Don’t Ignore Non-Retirement Accounts

By Justin Pritchard, CFP®

When planning for retirement, we often focus on managing taxes and investments in IRAs and workplace retirement plans like 401(k) plans. But there’s another universe of non-retirement accounts available that deserve attention. Those accounts, also known as taxable brokerage accounts, can be useful tools for saving and investing.

Clients often don’t realize that these accounts are available. And even when they’re aware of the option, they have a lot of questions about how taxable investment accounts work. So, we’ll cover some of the essentials here.

Continue reading below, or get similar information from this video.

What Is a Taxable Brokerage Account?

We’ll start with some highlights to help you understand the basic features of taxable accounts. Then, we’ll move on to tax-smart strategies in taxable (or non-qualified) investment accounts.

The most important things to know are:

  • You can invest in accounts beyond your IRAs and workplace retirement accounts.
  • These accounts can be surprisingly tax-friendly (in some cases).
  • You can invest at any level of risk, from FDIC-insured bank products to high-risk portfolios.

We’ll assume that you’ve already done all of the saving and investing you want to do in retirement accounts like your 401(k) and IRA. But you have excess funds, whether that’s a lump sum of cash or extra money each month. That’s where a taxable account might make the most sense. That said, you might have cases where you want to forgo contributions to retirement accounts and use a taxable account instead.

Non-Retirement Accounts

Because these accounts are not “retirement accounts,” they lack many of the features and restrictions you’re used to with IRAs, 401(k) or 403(b) plans, the TSP, and similar vehicles. As a result, these accounts can offer more flexibility than retirement accounts.

No annual limit: You can add as much money as you want to taxable accounts each year. If you’ve maxed out other tax-favored accounts like your 401(k), you can still save money in taxable accounts. There are also no limits based on your income—you’re eligible regardless of how much you earn.

Flexibility: You can withdraw funds whenever you want, although you may face capital gains taxes. You do not need to worry about being eligible to withdraw funds (such as after you leave a job) or an early withdrawal penalty before age 59.5.

Example: Clients with extra money often ask if they can put the money into their 401(k). Maybe they got an inheritance or bonus, or they just have extra funds sitting around. That’s possible (sort of), but 401(k) contributions generally must go through salary deferral. So, one approach is to increase your contributions while spending from your lump sum. However, it’s not a direct addition to the plan. You might also put money into IRAs or an HSA if it makes sense.

No tax deferral: Because these are taxable investment accounts, earnings in your accounts may be reported to the IRS each year. That’s different from retirement accounts, which shield your earnings from taxation—typically until you withdraw funds, or possibly forever (in the case of qualified Roth withdrawals). You typically get a 1099 that reports dividends, interest, and any realized capital gains each year.

Potentially tax-efficient: Although they’re “taxable” accounts, non-retirement accounts can be surprisingly tax-friendly. The income you get might be taxed at favorable rates, and it’s possible to spend from those accounts with little or no tax impact (more on that below).

Use for anything: While some accounts have restrictions (such as using funds for healthcare, education, or only after a certain age), you can use non-qualified investment accounts for any purpose. That makes them helpful for dealing with surprises and emergencies. But keep in mind that emergency savings are typically held in safe vehicles like government-guaranteed bank accounts or similar holdings that provide more predictability.

How Taxes Work in Brokerage Accounts

This can be confusing territory, but we’ll cover some of the basics here. Be aware that tax laws are complicated. There are always exceptions—and exceptions to the exceptions. While the information here might apply to the simplest cases, your situation may be different.

Once you understand the landscape, you can start to strategize and manage your finances with tax-smart strategies.

Income Taxed Annually

Income you receive is typically reported and taxed each year. That income might include:

  • Dividends
  • Interest
  • Capital gains (including assets you sell or distributions from mutual funds)

In some ways, these accounts create “forced income.” The earnings may generate a base of taxable income, and any earnings from work or taxable withdrawals from retirement accounts further increase your income. That can be a non-issue, a nice problem to have, or the cause of tax headaches.

