Standard financial advice is that you should save and invest in tax-advantaged retirement accounts before taxable accounts. This is almost always good advice.
However, supersavers planning for early retirement may have no choice but to use taxable accounts if you want to save more after maxing out all of your tax-advantaged options. You may have intentionally emphasized taxable savings in order to simplify the process of creating income in early retirement. Others may have gotten bad advice to bypass tax-advantaged accounts, and now find yourselves with most of your money in taxable accounts.
Taxable accounts, despite their name, can actually be pretty tax friendly. They are particularly valuable to early retirees because they allow access to money without the restrictions of retirement accounts. So it is important to understand the role taxable accounts can play in retirement and the rules that govern them….
Capital assets are subject to taxation of capital gains or losses. A capital asset is defined in IRS Topic No. 409 as “almost everything you own and use for personal or investment purposes.”
For the purposes of this post, I’ll focus on assets held as investments in brokerage accounts (i.e. stocks, bonds, mutual funds, ETFs, etc). It is worth briefly noting that other capital assets include collectibles, your personal residence, and property used in a business. Each is taxed differently.
Cost Basis vs. Capital Gains (or Losses)
Any time you sell a capital asset you need to know your basis. Your cost basis is the price you paid for the investment. If you inherited the asset, then your basis is generally the value of the asset on the date of the decedent’s death. Determining the basis of gifted property is more complicated, and won’t be covered in this post.
If you sell an investment for its basis, there is no tax consequence. As an example:
- Your Cost Basis = $1,000
- Your Sale Proceeds = $1,000
- Your Taxable Gain (Income) = $0
In this scenario, you can take $1,000 from your account to meet spending needs with no tax consequence.
If you sell an asset for a price greater than its basis, your profit is a taxable gain. As an example:
- Your Cost Basis = $1,000
- Your Sale Proceeds = $1,500
- Your Taxable Gain (Income) = $500
In this scenario, you can take $1,500 from your account to meet spending needs. Only $500 counts as taxable income.
If you sell an asset at a price less than its basis, your loss entitles you to a tax deduction. As an example:
- Your Cost Basis = $1,000
- Your Sale Proceeds = $750
- Your Taxable Loss = $-250
In this scenario, we only have $750 to meet our spending needs. We never want to lose money just to save on taxes. However, in instances where it happens, you can use this loss to offset gains on other investments or up to a limit against ordinary income.
Thus, it is important to know how much of your taxable investments are attributable to basis and how much is attributable to gains (or losses).
Methods to Determine Cost Basis
On an asset-by-asset basis, if you sell only a portion of an investment position, you have to use the same method until the asset is completely sold. There are several methods to determine your cost basis. Take time to understand this and select the most favorable one before you begin selling off a portion of any investment.
First-in, First-out (FIFO) means your cost basis of shares sold is determined by the shares that you bought first (i.e. held the longest). This is the default method of the IRS if another method is not selected.
Average Cost is determined by averaging all purchases. This is frequently the default position mutual fund custodians use to report cost basis.
Specific Identification allows you to select which shares are sold at which time. This gives you the most control over which lot of shares to sell at any given time.
After reading the next few paragraphs, you should have an understanding why Specific Identification is the single best method for controlling the amount of tax you pay. For now, the key take-home point is that you always want to select the Specific Identification method when setting up your taxable brokerage accounts.
Short-Term vs. Long-Term Capital Gains and Losses
All capital gains are taxable income. All capital losses can be used to offset income, providing a deduction that will lower your taxes.
However, not all capital gains and losses are the same. There are short-term gains and losses and long-term gains and losses. They are treated differently.
Short-term gains and losses occur when an asset is sold with a gain or loss after being held for 12 months or less. Short-term gains are taxed at ordinary income tax rates.
Long-term capital gains (LTCG) and losses occur when an asset is sold with a gain or loss after being held longer than 12 months. LTCG are taxed at special LTCG rates. Qualified dividends are taxed at the same rates.
When you sell multiple investment positions, you first have to net out short-term gains vs. short-term losses (i.e. subtract losses from gains) to arrive at your net short-term gain or loss. The same process is then followed to determine your net long-term gain or loss.
Your net short-term gain or loss is then netted against your net long-term gain or loss to determine whether you have a net gain or loss and the nature of it (short-term vs. long-term).
