There are a few different ways to build wealth in your 20s, 30s and beyond. Funneling money into tax-advantaged accounts such as 401(k)s and IRAs is a start, but you can only contribute so much every year. Once you hit the contribution limit, you could begin investing in a taxable brokerage account. Before you open one of these accounts, here are a few things to keep in mind.
Check out our investment calculator.
1. Contributions Aren’t Deductible
Unlike the money you save in an IRA or a health savings account, your contributions to a taxable investment account can’t be deducted at tax time. If you’re in a higher income bracket, it’s a good idea to completely max out all of your tax-advantaged options before investing through a brokerage account.
2. Tax Loss Harvesting Is Your Friend
When you sell an investment held in a taxable account for a profit, the sale counts as a capital gain. The short-term capital gains rate, which is your regular income tax rate, applies to investments held for a year or less. The more favorable long-term capital gains tax rate applies when you hold an investment for more than one year.
Investors with taxable accounts can harvest their losses to offset their gains. Essentially, this means that you can sell off an investment that’s underperforming and replace it with a similar (but not substantially identical) holding. At tax time, you can deduct your losses and minimize any taxes you owe on capital gains. That’s something you can’t do with a tax-deferred retirement account.
Related Article: 4 Ways to Minimize Capital Gains Taxes on Investments
3. Charitable Donations Aren’t Subject to Capital Gains Tax
When you donate an investment from a taxable account to charity, you pay no capital gains tax on any profits that are realized at the sale. Then, you can turn around and deduct the value of the gift on your taxes. As of tax year 2015, the IRS generally lets you deduct charitable gifts up to 50% of your adjusted gross income for the year. That’s a definite plus if your investments have performed well but you need to minimize your tax bite.
4. There Are No Early Withdrawal Penalties
Pulling money out of your 401(k) or IRA ahead of schedule is a bad idea for two reasons. First, if you’re under age 59 1/2, you’ll have to pay a 10% early withdrawal penalty on any money you withdraw unless an exception applies. Second, the distribution may also be subject to regular income tax if it’s coming out of a tax-deferred account. With a regular brokerage account, you can sell off investments at any time without paying an early withdrawal penalty.
5. Some Investments Are Tax-Efficient
Certain investments are better suited for managing your tax strategy than others. Those are the ones you might want to incorporate into your investment portfolio. For example, exchange-traded funds typically have lower turnover rates than actively managed mutual funds. That means that the assets held in the fund aren’t swapped as often, resulting in fewer taxable events.
By regularly harvesting your losses and using tax-efficient investments, you can keep your tax bill as low as possible.
Related Article: What Are Exchange-Traded Funds (ETFs)?
6. Fees Can Eat Into Your Returns
When you invest through a brokerage account, you might have to pay for every trade you execute. The fees that discount brokers charge can run between $5 and $15 per transaction so if you’re buying and selling fairly frequently, those costs can easily add up.
As you’re comparing fees, it’s a good idea to keep an eye on the expense ratios of your various investments. That’s the percentage of your assets that goes toward management fees. The higher that ratio, the more of your you’ll have to hand over.
Taxable accounts offer some advantages over traditional retirement accounts, particularly in terms of flexibility and control. Keeping fees in check and having a clearly defined tax strategy are two ways to make the most of your taxable investments.
Photo credit: ©iStock.com/HYWARDS, ©iStock.com/Steve Debenport, ©iStock.com/artisteer