Investors will often ask me whether they should have a taxable investment account, especially when that investor is evaluating the overall tax efficiency of their investments and corresponding accounts. Before we get into that, let’s first talk about a concept called asset location. In its simplest form, asset location is just a fancy way of saying, “what investments to put where.” Generally speaking, there are three types of investment accounts to choose from: taxable, tax-deferred or tax-exempt. The goal with asset location is to have the right investments in the right accounts. At the same time, it’s important to leverage the unique tax benefits available to you from these different accounts. Let’s take a closer look at some of the benefits of using a taxable account as part of your overall strategy to improve the tax efficiency of your investing.
Holding Period and Managing Capital Gains
Let’s say that you are a long-term investor that likes to invest in individual stocks and you are doing your trading in a taxable account. The amount of time that you hold that investment before selling becomes an important deciding factor in the taxes that you will pay. Especially if you’re realizing a profit, you will pay tax on that capital gain. The tax rate depends on whether the capital gain is short-term or long-term. If that investment is held for less than one year, the tax rate could be as high as 37 percent. If held for one year or more, that tax rate can be 0 percent, 15 percent or 20 percent.
Now, let’s go back to our example of the long-term investor. If that particular stock was held for more than one year in a tax-deferred retirement account like an IRA, despite it being a long-term capital gain, you don’t benefit from that lower tax rate. Regardless of the type of gain, the IRA only defers those taxes. And when you do decide to take that money out, it is typically taxed as ordinary income. But since the investor kept that stock in a taxable account, they are able to take advantage of a more favorable long term capital gains tax rate. This is one of the best examples that I can give of tax diversification in action while highlighting one of the benefits of using a taxable account.
Tax Loss Harvesting
Now let’s say that our long-term investor purchases $10,000 of a particular stock at the beginning of the year. After two months, that stock has gone down by 10 percent and its market value is $9,000. Rather than being frustrated by the decline in value, our investor can sell that stock and reinvest the remaining $9,000 back into a similar investment. This strategy keeps market exposure constant. Yet, for tax purposes, you just realized a loss of $1,000. This loss can be used to offset other capital gains that may have been realized in that same account. This is the process used for tax loss harvesting or harvesting your losses. And it is another great example of the benefits of using a taxable account. You couldn’t do this in a 401(k) or IRA because losses can’t be deducted in those types of accounts.
Having multiple types of investment accounts once you’ve retired will also help to give you more withdrawal options. Many advisors recommend withdrawing from taxable accounts first, followed by tax-deferred and tax-exempt accounts. Here’s why: This strategy allows your tax-deferred or tax-free accounts to continue to grow, even in retirement. Let’s go back to our example once more. Perhaps our investor has a number of highly appreciated stocks in their taxable account and they want to take full advantage of the long-term capital gains tax rate. Their withdrawal strategy might be to spend that taxable account to zero before ever using any other accounts. Meanwhile, they are able to sit back and watch their retirement accounts continue to grow, possibly for years to come, before ever tapping into that money.
Tax optimization is going to look different for every investor. Every strategy starts with being mindful of the different accounts that you have and the types of investments that you use within those accounts. From there, you can see if it would make sense to incorporate a taxable investment account into your overall financial plan. This is a great topic to discuss with your tax advisor or CPA to determine what strategy is best for your personal financial situation.
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This commentary does not constitute tax advice. Fiduciary Investment Trusts, LLC (FF4L) and its associates do not provide tax advice.
Senior Financial Consultant