Even if you reinvest that money, you still pay taxes. But those investments can add to your cost basis and can eventually come back to you tax-free. For example, if you get a dividend from an ETF and reinvest it:

  • The dividend income is reported on your taxes
  • The reinvestment is essentially a new purchase with after-tax money

So, you shouldn’t get taxed twice when you reinvest dividends, interest, and capital gains in a taxable account. This is confusing for most people.

Capital Gains and Losses

When you sell holdings in taxable accounts, you might have a gain or a loss.

Example: Say you buy a stock for $10 per share. There are no dividends. Over time, the market price rises to $14 per share. You have a gain of $4 per share. Until you sell, you haven’t realized a gain. But if you sell, you lock in the gain (or loss), which may affect your taxes.

Your realized gains and losses are generally taxable events, and gains in taxable brokerage accounts are typically reported to the IRS.

  • Assets held for one year or less have short-term capital gains (STCG).
  • Assets held for more than one year have long-term capital gains (LTCG).

Again, there may be exceptions, such as when somebody gifts you stock or ETF shares.

In general, long-term capital gains are taxed more favorably than short-term capital gains. That’s because short-term gains can be treated as ordinary income, and are potentially taxed at the highest rates. But long-term capital gains are taxed at 0%, 15%, or 20%. The level depends on your income.

When you have losses in your account, you can potentially put those losses to good use. You might offset capital gains, or you might reduce your ordinary income by up to $3,000 per year, which can help you save a little bit of money on taxes.

In some cases, mutual funds that you own will buy or sell assets, and the gains or losses get passed on to you—even if you didn’t take any action.

Unrealized Gains and Losses

For the most part, you only have capital gains and losses when you sell your holdings. If they gain or lose value and you never sell, there’s typically not a taxable event.

Again, there may be exceptions (such as capital gains distributions from mutual funds, among other things), but if we’re talking basic investing with modest assets, capital gains and losses are primarily only an issue when you sell.

That might be good news, as you can let your assets grow over the long term without taxation. If you eventually sell your holdings, you’ll ideally have long-term gains taxed at favorable rates.

Dividends

Your investments might pay dividends.

Like capital gains, some dividends are taxed at favorable rates—sometimes as low as 0%. The lower your income, the lower your rate may be. But for the best tax treatment, you need to receive “qualified” dividends, which should be identified on your Form 1099-DIV.

Other dividends are treated as ordinary income, similar to pre-tax IRA withdrawals or earnings from work.

Interest

You’re probably familiar with the interest you earn on bank accounts. You can also earn interest in taxable investment accounts, and interest income is treated as ordinary income. The tax you pay depends on your income level, and more income generally results in higher tax rates.

Interest in non-qualified investment accounts may come from bonds or CDs that you hold in your account.

Net Investment Income Tax

In some cases, you may owe an additional Net Investment Income Tax (NIIT) of 3.8% on income in taxable accounts.

This applies when your income exceeds certain levels (see IRS website for current numbers). But the tax only applies to certain types of investment income—it doesn’t necessarily apply to all of your income.

For example, income from pre-tax IRA withdrawals would not be subject to NIIT, but interest and capital gains in a non-retirement account (including bank accounts) could have NIIT.

Step-Up in Basis

At your death, your heirs might benefit from a step-up in cost basis. When that happens, holdings in your non-retirement accounts may get updated to a cost basis equal to the value on the date of your death. As a result, heirs might be able to sell those assets with little or no capital gains.

Let’s say you’ve owned a stock for several decades, and it gained substantial value over the years. If you sell that stock, you might have a large capital gain, resulting in a healthy tax bill.

Example: Sue bought a total market index fund many years ago with $10,000. Ignoring dividend reinvestment, the original shares she bought are now worth $50,000. If she sells today, she’d have a gain of $40,000, and assuming LTCG tax of 15%, she’d owe an additional $6,000 in taxes.

But if Sue dies while holding the investment, those gains are essentially wiped out, and her heirs get a new cost basis. Assuming they sell before the value changes, there might not be much (if any) gain or loss on the position.

