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



Those of us who are passionate about paying down debt, saving for the future, and investing  are no doubt familiar with traditional, tax sheltered investment accounts.

The usual suspects are: 401k retirement plans, which allow you to defer your tax burden until age 59 1/2 when withdrawals are taxed as ordinary income, and Roth IRAs or Roth 401ks, where you are able to contribute after tax earnings now and never pay additional taxes on the earnings or interest as long as withdrawals are deferred until age 59 1/2.

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It’s common knowledge that traditional retirement accounts offer a great advantage to investors, especially those who are investing for the long run: You can save a fortune in taxes by allowing the money stashed away in these accounts to compound, unimpeded by heavy federal and state tax burdens.

What you may not know, however, is that traditional retirement accounts also have some drawbacks that are rarely touched upon during discussions about personal finance and investing. These drawbacks are significant enough that, if they apply to you, it is worth thinking twice about focusing all of your attention on the typical retirement investment options.

Read on to learn where the problems lie, and why the best alternatives may be the ones you least expect.

Pro tip: Do you have a 401k set up through your employer? If you do, you can sign up for a free analysis from Blooom. They will dig into your account to make sure it’s properly diversified, that you have the optimal asset allocation, and that you aren’t paying too much in fees.

Drawbacks of Traditional Retirement Accounts

Here are a few reasons why you may want to avoid putting all of your eggs in the traditional retirement account basket:

1. Contribution Limits
As some of the wealthiest Americans are well aware, there are limits on how much you can invest in tax sheltered accounts. For 401k accounts, this amount currently stands at $16,500 a year if you are under age 50, and $22,000 a year if you are over age 50.

For Roth IRAs, the limit is considerably less. Roth investors can only invest $5,000 a year into these types of tax-sheltered investment accounts. Granted, for most of us, maxing out a 401k and Roth IRA in one year may seem like a dream, but for some people, this is an issue. For more information, see the maximum 401k and Roth IRA contribution limits for this year.

2. Income Limits
Although there are no income limits for investing in a traditional or Roth 401k, there are income limitations on contributions to Roth IRA accounts. Currently you can only contribute to a Roth IRA if you earn less than $107,000 a year (single), or $169,000 a year (married filing taxes jointly).

3. Limited Investment Choices
In some traditional 401k accounts, there are limited investment options that not only hold back the potential upside of your investments, but also force you into investments that may have high upfront and recurring fees. As a result, in some cases, the tax advantage may only slightly offset the poorly performing or high-cost investment choices that employers offer.

4. Early Withdrawal Penalties
With traditional retirement accounts, you spend your life contributing to your nest egg, building up the bulk of your retirement savings, and watching these accounts grow unimpeded. But, what if you want to retire early? You can’t crack open the nest egg without incurring significant tax penalties.

5. Mandatory Distributions
So, if you want to get at that money sooner, you will incur fees and penalties. What happens in the opposite case, when you don’t need the money as soon as you hit retirement age?

Unfortunately, you can’t just leave the money to compound in tax sheltered accounts if you don’t end up needing it in retirement. The IRS requires mandatory distributions from your retirement accounts beginning at age 70 1/2.

Luckily, if you find that any of these apply to you, there are other options. For example, it may be appropriate to supplement your retirement savings accounts with taxable brokerage accounts.

Traditional Retirement Accounts Drawbacks

Advantages of Taxable Brokerage Accounts

At the risk of stating the obvious, these accounts are often overlooked when it comes to investing for the future because, well, they’re taxable. When used in combination with a traditional retirement plan, though, they can be very beneficial.

Consider some of the following advantages of keeping a portion of your savings in a taxable brokerage account.

1. Invest No Matter What Your Income
Make over $107k a year? Good for you! Once you max out your 401k , however, you don’t have the option to further tax sheltered Roth IRA contributions like those who make less than $107,000 annually. Your next stop for savings should probably be your taxable brokerage account, as there are no income limits for investing in taxable accounts.

2. Contribute as Much as You Want
No matter what your income, you can invest as much money as you want into a taxable brokerage account. In addition,  if you choose the right types of investments, you can be tax smart, even though technically you may not be investing in a “tax sheltered account.”

3. Unlimited Choice of Investments
Taxable accounts have an unlimited number of choices. In fact, some say there are too many choices. Sometimes it seems like there are more mutual funds in existence than individual stocks in the stock market.

