The Value of Investing in Taxable Accounts
Many people invest in their retirement years through various tax-deductible/pre-tax (Pay Later) retirement plans such as 401(k)s, 403(b)s, IRAs, and annuities. These accounts are great for reducing taxes today, but because they grow tax-deferred, many people may face a tax bomb in retirement when they start taxable distributions at future unknown tax rates. On the other hand, the after-tax, taxable (Pay Now) accounts can be valuable for tax planning later in your retirement to provide tax-efficient distributions and income. Gains and income are taxed in the year earned, reducing the taxable amount when distributed.
Contributions and Taxation of Taxable Accounts
Investors have many choices in the types of accounts to invest their dollars. One of the most valuable for future tax planning behind the Roth account is the after-tax/taxable account. Contributions to taxable accounts are made with after-tax dollars and are not tax-deferred. Owners are taxed on interest, dividends, and realized gains in the year received or recognized within the account. The owner will receive a Form 1099 yearly, regardless of if funds were distributed or not. However, current tax law allows preferred tax rates for qualified dividends and long-term capital gains (held for at least one year). The preferred tax rates may allow for more tax-efficient growth over the years. When funds are distributed, the owner will not be taxed on the portion of the account already taxed in the previous years, allowing for more tax-efficient distributions and income. Reducing taxable income in later retirement may allow for various income tax planning considerations when the account owner is in a lower marginal tax bracket. See Figure 1.
Advantages of Taxable Accounts
There are several advantages of taxable accounts that can benefit the account's owner(s) and the beneficiaries of those accounts.
First, long-term capital gains (held for at least one year) and qualified dividends are taxed at lower rates (0%, 15%, or 20%) than marginal income tax brackets.
Second, as interest, gains, and dividends are realized and taxed, the cost-basis increases. When distributions are made in later years, only the new realized interest, gains, and dividends for that particular year are taxed, potentially reducing one's overall marginal income tax bracket. This strategy is beneficial in early retirement to provide tax-efficient income and to allow for potential Roth IRA conversions at lower tax rates.
Third, beneficiaries are allowed a stepped-up cost basis upon the death of taxable account owner(s).
Example: Beth invested in a taxable account with an initial cost of $1 and later passed away. On the date of her death, her taxable account was valued at $100. Therefore, her beneficiaries get a stepped-up cost-basis of $100, and if they sell the holdings in the account later for $110, they will pay only $10 in capital gain since their new stepped-up cost-basis is $100.
Tax-Deferred Retirement Accounts and Annuities
Retirement accounts and annuities also offer tax deferral until distributions are made, allowing for the compounding of the funds that would otherwise be used to pay taxes. Having one's contributions tax-deductible and growing tax-deferred looks appealing until you realize how much tax you may owe in the end.
Future tax risk, coupled with Required Minimum Distributions (RMDs), requires careful consideration of each person’s situation and objectives. It should motivate investors to consider after-tax Roth contributions to their retirement plans, if available, as well as taxable accounts (individual, joint, or trust) that may allow for attractive tax planning options in our later years.
Summary of Account Types
Pre-tax only Example: If someone has only tax-deductible/pre-tax IRAs and 401(k)s and earn $100,000 per year income and plan to retire with living expenses of $100,000, they cannot reduce their marginal income tax rates because the pre-tax IRA distributions for income will be 100% taxable just like their pre-retirement income keeping them in the same marginal income tax bracket.
Pre-Tax and After-tax Example: If someone has both pre-tax IRA accounts as well as after-tax/taxable accounts, they may be able to take distributions from their tax-efficient taxable accounts and possibly drop their marginal income tax bracket down to lower brackets that may provide numerous tax planning strategies including possible being able to covert some the pre-tax IRAs to Roth IRAs at lower income tax rates. The optimal time to do so may be in early retirement when the 100% taxable salaries stop and before starting Social Security, since up to 85% of benefits may be taxable, and before Required Minimum Distributions begin. The required minimum distribution (RMD) age depends on your birth year: it's 73 for those born between 1951 and 1959, and 75 for those born in 1960 or later.
Below is Table 1. that illustrates the various taxation of these accounts. In most cases, these accounts can utilize the same investment (CD, mutual fund, brokerage account, managed account, and annuities). The account title (individual, joint, IRA, Roth IRA, trust, etc.) determines the account's taxation.
Bringing It All Together
All the account types listed above provide various tax benefits and add value depending on each person’s situation and objectives. Having various account types, including taxable accounts, may help us grow and distribute our wealth tax-efficiently while providing more tax planning options.
The challenge for many is the pleasure of immediate tax savings with the tax-deductible/pre-tax accounts that are hard to pass up, which can lead to potential tax bombs later when RMDs are required at future unknown tax rates.
In conclusion, think of it this way—pre-tax and tax-deferred accounts provide tax savings on the seeds/dollar contributions, but the harvest/distributions from these plans will be 100% taxable. Remember that qualified Roth distributions can be 100% tax-free; taxable accounts are only taxable on the realized interest, dividends, and gains not previously taxed.
Remember, Forward thinking is good planning!
About the Author
Tim Hudson, CFP®, APMA®, CEPA, CLU, ChFC, CRPS®, is a Certified Financial Planner® and Certified Exit Planning Advisor® and has over 25 years of experience specializing in advanced investment, retirement, business, and estate planning strategies designed to help high net worth individuals and business owners grow, preserve, and distribute wealth tax-efficiently.
Tim founded Wealthtrition.com to provide advanced wealth education, resources, and planning services for individuals and business owners.
You can reach Tim at (281) 477-3847 or tim@SilverStarWealth.com.
SilverStar Wealth Management, Inc.
17844 Mound Rd., Suite E, Cypress, TX 77433
(281) 477-3847 | www.SilverStarWealth.com
Important Disclosure
This material is intended for informational purposes only and is not intended to be a substitute for specific individualized tax or legal advice, as individual situations may vary. Securities offered through Kestra Investment Services, LLC, member FINRA/SIPC (Kestra IS). Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS). SilverStar Wealth Management, Inc., Bluespring Wealth Partners, LLC, Kestra IS, and Kestra AS are affiliated through common ownership by Kestra Holdings.
Investor Disclosures: www.kestrafinancial.com/disclosures
You should consult with appropriate financial, tax, or legal professionals before implementing any considerations discussed.