Capital Gains Rates and Brackets
As noted above, short-term capital gains are taxed at ordinary income tax rates. For this reason, you would want to avoid selling an asset with short-term gains if possible unless you have other losses against which to offset the gain.
Long-term capital gains on the other hand are taxed more favorably. The lowest rate for LTCG is 0%. This rate applies for single filers with taxable income up to $44,625 and married filing jointly filers (MFJ) up to $89,250 in 2023.
The next rate is 15% up to $492,300 taxable income for singles and $553,850 for MFJ filers in 2023. Thus, only the very highest earners will ever be taxed at the highest LTCG rate of 20%.
A few points often confuse people.
- Taxable income is in addition to the standard deduction (or your itemized deductions if you itemize). This means you really pay 0% tax on long-term capital gains or qualified dividends up to at least $58,475 total income for singles and $116,950 for MFJ filers in 2023.
- If your income exceeds these limits by a few dollars, only the amount over the limit is taxable at the 15% LTCG rate, not the entire amount.
How a Taxable Account Can Function Similar to a Roth in Retirement
If you have a taxable account that is invested in a tax-efficient way (invested in individual stocks, index funds, or ETFs that generate only qualified dividends and long-term capital gains) and an income that keeps you in the 0% LTCG tax bracket, your taxable account effectively functions as a Roth IRA.
You pay 0% tax on long-term capital gains and qualified dividends and on your withdrawals. Taxable accounts provide these tax benefits without age restrictions on when you can access the money.
Utilizing the Specific Identification method for determining your cost basis, you can elect to sell off positions with higher gains when the capital gains generated will not exceed the top of the 0% bracket. In years when you need more income, you can elect to sell positions with less capital gains (i.e. a greater portion attributed to basis) to generate the income you need while limiting your tax burden.
Disadvantages of Taxable Accounts to Roth Accounts
Taxable accounts clearly have some features that make them attractive. Before you get too excited, remember there are a few important advantages to Roth accounts over taxable accounts.
One is that Roth accounts eliminate tax drag in higher earning years. Once money is in a Roth account it always grows tax-free. Money only grows free of tax drag in taxable accounts under two circumstances:
- Total income is low enough that LTCG fall into the 0% tax bracket, AND
- Income is attributable to long-term capital gains or qualified dividends (short-term capital gains, interest income, and income distributions from real estate investment trusts (REITS) are all taxed at less favorable ordinary income tax rates).
Another key advantage of a Roth account is that qualified Roth withdrawals are always tax-free. This allows you to take larger withdrawals from a Roth account in a given year without triggering tax consequences. Taxable accounts are only taxed at 0% up to defined limits.
Finally, withdrawals from Roth accounts are not taxable income. Taxable gains, even if they are taxed at 0%, do count as taxable income. Therefore, they may impact how much you pay for health insurance by decreasing ACA subsidies or increasing IRMAA.
Disadvantages of Taxable Accounts to Tax-Deferred Accounts
Taxable accounts are far superior to tax-deferred accounts once you are in low income years of retirement. Taxable accounts don’t come with any of the restrictions on withdrawals for early retirees, and are not subject to required minimum distributions in your later years. Withdrawals from taxable accounts are taxed much more favorably than tax-deferred accounts, on which every dollar is taxed at ordinary income tax rates.
Again, you shouldn’t get too excited about taxable accounts and bypass these tax-advantaged accounts. Tax-deferred accounts are very valuable because they allow you to take a deduction in the year you make the contribution.
In general, especially for super-savers on the path to FIRE and people without pensions, these taxes paid at your marginal rate in your highest earning years will be higher than taxes paid on withdrawals in lower earning retirement years. Tax-deferred accounts also always grow tax-free in the same manner that Roth accounts do.
Take Home Message
Conventional advice to utilize tax-advantaged investment accounts is generally wise. However, taxable accounts also have features that make them advantageous, particularly for early retirees.
If you have a substantial amount of money in taxable accounts, don’t fret. Learn the unique benefits these accounts provide and plan accordingly to use them to your advantage.
Related: Early Retirement Tax Planning 101
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to firstname.lastname@example.org. Financial planning inquiries can be sent to email@example.com]
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