding a wedding, taxable brokerage accounts offer the growth and flexibility to help you reach your goal.

When You’ve Hit Contribution Limits

If you max out your 401(k) and IRA, you don’t have to stop saving. It just means you can’t contribute more money to those accounts. Taxable brokerage accounts have no contribution limits. You can use them to hold whatever extra cash you have that won’t fit within your retirement account contribution limits.

When You Need Flexibility

Everyone’s financial situation is different. You might want to keep some or all of your savings flexible in case you need to access it on short notice. You might want to retire early or have money available to help take care of a loved one in need. Penalty-free withdrawals provide the flexibility to make these things easy.

How to Reduce Taxes on Your Taxable Brokerage Account

Putting your money in a taxable account doesn’t mean you can’t take steps to reduce your tax bill. Following the right investing plan will reduce the amount you owe when you make withdrawals from your taxable brokerage account.

Hold Investments for at Least One Year

The IRS treats investments differently based on how long you hold the investment. The important cutoff date to remember is one year.

Any investments you sell within one year of buying are treated as short-term investments. You pay your regular income tax rate on any short-term capital gains you make from them.

If you hold an investment for at least one year before you sell it, you only have to pay the long-term capital gains rate.

In 2022, the long-term capital gains rates for single filers and those who are married filing separately:

IncomeTax Rate
$0 – $41,6750%
$41,675 – $459,75015%

For heads of household, the rates are:

IncomeTax Rate
$0 – $55,8000%
$55,800 – $488,50015%

For married people, the rates are:

IncomeTax Rate
$0 – $83,3500%
$83,351 – $517,20015%

Compared to the top income tax rate of 37%, the 20% long-term capital gains tax rate is a great deal that can make holding investments for the long-term well worth doing.

You’ll also pay the long-term capital gains tax rate on any qualified dividends you receive. These are dividends paid by U.S. or qualifying foreign companies on shares that you’ve held for a sufficient period of time before the ex-dividend date.

In other words, dividends are also taxed at a lower rate if you hold the dividend-paying investment for the long term, providing even more incentive to buy and hold.

Invest in Index Funds

If you invest in mutual funds, you’ll have to pay taxes based on the actions the fund managers take on your behalf. If the fund realizes capital gains, you will pay those taxes. The cost can add up quickly if you’ve invested in an actively managed fund that makes lots of transactions.

Index funds are more hands-off investments. They seek to emulate a specific stock index rather than outperform the market. That means managers make far fewer transactions, which in turn means investors realize fewer capital gains. The gains they realize are typically long-term, so the IRS taxes them at a lower rate than short-term gains.

You’ll still pay taxes when you sell your shares, but reducing the taxes you pay while your money is in the fund can increase your investments’ growth.

Invest in Tax-Advantaged Federal or Municipal Bonds

It’s possible to take advantage of certain tax benefits even if you hold the tax-advantaged investments in a taxable account.

Municipal bonds are bonds offered by local governments. They’re usually used to fund specific projects like improving a school or roadway. The interest you earn from municipal bonds is exempt from federal taxes. Most states also exempt you from taxes if the bond is from a city or town in the same state.

Federal savings bonds also offer some tax incentives. For example, bond interest is only taxable at the federal level; they’re exempt from state and local taxes.

You can even avoid the federal taxes on savings bonds if you use the proceeds to pay for qualified educational expenses, making them completely tax-free investments. For singles and heads of household, this tax incentive is only available if your Modified Gross Annual Income is less than $82,350.

After that amount, the tax incentive starts to phase out until you make $97,350 each year, at which point the incentive ends. If you’re married, the phaseout starts at $123,550 and you can no longer receive the incentive if you make more than $153,550.

If you are married filing separately, you’re not eligible for this tax incentive.

Final Word

Retirement accounts are fantastic for their intended goal: saving for retirement. But they’re not the be-all and end-all when it comes to investing. Taxable brokerage accounts are the right tool to use if you need more flexibility or have financial goals you want to reach before you retire.

TJ is a Boston-based writer who focuses on credit cards, credit, and bank accounts. When he's not writing about all things personal finance, he enjoys cooking, esports, soccer, hockey, and games of the video and board varieties.