Are you already saving at least 15% for retirement, and you’ve already built your emergency fund up to cover 6 months of basic expenses, and you still have extra money to save? This is a great opportunity for a taxable investment account, also called a brokerage account.
Your top two priorities, at most any stage, are going to be:
- An all-cash emergency fund.
- Saving (and investing) for retirement
These are, for most people, not negotiable. This is about as close as it gets to The Law in personal finance.
A taxable investment account might very well be #3.
What Is a “Taxable Investment” (or “Brokerage”) Account?
Most people have and understand 401(k)s because they’re an accepted part of work in the tech industry. But many I talk with don’t grok the whole “taxable investment account” thing. The concept is quite simple, if unfamiliar.
Here’s how a taxable investment account works:
- You open such an account at a Vanguard or Schwab or TD Ameritrade.
- You put money into it. Maybe you even set up a direct deposit straight from your paycheck! (Automation, paying yourself first…all fantastic ways to get around your unhelpful lizard brain.)
- Choose your investments from the world of investments. Of which I recommend you summarily reject 99% for being expensive and too narrowly focused.
It works pretty much like a retirement account does but:
- You don’t get any tax savings now (or down the line, if we’re talking about Roth accounts) with your contributions.
- On the other hand, there’s no limit to how much you can save/contribute to a taxable investment account.
Why Is It Important?
In a word, flexibility.
(This article goes over several other benefits, but for women in their early-to-mid career, flexibility trounces them all.)
The money you have in a 401(k) can pretty much only be used for retirement (and at that, only once you’re 59 ½ or older). The money you have in a 529 can only be used for your kid’s college. (For all you detail-oriented folks out there, yes, there are exceptions.) That lack of flexibility is the price you pay for the tax savings.
The money in your brokerage account? You can use that for Anything. Anytime. No penalties. No restrictions.
Want to buy a house? Use it for a downpayment. Kid going to college next year? Use it to pay her tuition. Want to retire early? Use it to pay your living expenses. Something completely unexpected happen that you need money for? Use it for that.
This is Investing, Not Saving
Even as I wrote that last paragraph, my own hackles were rising. I don’t want you to invest any money intended for a goal in the next 3-ish years. One way of defining investment is “the risk that you’ll lose money.” The shorter the time frame, the higher the risk of loss.
If you have a goal for some time in the next 3 years, you should just follow the boring rule of save, save, save to a bank account. This blog post is not for you!
But, if you’ve got specific goals that will come after that, or if you don’t have any specific goals but know that you’re going to want something down the road, you want to keep your options open, then a taxable investment account is appropriate for you.
How you invest your money in that account is going to be specific to you and your life. Generally, the longer you have before you’ll need the money, the more aggressively you can invest. But my point here is to invest the money at all. Specific investment strategies are a separate subject (and my oh my, much more highly regulated).
“But, But, I’ll Owe Taxes!”
We all love 401(k)s because of the tax savings: you either reduce your income tax now, or know that you’ll be able to get at that money tax-free in retirement (in the case of a Roth account). I often encounter people who get worried about all the taxes they’ll pay in a taxable investment account, because it doesn’t have that lovely tax wrapper around it as a 401(k) or IRA does.
Let me assure you that there are tax-savvy ways to invest a taxable investment account to minimize taxes.
- Certain funds (primarily ETFs, index mutual funds, and other “low turnover” funds) generate very little taxable income each year.
- Don’t buy and sell your investments very often (a good lesson in general, not just for tax purposes).
- Buy tax-exempt bond funds instead of the usual “yes we tax these”-bond funds.
- Harvest tax losses.
To boot, the tax rate you pay on the gains in your investments (“capital gains”) starts at only 15%. And you only pay it on the gains, not the whole amount.
All that said, “don’t let the tax tail wag the investment dog.” The point of the taxable investment account is flexibility, choice in your life. Not saving on taxes. And remember, if you end up paying more taxes on your investments, that’s because your investments gained in value! That’s good!
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.