Learning the rules to saving with a 401(k) or IRA can be as tricky as learning the rules to Dungeons and Dragons. Just as you might not understand a word you overhear your kids use when playing D&D, terms like required minimum distributions might send your head spinning. But there’s a type of retirement account that takes most of the mind-boggling rules out of the equation — taxable accounts.
You’ve probably heard about 401(k)s and IRAs, but taxable accounts are options often left out of the conversation. These accounts are unconventional, but with a professional by your side, they can make retirement much easier.
If you’re developing a financial plan for retirement, understanding how you’ll be taxed on your savings is crucial. And while taxable accounts offer unique opportunities, they also require special attention to maximize returns.
Types of Retirement Accounts
You may be familiar with 401(k)s, 403(b)s, traditional IRAs, or profit sharing accounts. These are tax-deferred accounts, and they allow you to put off paying taxes on contributions until you make a withdrawal as a retiree. You can shelter your interest, dividend earnings, and capital gains from being taxed until retirement. Tax-deferred accounts are ideal for people with a high income, because there’s no income limit for opening an account.
Roth IRAs and Roth 401(k)s are known as tax-free accounts. You don’t receive any immediate tax advantages—those come later. Roth IRAs are ideal for people with a lower income, because you can only contribute if your annual modified adjusted gross income is $124,000 or less.
With tax-free accounts, you pay taxes on contributions now so that you don’t have to pay taxes on contributions when you make withdrawals. You’ll hear people refer to tax-free accounts’ basis, which is the amount of money in an account that has already been taxed.
If you contribute $20,000 to your Roth IRA and earn $5,000 from investments, the basis is $20,000, and you’ll have to pay taxes on those investments when you withdraw it upon retirement. (Basis becomes relevant in situations like paying your child’s tuition with a tax-free account.)
Finally, there are taxable accounts, which are retirement accounts you set up with a brokerage firm. Unlike other types of accounts, these don’t offer any tax benefits—but they do offer plenty of perks IRAs and employer-sponsored accounts lack. You can open an individual taxable account for yourself or a joint one with a spouse, family member, or even a friend.
4 Things to Know About Taxable Accounts
1. They’re Not So Different from Regular Bank Accounts
Is all this retirement jargon throwing you off? There’s no need to be scared of the mumbo jumbo, especially if you’ve teamed up with a professional who can walk you through the details.
Of all types of retirement accounts, taxable accounts might be the least intimidating, because they’re very similar to regular bank accounts. You deposit money and withdraw money when you need it. It’s that easy!
The main difference is that you can do more with taxable accounts than with a regular account. Think of them as Savings Accounts 2.0. With a taxable account, you can use your funds to invest in stocks, bonds, mutual funds, and more, which helps you earn even more money. As a result, taxable accounts have basis, just like tax-free accounts.
2. You’ll Exchange Tax Benefits for Other Perks
You’ve probably heard people talk about the tax benefits of opening a retirement account. So, why would you bother opening a taxable account if it offers no tax benefits?
Well, tax-deferred and tax-free accounts may offer tax benefits, but the tradeoffs are some major restrictions. For example, you can only contribute a certain amount of money to traditional or Roth IRAs annually. You also have to abide by rules for required minimum distributions (RMDs) with most accounts, which require you to withdraw a certain amount every year once you turn 72.
Taxable accounts don’t hold you hostage with any of those rules. You can start and stop contributing money whenever you want (as long as you’re at least 18 years old), contribute as much as you want annually, and withdraw money whenever you want without being penalized.
Taxable accounts are especially helpful if you already save with another retirement account but want to kick things up a notch. Let’s say you’re maxing out your annual contributions to your IRA, but you want to keep saving. Open a taxable account to keep saving, and enjoy the freedom that comes with it.
These accounts usually include more investment options than employer-sponsored accounts and IRAs. If you want to get creative with investing, taxable accounts offer a lot more freedom.
3. Interest, Dividends, and Capital Gains Are Not Sheltered
Sorry—interest, dividends, and capital gains are not sheltered from taxes with a taxable account. But you do have a little control.
You choose when to “realize” gains or losses. When you sell an asset, it becomes “realized.” So if you want to put off paying taxes until next year, you can hold onto a capital gain or loss for now.
4. There Are Strategies for Paying Less in Taxes
I know, I know, it’s annoying that you don’t get any tax benefits out of saving with a taxable account. But did you know you might be able to avoid paying taxes altogether?
No, I’m not talking about tax evasion. I’m talking about perfectly legal strategies.
You can give assets from your taxable account to a qualified charity through a Donor Advised Fund (DAF). By donating stocks or bonds, you can avoid capital gains and receive a huge tax deduction, all while contributing to an organization that helps others. If you really want to try an advanced strategy, try donating to charity through a charitable trust.
Know How Taxes Will Affect Your Retirement
Whether you save with a tax-deferred, tax-free, or taxable account (or all three!), it’s crucial to understand how and when you’re paying taxes. Saving for retirement isn’t just about how much you earn. It’s about how much you can legally keep. Reach out and book a one-on-one meeting to discuss the details of your retirement account. If you’re being smart about saving, you’re setting yourself up for a happy retirement.