More ways to avoid the crunch of ‘Uncle Sam.’
Last month I discussed five reasons why you should consider investing in a taxable account: no contribution limits, no income restrictions, ultimate flexibility, potentially lower cost and more diversified investment options, and tax diversification.
Here are five more benefits to investing in a taxable account.
- Your heirs get more money
Suppose over your lifetime you invest $500,000 into a taxable account and it grows to $1.5 million, which represents a $1 million gain. If you sell the securities in the account, you’ll be on the hook to pay capital gains taxes on the $1 million gain. Instead if you don’t spend the assets in the account by the time you die, the account passes through your will to your children so they receive the entire $1.5 million. If they sell the securities, they will not pay tax on the $1 million gain because at your death it’s as if your children bought the securities at $1.5 million instead of the original $500,000. This is known as a step up in basis. Assuming the $1 million gain would have been taxed at a 15% capital gains tax rate had you sold during your lifetime, then that saves them about $150,000 in taxes at your death.
Tax deferred accounts such as IRAs and 401ks do not get such favorable treatment at death. Instead tax deferred accounts pass on to your heirs and they will be forced to withdraw a certain amount of those accounts annually and be taxed on them at ordinary income tax rates, not capital gains tax rates.
- No “Uncle Sam giveth and Uncle Sam taketh away”
You might think that investing in a 401k is tax free, but it’s not. It’s simply tax deferral. What this means is that when you withdraw money from a 401k and other similar accounts, those withdrawals will be reported as income on your tax return. Uncle Sam lowered your tax liability when you made contributions to your 401k, and Uncle Sam wants his “fair share” when you start taking the money out at retirement. You will likely be in a lower tax bracket during retirement than you are while working so the tax on the withdrawals is likely to be lower than the taxes you saved when you made the contributions. But the point is — it’s not tax free.
Now you might think “Can’t I just not take withdrawals or minimize withdrawals?” Not so my friend. At age 70.5 the IRA says you must take at least a certain amount of withdrawals every year (called required minimum distributions or RMDs). And if you don’t? Well be prepared to pay a 50% penalty on the amount of money you should have withdrawn but did not.
With a taxable account there are no RMDs. You can sell securities and withdraw a lot, a little, or none at all and pass on to your heirs. Yes, you’ll pay capital gains tax, but that tax applies to the gains not the entire amount you sold.
- Penalties — what are those?
Speaking of penalties, one of the features I really dislike about 401ks and other tax deferred accounts is that the money is tied up and generally not accessible until after age 59.5 without incurring a penalty. I understand that the goal of these accounts is to fund your future spending in retirement, but there are simply times that you might need some of the money. Taking an early withdrawal from an IRA or 401k before age 59.5 usually results in a 10% additional penalty in addition to the regular income tax. If you’re in the highest tax bracket of 37%, that means you’ll lose almost half of the withdrawal to taxes after factoring in the penalty. While there are some limited exceptions to the penalty including death, disability, excessive medical expenses and others, you’re essentially locked into those accounts.
In a taxable account, penalties don’t exist. Yes, you’ll still pay capital gains tax — only on the gains — but you’ll avoid the 10% penalty. This means the account is more accessible to you.
- Gifting is easier
Let’s say you want to gift money to your children or other family members. One option is to gift cash out of your checking account, but if you don’t want to touch the cash, can you gift out of your IRA? No, unless you die and that IRA turns into an inherited IRA. Or you could withdraw money from the IRA and then gift that money, but from the IRS’s perspective that’s considered a withdrawal and you’ll be taxed and also penalized before age 59.5.
In a taxable account you can easily gift securities directly. Let’s say you bought some shares of a mutual fund for $5,000 and now those shares are worth $9,000. Instead of selling the shares and paying the capital gains tax on the $4,000 gain, you can gift those shares directly to someone else and avoid the capital gains tax for yourself.
It works the same way with charitable gifts. Rather than gifting cash to a charity, you can gift appreciated shares of securities from a taxable account. In an IRA you can gift assets to charity, but you must be over age 70.5 and you’re limited to $100,000 annually.
- Early retirement is possible
If you make higher income, you’re a modest spender, you max out your tax deferred accounts, and you save even more money into a taxable account, you’ve got a chance to cut down on your shifts instead of working full time into your 60s.
Suppose you’re 35 years old, you’re an independent contractor and make $400,000 gross annual income. You’re a big saver and save a total of $100,000 annually. At that level you’ve maxed out your SEP IRA or individual 401k at $56,000. This means you can save another $44,000 into the taxable account annually. Assuming a 4% average annual return after inflation on the $44,000 taxable account, you can reach about $1.3 million by age 55 just in the taxable account. At that point (or even earlier) you don’t necessarily have to work as many shifts as before — unless you really love working nights and weekends. The taxable account can serve as a bridge until you withdraw money from the tax deferred accounts.
I hope you now see some of the benefits of investing in a taxable account. Go ahead and make contributions to your pretax accounts to get the current tax benefit. Once you’ve maxed out those accounts, turn your attention to the taxable account. With the combination of flexibility, wide open investment options, tax diversification and fewer restrictions you should consider a taxable retirement account as a potentially important part of your financial plan.