Why you should be saving in a taxable investment acount

There are three main types of accounts that you can invest in.

Today, we're going to talk about the account that I believe is the most powerful and yet the most under utilized...

A Taxable Investment Account.

This is part 2 in this series.

Part 1 was about "where to save your money".

I often get asked where and how to most effectively save your money. If you'd like to know more, read part 1.

To skip over the recap and straight to the strategy, click HERE.

Just a quick point of clarification:

Since investing is a long term plan and we assume that your invested money will grow over time, we're going to call the money you invest today the Small Dollar.

We'll call your future invested money the Larger Dollar.

Today

30 years from Today

Understanding the types of accounts

You have many accounts that you can save in, but they fall into three main categories. This article will focus on the Taxable Account.

Pre-Tax
Post-Tax
Taxable

Pre-Tax - you pay taxes LATER

(the larger dollar)

Post-Tax - you pay taxes NOW

(the smaller dollar)

Taxable - you pay taxes LATER

(only on gains)

Taxable Accounts

Think of your checking & savings account or brokerage investment account.

Your contributions to these accounts are after tax. You get no tax deduction.

IE, if you make $100k this year and you contribute $5k to your Taxable Account, you DO NOT deduct the $5k from your income when you file your taxes.

You end up paying taxes based off your full $100k income.

The real power of these accounts comes from how you pay the taxes.

You only pay taxes on the GAINS, and it's at a lower rate than your income tax rate. *assuming you've held your investment for more than one year.

(Taxes paid on gains)

You pay DON'T pay taxes Today

You pay taxes on the GAINS, and only when you "realize" the gain.

Let's unpack a few of the tax caveats first.

1) I was over simplifying earlier when I said you "only pay taxes when you realize the gain."

In reality, you'll likely receive a 1099 every year with taxable income for any interest, dividends or capital gains if you're investing into some type of actively managed mutual fund.

So for simplicity to illustrate this I'm writing as if you bought one single, non dividend paying stock.

2) The taxes owed are broken up into Short term and Long term Capital gains.

Short Term Capital Gains

Held less than one year

If you buy XYZ stock for $10 / share on Jan 1, 2020 and sell it for $15 / share anytime in 2020, you owe taxes on:

The $5 in gains payable at:

Your Ordinary Income Tax Bracket

($5 Taxes owed)

$10

$15

Your current tax bracket.

Long Term Capital Gains

Held more than one year

If you buy XYZ stock for $10 / share on Jan 1, 2020 and sell it for $15 / share anytime after 2020, you owe taxes on:

The $5 in gains payable at:

A Preferred Tax rate.

($5 Taxes owed)

$10

$15

A Preferred Tax rate.

Strategy

A few things to note about this type of account:

Like your checking and savings, you have access to this money anytime. There are no restrictions prior to 59 1/2 years old like there are with the pre-tax and post-tax accounts.
Building up this account with time can be incredibly powerful in retirement because you can have more control of your taxes.

You may be familiar with all of this so far. I certainly was.

But two years ago, I actually saw the power of this taxable account in action and I was shocked.

Let me show you.

This example is from a 2017 tax return, but it's the best example I have.

We'll just focus on the main parts.

Stocks sold at a long term capital gain.

This clients total income for the year.

Adjusted Gross Income

$120k a year is a pretty comfortable retirement income right?

I'd certainly be happy in retirement making $10k a month.

But the best part is next...

What??

Yes, Zero dollars in taxes.

Their taxable income of $72,669 put them in the 15% tax bracket. In 2017, that meant that their taxes owed on their Long Term Capital gains was ZERO%.

This is just an example. You may not have $40,000 in itemized deductions like they did but the concept is still the same.

If your taxable income is within the below ranges,

You would pay this in long term capital gains rates

So what does this really mean for me?

Let's first break this up into two life stages.

Pre-Retirement
Post-Retirement

Pre-Retirement

As you are building up a taxable investment account pre-retirement, you are building up an account that is fully accessible to you at any time.

Unlike your 401k or IRA's, there is no penalty for using the funds prior to 59 1/2 years old. You just pay the taxes on any gains.