Example (continued): Sue dies the next day, leaving the investment to pass to Pat. The market is roughly flat while administering Sue’s estate, and Pat sells the original shares for $50,000. There is no capital gain or loss, and no additional tax due.

The step-up in basis might be one of the most powerful tax benefits of taxable brokerage accounts. This can also apply to other holdings, such as real estate.

Things can get complicated when there are multiple owners, so verify the details with a tax expert and an attorney who are familiar with your situation before making any assumptions. Different ownership types and state laws can have a surprising impact on the step-up.

Tax-Smart Strategies for Non-Retirement Accounts

With an understanding of the tax features, you can see how to minimize the tax impact of taxable brokerage accounts and even take advantage of them.

Control Taxable Gains

When you need money from a non-qualified account, you might be able to manage the capital gains from selling assets. For example, if you want to keep your income low, consider selling shares that have the highest basis (or even shares with a loss).

In many cases, you can specify which shares you sell or favor shares with the highest cost basis. Or, you might simply sell holdings that have the smallest gains. Either way, you can limit additional income from realizing capital gains.

This might make sense if you’re trying to minimize your income to manage health insurance premiums. You might need extra money for spending or for emergencies, and managing gains can help prevent problems.

“Harvest” Gains

You might also be able to take gains at a 0% tax rate. This applies when your income is below certain levels (see IRS website for current numbers).

Yes, you’re reading that correctly: You can potentially pay zero tax on capital gains. But you need to satisfy certain conditions. Any taxable income from other sources can bump up your income to levels that prevent you from harvesting tax-free gains.

Example: Sue, a single taxpayer aged 62, withdraws $25,000 from her pre-tax IRA. But she wants more money to spend for the year. She sells ETF shares in her taxable brokerage account and realizes a gain of $10,000. Her income is low enough that the capital gain is not taxed. Her total federal income tax due is $1,042.50.

Example (continued): Jane realizes she may have an opportunity to harvest gains, so she sells holdings and realizes an additional $15,000 of gain (for a total gain of $25,000 for the year). Her income is still low enough for 0% treatment, and her tax bill is not any higher. Her total federal income tax liability is still $1,042.50.

Jane could take additional gains for this year, if she wanted, and still pay 0%.

Social Security Bridge

Using taxable accounts strategically can help you maximize your Social Security benefits and manage taxes. Social Security is tax-favored income because at least 15% of your retirement benefit is tax-free.

In some cases, your entire benefit is free of income tax, so it makes sense to strategize here.

You don’t need to take Social Security immediately when you retire, and you don’t need to claim as soon as you’re eligible. By delaying, you can potentially improve your tax situation while allowing your Social Security benefit to grow.

If you delay claiming, you’ll need money from somewhere. Spending from pre-tax retirement accounts is often worth exploring, as you might have opportunities to manage your taxes.

It might also make sense to spend down taxable brokerage accounts or other taxable assets. In part, you’re helping to lock in a bigger Social Security benefit. But spending non-retirement assets helps to reduce the size of your holdings in taxable accounts. As a result, you’ll likely get less “forced income” from those accounts each year. That might enable you to keep your income lower and use other tax strategies.

Example: You have $300,000 in non-retirement accounts that generate interest income of roughly 4%. As a result, you get $12,000 of ordinary income each year. By spending down some assets and using that money to pay taxes on Roth conversions, the account balance decreases to $50,000. Assuming the same yield, your forced income is closer to $2,000.

With less forced income, you might benefit in several ways:

  • You could convert $10,000 more to Roth and end up with the same income
  • Less of your Social Security might be taxable
  • Your income might be lower for health premiums

Harvest Losses

It could also make sense to harvest losses. Put another way, you might intentionally sell holdings to create a favorable taxable event.

If you own investments that have unrealized tax losses, you can sell the holdings to lock in the loss. There might be two potential benefits:

  1. You might offset capital gains from other investments, which could reduce or eliminate your overall gain. As a result, you might pay less in taxes.
  2. If losses exceed gains, you may be able to use losses to reduce your taxable income by up to $3,000 per year. If you’re paying taxes at 20%, that could be a savings of roughly $600.

