Whether I meet with a new client, existing client, or a family member, I always seem to hear the same question; where can I allocate available funds after I have maxed out my retirement accounts? Therein lies the taxable investment account – often referred to as a ‘brokerage account’. In my opinion, taxable investment accounts are a great place to allocate monies outside of a designated retirement account while still providing flexibility and choice both today, and down the line.
To recap, this type of investment account accepts deposits of after-tax money, and there is no limit on how much one can deposit. You can also touch the funds invested if need be, at any point with no penalty -if there is a gain realized you do need to consider capital gain taxes. Unlike retirement accounts where your withdrawals are subject to your income tax rate, withdrawals from a taxable investment account (if there is a gain) are subject to long term capital gains rate (0%, 15% or 20% on assets held longer than a year).
However, if you hold a security less than one year, you are subject to short term capital gains tax which is simply your ordinary income tax rate. You should always consult with your tax professional before taking any action.
Below are a few important aspects of these accounts you should be aware of:
Securities held in the account
First, the securities held in this account should be ones that are the most tax advantaged given the tax treatment upon sale or withdrawal. Understanding where your assets are positioned and what the tax treatment is on the way in and on the way out is crucial to not only manage your current and future tax situation, but to provide yourself with an opportunity to use the tax code efficiently.
With that said, a few mistakes I typically see folks make when they come to see me is that they own taxable bond funds and mutual funds in this account. Unlike a retirement account, any income or dividends that are generated are realized as income for you in the current tax year – even if the dividends are reinvested. So, when owning bonds in a taxable account you want to make sure you understand how the dividends could affect your tax situation.
In my opinion, a good rule to follow is if you are a high-income earner, you should be utilizing municipal bond funds instead of taxable bonds funds. Municipal bond funds distributions of dividends payments are typically not taxed at the Federal level, or on the state level if state specific ones were purchased.
Along these same lines, owning mutual funds in your taxable account can have a similar surprise tax implication with the way that mutual funds are structured or ‘packaged’. Generally, mutual funds are required to distribute capital gains recognized by the underlying fund throughout the year to the individual mutual fund investor. This occurs even if the fund has done very well throughout the calendar year, or sometimes mutual funds will pay out capital gains built up over time during down markets.
In this case, the mutual fund could be down 20% for the year, but they still distribute a capital gain that an investor still has to pay taxes on – fun stuff! For some folks, these capital gains distribution can be substantial – in some instances I have seen folks receive a surprised $20,000 or $30,000 capital gains distribution from a mutual fund they own in their taxable account. Of course, there is some planning one can do around this, but your entire situation needs to be taken into account.
Furthermore, rather than owning mutual funds in this account I typically suggest folks use exchange-traded funds (ETFs) instead for their tax efficient structure. Or in some cases, an individual could own individual stocks. You should always consult with your tax professional before taking any action.
Tax Loss Harvesting
Enough about the money invested in the accounts – let’s dive into how you can leverage this account for tax efficiency. The first of two strategies I will explain is reviewing your account for tax loss harvesting opportunities. Simply stated, this is where an investor sells a security in a taxable account for a loss – you are allowed to use up to $3,000 of tax losses each year to offset any gains, or to simply offset your ordinary income. Any additional loss realized can be carried over to future tax years.
To be clear, this does not in any way mean you should sell an investment that is at a loss - which may have the potential to come back - simply for tax purposes – especially if you do not purchase another security to remain invested in the marketplace (more on this below).
For example, let’s say you sold a large cap value ETF in the current tax year at loss, and the loss generated was $9,000 – you can take a deduction of $3,000 on this year’s tax return (as long as there is no gain to match up with), then you can use up the remaining $6,000 of loss ($9,000-$3,000 used), over the remaining two tax years. In this case I would also purchase a different large cap value ETF to reset my cost basis and keep the funds invested in the marketplace. As a note, the IRS does have specific guidelines around what is a ‘similar security’ if the security is too similar you may not be able to take the tax loss.
A similar example is using tax loss harvesting to reduce a gain realized. Say I go into my account, and I want to sell an energy ETF to lock in my profit of $6,000, I can then go and sell a different healthcare ETF at a loss of $4,000 to offset a portion of the $6,000 gain. So, in this case I would have a gain of $2,000 ($6,000-$4,000), instead of the $6,000 realized). Of course, there needs to be a good reason for selling the mutual fund at a loss. You should always consult with your tax professional before taking any action.
Long Term Capital Gains Tax Planning
Lastly, in some scenarios we can help clients use the tax code efficiently by realizing capital gains built up in taxable accounts while paying 0% capital gains taxes. I will go into an example of how this works, but first, a quick note.
Even though capital gains realized will increase your adjusted gross income (AGI) which in turn could phase you out of itemized deductions, some tax credits, push one above an income threshold to qualify for ROTH IRA contributions or a deductible IRA. Realizing a long term capital gain will not push your ordinary income into a higher tax bracket, because ordinary income rates and capital gains rates are separate (as we reviewed from the beginning). On the other hand, realizing short term capital gains will push you into a higher bracket because these gains are taxed at your ordinary income tax rate.
Therefore, as stated above if you have capital gains to realize you can use the tax code to your advantage. This happens by understanding the amount of long term capital gains you can realize while keeping your taxable income in the 12% ordinary income tax bracket (in 2024 this level is $94,050 of taxable income for married couples & $47,025 of taxable income for single filers), if your income spills over the $94,050 the capital gains rate is 15% until your reach $583,750.
I understand the above is a lot of number but stick with me!
Let’s go over a real example to further illustrate the opportunity. Let’s say a couple has combined income (salary) of $94,100 for tax year 2024, they then realize a capital gain of $29,300 which puts their total income at $123,400. They will then take the standard deduction in 2024 of $29,200 and their taxable income would be approximately $94,200, which is just below the top of the 12% marginal tax bracket. So, in this example the couple paid 0% capital gains tax on the $29,300 while still keeping themselves in the 12% marginal bracket. Simple example – but it gets the point across.
When we do this type of planning with clients there is usually a reason – i.e. bridging the gap before they can touch retirement assets at 59.5 if they retire early, keeping their income low for health insurance purposes, utilizing gains they have built up over the years, etc. Moreover, when I assist clients with this type of planning, it goes without saying that a lot of time, effort, and discussion is required before going down this path - as we need to determine how much income they will need to live on, how much gain they can realize depending on how the tax brackets could change, etc. In addition, you should always consult with your tax professional before taking any action.
Upon reviewing the above, you may still have many questions on how capital gains are taxed compared to ordinary income rates, or how to even go about this type of strategy within your own personal situation. With that said, if you are interested in learning more, I’d be happy to set up an introductory call to discuss your situation. Please use the email or phone below to contact me directly.
https://www.bankrate.com/investing/long-term-capital-gains-tax/ - used for capital gains tax brackets for 2024.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.
Matthew Bouthillette CFP®, AIF®
Financial Advisor
Phone: 401-244-3200 ext. 218
matthewbouthillette@pioneerfg.com