A taxable investment account can supercharge your overall savings. No hoops to jump through, just a straightforward process to get started. But don’t be fooled by its simplicity because within this ordinary account are several crucial details not to ignore. From tax considerations and smart ownership titling to savvy estate planning, mastering these aspects is the key to maximizing the efficiency of your taxable account.

Individuals opened 10 million taxable accounts in 2020, according to JPM Securities.

What is a taxable account?

A taxable account, sometimes called a brokerage account, is just an investment account. There are no income, contribution, or distribution restrictions. Nor are there any tax benefits. With a taxable account, you can allocate money for retirement, college tuition, a new home, car down payments, other significant life events, or for no reason other than you want to invest. 

No Limits for taxable accounts

Anything goes when it comes to taxable accounts. There are no limits or restrictions. 

• No Contribution Limits: Unlike retirement accounts, you can put as much in a taxable account as your heart desires. 
• No income limits:  Your income does not affect your ability to contribute. Some tax-advantaged accounts, such as traditional and Roth IRAs, have income limits. 
• No withdrawal rules: There are no restrictions on withdrawing from your taxable account. Retirement accounts restrict when you can withdraw funds or may require you to begin distributions at a certain age, depending on the account. You can take money from a taxable account anytime. 

What is the tax in taxable accounts?

Let’s cut to the chase – taxable accounts do not offer the same tax benefits as retirement accounts. Traditional IRAs, 401ks, and 403bs allow you to make pre-tax contributions and defer taxes until you take distributions. Distributions, however, are taxed as income.

Roth IRAs, 401ks, and 403bs allow investments to grow tax-free, and the distributions are also tax-free. Contributions are considered after-tax and do not reduce your taxable income.

All income generated in the taxable account is taxed and reported on your tax return every year, whether you take funds out or not. There are no deferred taxes. In addition, many investors may be subject to a not-as-well-known Net Investment Income Tax.

There is some good news. Distributions are not subject to income tax. Remember that little nugget when we discuss the retirement benefits of a taxable account!

Favorable tax preference Items

Although a taxable investment account does not offer the same tax benefits as qualified retirement plans, there are specific ways to make it as tax-efficient as possible through qualified dividends, long-term capital gains, and the ability to deduct capital losses.

Qualified Dividends: Qualified dividends receive favorable rates but must meet two IRS requirements. 

1. A U.S.-based corporation must distribute them, or a foreign corporation must be listed on a major U.S. stock exchange. Some investments are excluded, such as Real estate investment trusts (REITs) and certain master limited partnerships.
2. You must own the stock for over 60 days within a specific 121-day holding period. The 121-day period begins 60 days before the stock’s ex-dividend date, precisely 60 days before the subsequent dividend distribution. The mandatory holding period prevents traders from earning tax-advantaged income on stocks they hold for only a few days.

Long-term Capital Gain: The long-term capital gain tax is a tax on the profit from the sale of an investment held for more than a year.  

Qualified dividends and long-term capital gains are subject to the same tax rates and taxable income thresholds.

Capital Loss Deduction: There may be times when some investments are at a loss. When held in a taxable account, you can sell them to offset gains or report a loss on your tax return. You can take up to a $3,000 capital loss deduction each year. Any loss not deducted gets carried forward until fully deducted.

No one likes to see investment losses, but they happen occasionally. You might use them to reduce your income and reallocate your portfolio simultaneously.

Unfavorable tax items

Interest: Interest income is taxable as ordinary income on your federal tax return and is subject to ordinary income tax rates.

Ordinary dividends: These do not meet the standards to be considered qualified and get reported as income taxed at regular income tax rates.

Short-term Capital Gains: The shorter-term capital gain tax is a tax on the profit from the sale of an investment held for less than a year and taxed at your ordinary income tax rates.  

Net Investment Income Tax (NIIT): Taxable accounts are subject to the NIIT when your Modified Adjusted Gross Income (MAGI) is >$200,000 (Single) or >$250,000 (MFJ). Capital gains, interest, and dividends are subject to an additional 3.8% tax when your income crosses that threshold. This tax is not subject to inflation increases.

The calculation depends on, one, how far above the threshold you are, and two, how much net investment income you have. A few examples will help explain.

• Net investment income is less than your MAGI overage. 

You are married and have $75,000 in net investment income, and your MAGI exceeds the threshold by $100,000. You’ll owe the 3.8% tax on the entire $75,000 of investment income you have—since it’s less than your MAGI overage. Your additional tax would be $2,850 (.038 x $75,000).

• MAGI overage is less than your net investment income. 

You have $25,000 in net investment income, but your MAGI only exceeds the threshold by $10,000. In this case, you’ll owe the NIIT on the $10,000 MAGI overage—since it’s less than your net investment income. 

Your additional tax would be $380 (.038 x $10,000).

The moral of the story is if you are subject to the NIIT, consider investing in tax-efficient investments for your taxable account.

Taxable account types

Taxable accounts are flexible, offering multiple ownership titling options.

Individual taxable account: You are the sole owner, meaning it will be in your name and your name only.

Joint Taxable Account: You can own a taxable account with other people, typically spouses, children, parents, or other family members. However, joint ownership does not have to be between relatives but between people with mutual financial goals. The three types of joint brokerage accounts include:

• Joint tenants with survivorship rights: The individuals share equal ownership rights; if one dies, the other will receive the remaining share.
• Tenants in common: If one owner dies, there is no right of survivorship. The deceased’s share gets allocated to their estate.
• Community property: This taxable account is for married couples. If one spouse dies, the assets get split equally, and the deceased’s share goes to their estate. This type of ownership is not available in all states.

Transfer on Death (TOD): Unlike retirement accounts, taxable accounts do not have beneficiaries. You can add a TOD designation to a taxable account. Hence, it passes to your chosen heirs without the need for probate. TOD is not available in every state.

Taxable investment account estate planning

A taxable investment account receives a stepped-up basis on the owner’s death, which resets the cost basis of the inherited asset from its purchase price to the investment market value on the date of the owner’s death, or if the executor chooses, on the six-month anniversary of the passing, called the “Alternate Valuation Date.” 

For example, suppose you inherited a share of stock at $50 that the original owner purchased for $10. Your new cost basis is $50. Not the $10, saving you significant capital gains.

Suppose the cost basis is lower at the time of passing. The asset is stepped down. So no, you cannot take a loss.

Community property state residents receive a double step-up on all community assets. In non-community property states, jointly owned assets receive only half the step-up basis.

The stepped-up basis does not apply to qualified retirement accounts.

Bottom line

Although opening a taxable investment account seems relatively straightforward, you must consider several factors to get the best value from your taxable account. While appearing minor, the tax ramifications, ownership titling, and estate planning could make your taxable account less efficient.