You will likely pay some tax on these gains since you will also have income from employment, but it should still be lower than your marginal tax rate.

This means that if you come across a buying opportunity (for a rental property, business or other investment), you would have money that is accessible.

Post-Retirement

This is where the real power of the taxable account is.

One of the most important recommendations I make to my clients is for the larger income earner (in a married couple) wait until age 70 to take Social Security.

For most, this leaves up to a 5 year gap where we need to find income somewhere else.

We'll overly simplify this example to illustrate the point.

You Retire at 65

You Plan to take Social Security at 70

Your Annual income needs are $100,000

And you've saved up:

Pre-Tax - $500,000

Post-Tax - $500,000

Taxable - $500,000

Year One of Retirement

You live off of $100,000 from your Taxable Account.

Assuming this is all long term capital gains, you have:

$100,000 of income from your taxable account

- $26,100 standard deduction (assuming over age 65 and filing jointly)

$73,900 Taxable Income

This would mean you could owe ZERO TAXES.

OR... You could REALLY LEVERAGE the long term benefits of the Taxable Account.

Year One of Retirement

You live off of $100,000 from your Taxable Account.

You do a Partial Roth Conversion of $94,500.

($100k income + $68,400 to fill up 22% tax bracket + $26,100 for your standard deduction)

You have

$94,500 taxed at 10, 12 & 22% brackets* = $12,506
$100,000 taxed at 15% = $15,000

*Assuming 2020 married filing jointly tax rates

Total potential tax paid of $27,506

Divided by your total income of $194,500 and your

Effective tax rate is ~14%

Remember, when you contributed the money to your Pre-Tax account, this was Tax Deductible. This means you reduced your income by your contributions. It's likely that you were in a higher tax bracket then.

So in a sense you "saved" yourself from paying 22%, 24% or more in taxes when you contributed to your 401k in high earning years.

When you converted the money to your Post Tax account, you paid roughly 14%.

That 8-10% difference in taxes is money you get to keep and you NEVER have to pay taxes on that money again!

1) When you contributed money here, you DEDUCTED this from your income tax while you were working (assuming 22% - 24%)

Pre-Tax - $405,500

Post-Tax - $594,500

Taxable - $400,000

2) You paid taxes on your conversion amount at roughly 14%

3) You used your Taxable money to pay your bills

You could do this strategy every year for 5 years between age 65 and 70. (final math below is simple math, we're ignoring tax law changes and annual changes to tax brackets.)

Five Years Later (Age 70)

Pre-Tax - $27,500

Post-Tax - $972,500

Taxable - $0

Age 70 and beyond:

If you are left with your assets close to the proportion above you can potentially avoid:

Your Social Security benefits from being taxable.
Medicare surcharges due to high taxable income.
Being "bumped up" a tax bracket when required minimum distributions start from your Pre-Tax account.
Leaving assets to heirs that will be taxable to them.

DISCLAIMER: This illustration is overly simplified and merely meant to illustrate the benefit of using your taxable money for income so you can do Partial Roth conversions.

All calculations were made assuming 2020 tax rates, married filing jointly.

Tax code is very nuanced and personal. Please consult your tax advisor before you pursue this strategy.

I've been a financial planner since 2007 and I think that Partial Roth conversions are one of the most powerful tools you can utilize.

But, in order to fully maximize the power of Partial Roth conversions, you need to have a taxable account built up in order to use it for your income to survive, plus the tax liability of Partial Roth conversions.

Even if you never did a Partial Roth conversion, I would still recommend building up a taxable investment account as a part of your financial planning strategy.

A taxable investment account provides you with:

Options (another way to manage your taxes)
Flexibility (it's not tied up until 59 1/2)

With so many variables surrounding financial planning, I think two of the most underutilized topics are saving in a way that gives you the Option of paying taxes in a different way.

And the Flexibility to use money at different points in your life for different goals.

Now that you (hopefully) believe in the importance of why you need a taxable investment account, continue onto part 3 to understand why you should invest differently in each of your three accounts.

If you are interested in learning more about taxable accounts, but don't know how to get started feel free to schedule a phone call. We're happy to help...

We're a different kind of financial firm than you may be used to.