Tax Season Part 2: Smart Ways to Manage Taxable Accounts

Tax Season Part 2: Smart Ways to Manage Taxable Accounts
Tax Season Part 2: Smart Ways to Manage Taxable Accounts

Tax season is about more than just reluctantly handing over hard-earned dollars to Uncle Sam. It is also a time to reflect on the multitude of options and vehicles available to the astute investor. It is a moment to refocus your attention on diversification and portfolio construction, to check the choices you’ve made in the past still align with your long-term goals, and ensure you’ve factored all tax savings into the equation.

In this quest for tax efficiency, it is easy to get caught out by the face-value appeal of ‘tax-advantaged’ accounts.

These vehicles typically enable holders to defer paying taxes into the future or contribute after-tax funds in order to grow capital tax-free. Yes, that seems attractive, but this narrow focus often leaves the taxable account out in the cold. However, it too has a part to play.

Recapping the Typical Investment Accounts

While this blog focuses on taxable accounts and how best to manage and incorporate these as part of your portfolio, it’s important to understand how taxable accounts fit in with the other well-known investment vehicles: tax-deferred accounts and tax-free accounts.

So, let’s bed down the definitions and get to know a bit more about the respective pros and cons.

  • Tax-Deferred Accounts: The most well-known example of tax-deferred accounts are traditional 401(k)s and individual retirement accounts (IRAs), so let’s focus on these. With these accounts you can invest your dollars towards retirement tax-free. Of course, nothing is really tax free, and you will have to pay tax down the line when you make future withdrawals. Your tax is simply deferred until a later date.
  • Tax-Free Accounts: Again, retirement accounts feature strongly in this category – including the Roth 401(k) and the Roth IRA. In this case, you invest after-tax dollars and when age 59½ rolls around you can withdraw funds tax-free. But you do pay tax upfront.
  • Taxable Accounts: Generally bank accounts or brokerage accounts fall under this category, but taxable accounts include any vehicle where you hold funds on which you have already paid taxes.

You might be looking at these definitions and thinking that deferred tax would be ideal for you, but this is not always the case. For instance, if you are at the pinnacle of your professional career and paying taxes at the top rate then it might serve you to defer paying taxes until retirement, when you’d presumably be taxed at a lower rate.

If you are at the start of your career and being taxed at a lower rate than you expect to achieve, then why not take advantage of paying your taxes at the lower rate today?

As a rule of thumb, remember that tax-efficient investments (such as tax-managed funds and exchange-traded funds) work well when housed in taxable accounts and less tax-efficient investments (such as actively-managed funds, which buy and sell securities more frequently) are better in tax-deferred or tax-exempt accounts. So, both types of accounts can be used well as part of a tax-efficient investment strategy.

From time to time, however, you may want to rebalance your portfolio and consider which combination of accounts are best for your current and long-term interests. That’s when I recommend scheduling time with a professional financial planning expert such as myself, so we can ensure that your target asset allocation is being best served by the vehicles being used.

The Benefits of Taxable Accounts

While it is human nature to see the words ‘tax-advantage’ and assume this is the best way to go, this is not always the case. Paying tax is inevitable, but having the ability to decide when to make the payment can be a decided advantage in the world of financial planning.

Of course, that is not the whole story. Sometimes the flexibility associated with taxable accounts can be an attraction since these accounts are not restricted by the sort of convoluted rules and penalties associated with IRAs or 401(k)s. In addition, there are no age limits affecting when you can withdraw funds and account holders enjoy greater freedom when it comes to deciding how, when and on what to spend their money.

However, there are considerations you should be aware of. For instance, if you choose to sell securities you have held in a taxable account for more than a year, then instead of paying taxes at your current income tax rate you will only pay taxes at the more favorable capital gains tax rate. It is clear to see, therefore, that aiming for low turnover within a taxable account is ultimately the most tax-efficient way to use these vehicles.

3 Smart Ways to Manage Your Taxable Accounts

#1. Keep an Eye on Estate Planning

If you are planning to make charitable donations or intend leaving stocks to your heirs then consider using a taxable account. Remember that in the case of stocks, the value of the asset for tax purposes is determined based on the market value at the time of death, not when they were first acquired. When directly donating stocks to a charity, if they have been held in a taxable account for over a year then you avoid paying capital gains tax and the charity receives a higher amount.

#2. Use Taxable Accounts During Your Retirement

Having the option of withdrawing funds from a taxable account can prove a handy financial planning tool in retirement. Instead of withdrawing more from your 401(k) or traditional IRA, and possibly bumping yourself up to the next tax bracket or impacting your required minimum distributions, simply make a withdrawal from a taxable account.

A similar approach can be used to supplement a 529 college plan, using funds held in a taxable account to cover expenses not deemed educational or any related costs.

#3. Open the Door to Broader Investment Options

The flexibility associated with a taxable investment account such as a brokerage account, means that investors can use these vehicles to hold individual stocks, index funds, exchange-traded funds, savings bonds and tax-managed stock funds. Dividends can also be received into this account.

Seek Professional Support

One of the arguments clients may use against using taxable accounts is that this added control and flexibility often comes with the need for a more hands-on approach. Fortunately, taxable accounts can be managed on your behalf by a professional firm like Method Financial Planning. Get in touch, and we’ll see how taxable accounts can be successfully used as part of your wealth management planning.

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