Asset location is just as important as asset allocation. Where you hold your investments will determine your personal after-tax return. Some goals and investments have long time horizons and can withstand to be in a retirement account that may not be touched for years.
However, what if you have a short-term goal like a downpayment on an investment property or you want to have a certain level of portfolio income so you can be part-time at your job sooner rather than later? These goals may be realized with the help of a non-retirement account, commonly called a taxable account.
What is a taxable account?
A taxable account allows you to invest in traditional investments (stocks, bonds, CDs, mutual funds, ETFs) that are publicly traded without all the rules that IRAs have to play by. That means no withdrawal restrictions, no age or income limits, and you can use almost any investment strategy you’d like!
The reason it is called a taxable account is that you will be taxed on your realized gains and income in the year it occurs. Here’s a couple examples:
When you sell one of your individual stocks, you will realize (lock in) the capital gain or loss for that investment. You will be taxed on the net gains (capital gains – capital losses) and any dividend income you receive.
As a passive investor, your main task will be managing your income as it can either be taxed at ordinary income or receive qualified dividend tax treatment (long-term capital gains tax rate) which is more favorable.
Similar to stocks, bonds can be traded before their maturity dates are up, thus you can still incur capital gains and losses. The income from a bond is counted as interest which is taxed at ordinary income, IF it is either a corporate bond or a US federal government security.
In the US, a bond income offered by your state or city that you live in is actually tax-free (even in a taxable account)! The coupon or rate of interest you’ll receive on the municipal bond is often much lower than what you can get from a taxable corporate or federal government bond. This can be beneficial if you are bumping up against a tax bracket limit, need more income, and don’t want to push yourself into a new tax bracket which would tax your new income at a higher rate.
Certificates of Deposit (CDs)
Brokered CDs can be bought and sold just like stocks and bonds. These are obligations of the financial institution who issued them and follow similar tax rules to bonds.
There isn’t a municipal tax free option, however similar to bonds the CD has a variety of maturity dates from 1 month to +20 years. In the US, CDs are typically covered by FDIC insurance meaning if the financial institution who created the CD fails, you are guaranteed to at least get your money back up to $250k as opposed to bonds in which default risk is ever present if not backed by the government.
These “pooled” investments’ distributions have differing tax consequences depending on the strategy the portfolio managers decided to use. Buying and selling fund shares follow the same rules as stocks.
Mutual funds and ETFs that follow an active strategy are buying and selling investments in order to beat a benchmark (NASDAQ, S&P500, etc.). In turn, this will produce capital gains, losses, and dividends, of which the net gains and dividends will be distributed to shareholders after losses and fees are factored in. That means distributions can vary year to year with some years having large short-term capital gains which are taxed at ordinary income and can increase your tax liability.
Mutual funds and ETFs that follow a passive strategy will not be constantly buying and selling investments, rather they just try to replicate the benchmark they are tracking. Compared to the active strategy, this greatly reduces the realized capital gains distributions you can expect on an annual basis which means a reduced tax liability. You may still receive dividends but if they are qualified dividends then they are at least taxed less than your ordinary income.
Regardless of which product you choose to invest in, you just want to be aware of how the fund aligns with your goals and if you will receive a better total or after-tax return.
Taxable Account Features
There are numerous firms now that offer taxable accounts. For example, Robinhood is a popular firm due to its little to no fees charged when submitting trades. Another popular one is Acorn which will round up your everyday purchases to the nearest dollar and invest the difference for you.
Of course many of the big names such Vanguard, Charles Schwab, Fidelity, etc. have non-retirement accounts as well but they all have common features such as automatic investment plans, choosing your cost basis, and potentially margin trading which opens up options trading and leveraging your account.
Automatic Investment and Withdraw Plans
This feature allows you the ability to invest money automatically into your account from your bank account. You can even receive instructions for your HR to have a portion of salary go to your chosen taxable account.
Money can typically be automatically funneled either into a cash or money market fund position within the account to await your investment decisions or directing into an investment depending on the financial institution.
Same goes for taking money out. You can set it up so that dividends, distributions, or cash piles can be sent to your bank account automatically on your schedule.
Since you are taxed when you sell your investments, cost basis is important to understand as it determines the amount of gains you will realize on each sale. The initial price of each investment is considered your cost basis, however you get to choose which shares are sold. There are 4 main options you can choose from when you place a sell order:
- First in, first out (FIFO) – Oldest shares will be sold first
- Last in, first out (LIFO) – Newest shares will be sold first
- Average Cost – the prices you bought shares at will be averaged together, but the actual shares sold will be the oldest which could change the “average” price over time
- Specific Identification (SpecID) – you can choose which shares to sell
Thankfully, you are not locked in forever with your decision and can change it anytime for each investment individually. Also, as a passive investor you shouldn’t have to change this a lot, but it is good to keep in mind when you are looking to rebalance your portfolio.
One of the side benefits of a taxable account is the ability to leverage your investments value and borrow against it. Financial institutions will let you open a margin account and lend you money based on the securities you hold. You can use this line of credit to buy more shares if you see a good opportunity or you can take out a loan and use it for something else. Margin interest isn’t cheap, so be sure to run the numbers!
Either way, this increases the investment risk since securities typically fluctuate in value and if there’s a price drop, you may be asked to cover the difference between the current value and the value the institution is willing to lend on.
How does this help me grow my passive income?
By understanding both the investment options and account features, you are able to make better decisions about which assets to hold in this account.
If your strategy is to live off dividends, you may consider using the taxable account to keep investing after you’ve maxed out other tax-differed or advantaged accounts (Roth IRA, HSA, 401k, etc.). That way you may be able to start using the dividends in your taxable account to start paying your bills which would allow you to delay pulling funds from your retirement accounts (more time to grow tax-free)!
You may wish to be completely passive and set up automatic investment and withdrawal plans. This way you can have the system both invest excess cash for you and/or have funds sent to your bank account. This may be beneficial when you’ve already made investment decisions and want to build a position in certain investments. This allows you to focus on making and saving money and letting your system do the rest.
Let’s say you find an investment that is undervalued and pays consistent distributions. Since the price is low, you can buy more of shares and get more overall income than when the price is higher. Only one problem, you only have half the amount you want to invest ready to go. Instead of missing out on the opportunity, you could decide to leverage your investments and use margin to make the full purchase.
If the income from the investment covers the margin interest expense, then you can now work on paying back the margin line of credit in full with regular contributions and the investment income over time since there’s no repayment timeline. You might call this “good” debt since it was used to buy income and once the debt is paid off, the new income stream remains.
Risks and Considerations
Taxable accounts have the flexibility to have multiple owners. This can be good if you need to share your finances with someone but can also create issues if you want the assets to go to someone else upon your death. The transfer on death plan attached to most taxable accounts requires you to name out who will get your assets if you die. If it’s not up to date, or not in line with your other estate planning documents, you may end up leaving your assets with the wrong person.
Investing with margin debt is risky. You can lose more than your initial investment since you also pay interest to the financial institution you are using. As mentioned previously, you can also lose your assets if the value drops too low and the institution has to sell your other assets to reconcile your account if you can’t bring in new money.
You have to be careful when selling assets. You may incur either capital gains or losses which may increase your tax liability or lock in your losses. If selling for a loss on purpose, you must be careful not to sell before or after 30 days of buying the same investment. This is what is known as the “wash sale rule”. This basically cancels out the loss. However, if you sell an investment with a capital gain and another investment (or the same investment but just the shares that are at a loss) with a capital loss then you can net each other out and you won’t owe taxes. ($100 gain = $100 income to be taxed vs $100 gain + $100 loss = $0 income to be taxed)