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A Tax-Free Retirement Building Block: The Taxable Investment Account

Way To Wealth


Way To Wealth


A Tax-Free Retirement Building Block: The Taxable Investment Account

Luke DeBoer, CFP®

There are many ways to build wealth, some of them easy, some accidental, most require a lot of hard work and patience, many of the ways are worth it in the end. For all the ways to build wealth though, there are probably just as many wealth destroyers. Many of them are self-inflicted, some are not though, such as expenses, bad luck, and one of the two guarantees in life ... taxes. Though few will ever be able to completely (and legally) avoid taxes, there are ways that we can legally limit them. Some of those tactics need to be thought of and acted on years, even decades, in advance. One of these ways to limit taxation is choosing where, as in what type of account(s), to save and invest in. 

With that being said, if you were to compare all of the different types of long-term accumulation accounts in isolation, a certain hierarchy would emerge for which is "best" or, perhaps better stated, better than the next. 

If all returns and time horizons were equal, everyone should follow this order for saving:

1.) HSA

2.) Pre-Tax or Roth Accounts (If all things were equal these are actually identical on net.)

3.) Taxable Investment Account 

4.) In no particular order: annuities, cash-value life insurance, real estate, alternative investments, others as applicable

Here's the thing though, all things are not equal. In fact, when fused together into a comprehensive plan, most or all of the above types of asset accumulation vehicles can be wholly appropriate. What makes them appropriate is how they interact with the other types of accounts when it comes to taxes; because if all other things were equal, it's just taxes and transaction costs that differentiate them. 

An analogy if you will: most reasonable people would probably agree that if we were to compare nutritional items, water is the better thing to have/survive versus carrots. That doesn't make carrots bad, it's just that water is incredibly good for us so we should probably all prioritize it over eating carrots. However, we'd probably also all agree that consuming both water and carrots is better than just consuming water. In fact, it gets better still if we also include apples ... and a protein like chicken ... and so on and so forth. The point being that although there is a proper hierarchy of "good," there is ever more benefit to be found in diversifying. The same thing generally applies to other areas of life as well, including how to accumulate wealth.

Anyway, back to the technical part.

Though all of the vehicles above can have their place, it's #2 & #3 above that make things quite interesting in the world of tax-efficient planning (#1 is just a no-brainer and the items in #4 can make sense but just more sparingly). 

It's the taxable investment account that I want to concentrate on here in particular, as it unlocks some incredible opportunities for pre-tax and Roth accounts. To understand why though, some recognition of how this type of account is taxed is necessary. 

1.) How is it taxed upon contribution?

With this type of account you do not get a tax deduction for contributions. In a way, we could properly call this an "after-tax" account. Though in the personal finance vernacular you will probably never hear it called an after-tax account. 

Let's think about it a slightly different way; let's think of it in terms of how much money it costs to put a deposit of a $1 into one of these accounts. Because it's after-tax, it actually costs more than $1 to actually put $1 in. 

Let's say that we have John Doe with a taxable income of $60,000. He is in the 22% Federal tax bracket and 7.05% Minnesota state (substitute your state if you aren't in Minnesota). Additionally, he has to pay 7.65% for FICA (Social Security and Medicare). All told, he has a marginal tax bracket of 36.7%. So to put $1 into a taxable investment account it "costs" him $1.58 ($1.00 divided by (1 - .367)). 

This upfront taxation makes it different than pre-tax but similar to Roth, though as you'll see here shortly there are many differences yet to be found. 

2.) How is it taxed upon taking the money out?

It gets a bit complex here. With this type of account you aren't taxed when you take the money out of the account, as in the case of a pre-tax Traditional IRA or 401(k), but instead you pay taxes when you a.) receive a dividend, b.) earn interest (excepting interest on certain types of bonds), and/or c.) sell a position that has a gain (called a Capital Gain). So if you want to sell one investment just to buy another one you may be causing a taxable event, even though you aren't "using" the money yet. It should also be noted that when one sells, only the portion that is a gain is taxed, unlike, for example, a pre-tax 401(k) distribution in which the entire amount is taxed. 

The rate(s) that you pay taxes on these events are a bit different than what you would pay from wages or from a 401(k) distribution. 