Whether or not you see it as a good thing, you certainly will not be limited in your choice of investment within taxable brokerage accounts. And if you do somehow feel constrained, you can easily find a new discount broker (e.g. Ally Invest or Scottrade).

4. Withdraw Your Money at Any Time Without Penalty
Want to retire before 60? Your best bet is to invest heavily in taxable brokerage accounts, as having too much of your net worth tied up in tax sheltered accounts will incur significant penalties if you take out any distributions prior to age 59 1/2.

5. Keep Your Money Invested
Taxable investment portfolios do not require mandatory distributions at age 70 1/2. Therefore, if you aren’t planning to need a lot of additional income in retirement because you have a traditional pension, have passive income from a business, or are otherwise independently wealthy, taxable brokerage accounts could work well for you.

This is going to become more of a widespread issue in the future. As years of healthy and productive life continue to increase, many people may be in danger of outliving their retirement savings if they don’t defer retirement for a few years.

As you can see, there are a lot of perks to placing some of your hard-earned money in taxable brokerage accounts. But there’s still that nagging, and potentially major, tax issue. Is there anything you can do to ease the financial blow to taxable accounts?

What About Taxes?

Taxable Brokerage AccountSome people will undoubtedly take issue with the contention that everyone should have a taxable brokerage account. I’ll admit that taxes can eat away at investment returns over time, not to mention become extremely complicated in many cases. This is especially true for short-term investments (defined as less than 1 year), which incur significant short-term capital gains taxes.

However, there are some simple ways to make your investment in a taxable brokerage account much more tax efficient, allowing you to increase the potential for large gains, while not suffering major tax consequences.

Take a look at some of the most tax efficient strategies for your taxable brokerage portfolio:

1. Hold Stock Investments for More than 1 Year
If you are going to invest in individual stocks, hold them for more than 365 days. Holding a stock for more than a year allows you to pay the low, long-term capital gains tax of 15%, rather than the higher short-term capital gains tax rate (which is taxed as ordinary income). In addition, if you choose to invest in a stock that does not pay a dividend, you can be assured that you will only be taxed when you sell the equity.

A quick side note on dividend-paying stocks: Dividends are taxed at only 15% through 2012. This rate is something to take advantage of if you like the idea of short-term payments on a long-term investment.

2. Invest in Stock Index Funds
If you are a more hands off investor, you may want to look into index funds for your taxable brokerage accounts. Because they aren’t actively traded by management, they rack up less in realized gains on an annual basis. To break it down a bit:

  • Realized gains are taxable capital gains that you pay when you sell an equity for a profit. These are referred to as short-term (a year or less), or long-term (more than a year).
  • Unrealized gains refers to capital appreciation achieved prior to selling a stock. Unrealized gains are not taxable, and thus are a great way to steer clear of incurring a large tax burden.

Because index funds buy and sell equities less frequently than many actively traded stock funds, they experience less in realized gains. This includes short-term realized gains, which are taxed at a significantly higher rate. As a result, index funds generally incur relatively low tax rates. But perhaps more importantly, by tracking historically hard-to-beat indices like the S&P 500 or Dow Jones Industrial Average, index funds still provide investors with significant returns.

In addition to being tax efficient, most index funds have the added bonus of low expense ratios, helping you keep more of your cash in the long run.

3. Consider Municipal Bonds / Savings Bonds
Municipal bonds are generally issued as tax exempt on the municipal, state, and federal levels, making them an extremely tax efficient investment.

Federally-issued individual savings bonds can also be a tax efficient investment and, when used for qualified educational expenses, tax-free.

Final Word

While traditional retirement investment accounts like 401ks and Roth IRAs are great, they do have limitations and drawbacks. Taxable brokerage accounts, though often misunderstood and shunned by long-term investors, can be a wise choice if your traditional accounts aren’t meeting your needs. In the end, choosing to diversify with a taxable account may help you achieve some of your intermediate and long-term financial goals.

What are your thoughts on whether or not the average Jane or Joe should invest in a taxable brokerage account? Leave your thoughts in the comments below!

Pat S
Pat S is an active duty military officer. On his off time he enjoys working out, reading, writing and spending time with his dog. Pat became interested in personal finance after several costly mistakes early in his military career that could have been avoided by a basic understanding of personal finance.

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