Taxed at either 0% or 15%*



Taxed like wages or pre-tax account distribution; called Ordinary Income


Short-Term Sale

Taxed like wages or pre-tax account distribution; called Ordinary Income


Long-Term Sale

Taxed at either 0% or 15%*

*There are exceptions to these rates depending on the type of dividend and/or the level of total taxable income. For the purposes of this post, we'll use the two common rates of 0% and 15%. It'll be clear why we ignore the other possible rates in a moment. 

Since a 0% rate is technically possible, the reality exists that this type of account can look similar to a Roth IRA. However, unlike a Roth IRA - where one simply needs to wait till a certain age and longevity of account holding has been attained to get tax-free status - you need to be fairly careful in a.) how you invest the funds and b.) how/when you sell the investments in the account. It's important to remember that the taxable event with a qualified retirement account is associated with the distribution of funds from the account, whereas the taxable event in a taxable account is associated with the liquidation of the investment in the account.

This doesn't sound all THAT appealing. Why is this a good idea?

As you'll see here in a moment, it can be quite appealing because of the ability for a 0% rate on the gains coupled with what you can do with your pre-tax assets in conjunction with the taxable account.

The 0% rate noted above is possible when the combination of Capital Gains and Ordinary Income (which comes from wages, pre-tax retirement account distributions, pension income, interest income, rental property income, etc.) is below a certain threshold. This threshold for a Married-Filing-Jointly couple is $77,200 in 2018. 

Example: John and Jane Doe have $50,000 of Ordinary Income. John and Jane achieve a 0% rate for $27,200 of Long-Term Capital Gains on their taxable account, if we assume they have them. If they have $27,201 of LTCG they would still get the $27,200 taxed at 0% but the additional $1 would be taxed at 15%. 

Here in lies the possible benefit. We'll make this an extremely simple example for effect. Let's say we have John and Jane Doe, both 65 years old. They are about to retire, want $50k of income, are waiting until age 70 for Social Security, and have:

  • $600,000 in pre-tax retirement accounts and
  • $200,000 in taxable investment accounts with a basis (that's how much they paid for the investments and is available tax-free) of $100,000; with the $100,000 of gain being "Long-Term."

They could take their entire income need of $50,000 from their taxable account. In practice it's more complex but to keep it simple let's say they are able to take:

  • $25,000 from basis (not taxed) and
  • $25,000 of gain (taxed at 0% because they are under the $72,200 threshold)

First off, awesome news: their gain is tax-free, making it look like a Roth distribution. However, this is where having a taxable investment account can pay dividends to their plan (pun intended). John and Jane still have "room" in their tax-free threshold. They can have aggregate taxable income of $77,200 yet they only used up $25,000 of it. So they could, if they wanted to, either a.) sell some more of their taxable investments to recognize some gain and reinvest those funds, thereby resetting the basis for future tax-free income and/or b.) convert some of their pre-tax assets to Roth in an effort to fill-up their tax bracket. 

Let's go with the conversion strategy for a moment. Remember that they have "room" within their threshold, namely they have $52,200 that they can use up. If they converted $52,200 of their pre-tax assets to Roth they would still get their $25,000 of LTGC tax-free. It's true that they would owe taxes on the conversion but they are comfortably in the 12% Federal bracket. They now have $52,200 growing tax-free for the future due to it now being in a Roth IRA! Additionally, Roth IRAs don't have minimum required distributions, so when they start taking Social Security they'll have gained flexibility in when they get to take their funds out in addition to the benefit of lower aggregate taxes. It's a gift that keeps on giving. 

Not to belabor the point too much but in the made up example above, John and Jane still have a healthy amount in their taxable investment account. So much so that they could do the exact same thing for several years. This would allow them to convert over $200,000 of pre-tax assets to Roth at fairly low tax rates. 

All of this is possible only because this made-up couple saved and invested in a taxable investment account in the first place!

In truth it can get even better once one starts sprinkling in other accounts/vehicles, such as HSA, Roth, and occasionally more exotic types like rental property or insurance products.

All that being said, it's important to remember that one of the primary building blocks to a tax-efficient retirement ... maybe even a close-to-tax-free retirement ... is the plain-old taxable investment account. 

Taxes can be death to wealth accumulation and maintenance; be sure you're battling back (legally). 

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