Now, you might prefer to stay invested, so selling may seem like a bad idea. But you can immediately reinvest in similar investments, which might have a similar risk/return profile. The IRS does not allow you to invest in “substantially equal” investments—they might disallow the loss. So, be sure to understand wash sale rules and other details. And be mindful of where you might be investing in the same securities in different accounts (like an IRA, for example).

It’s important not to let the tax tail wag the dog, so you need to evaluate whether or not it makes sense to harvest losses. In some cases, all you’re doing is setting up a low cost basis for investments you’ll just sell in the future. You might end up taking bigger-than-otherwise gains, in that case. And the overall benefit might not be big enough to justify the exercise.

Asset Location

Some people use the same allocation across all of their accounts. For example, they might have 60% in stocks and 40% in bonds—the exact same proportions—in their pre-tax IRA, their Roth IRA, and their taxable accounts.

In some cases, you can benefit from holding different investments in different types of accounts. For instance, it might make sense to favor stocks in a Roth IRA if you expect significant growth. The idea is that you could eventually withdraw all of that growth tax-free, assuming you satisfy the IRS requirements to do so.

Consider how you’ll use your taxable accounts and which investments might make the most sense there. The right solution depends on the makeup of your assets and your plan, so this can get complicated. In general, the more tax-efficient an investment is, the more it might make sense to hold that investment in non-retirement accounts.

For example, a total stock market ETF is typically tax efficient, so holding in non-qualified accounts could make sense. But there may be a conflict because you might want to favor stocks in your Roth IRA. On the other hand, maybe it’s a good idea to keep that ETF in your taxable account if you expect it to receive a step-up in basis at your death. By considering all of the pros and cons, you can eventually figure out which assets go where.

Choose Bond Issuers

If you’re going to hold bonds in taxable accounts, evaluate what types of bonds might be best. A broad mix of bonds might be fine, but be mindful of how much interest income you earn.

If income taxes are a problem for you, you might consider bonds that get favorable tax treatment. But remember that when you make decisions based on taxes, you typically make tradeoffs. For example, you might reduce the universe of bonds, resulting in less diversification, and you might end up with certain risks.

Municipal bonds may be exempt from federal income tax, and you might even dodge state income tax in your home state. But in some cases, that interest income gets added back in. For example, when determining how much tax you pay on Social Security benefits, your modified adjusted gross income (MAGI) includes that municipal interest—which was initially ignored for federal income tax.

Treasury bonds can also be interesting in taxable accounts. That interest may be exempt from state and local taxes.

Give Assets With Gains

If you have holdings that have gained a substantial amount, consider using those assets for giving.

For charitable giving, this might help you maximize your impact. Instead of selling the holdings, paying taxes on the gains, and writing a check for the remainder, you can give the full value of the holding before you sell.

Tax-qualified charities do not pay taxes on the gains, so they can put 100% of the value to work. Plus, you skip the step of putting extra income on your tax return, which could cause complications.

When giving to loved ones, it can also make sense to gift appreciated shares. Again, you avoid selling and realizing the gain. And if the recipient is in lower tax brackets, things might work well if they sell and realize the gain.

Giving away holdings that have gained value can help you diversify in a tax-efficient way. You can chip away at those holdings (that are often bigger than you’d like) while making a difference in someone’s life.

Reinvest Your RMDs

While this isn’t exactly a tax management strategy, people often wonder what to do with their required minimum distributions (RMDs). You’re required to take that money out of pre-tax accounts, but what if you don’t need the money?

There are several ways to use unneeded RMDs, and one of them is to simply reinvest the money in a non-retirement account. The IRS doesn’t require that you spend the money or put it in a bank account—the requirement is that you take a distribution.

General Tax-Efficiency

In general, brokerage accounts are good places for tax efficiency. Other tactics may also help, such as keeping turnover low (or avoiding excessive buying and selling, particularly with short-term gains, unless it actually makes sense). If you pursue that goal, passive strategies or index funds might be a good fit. You’ll also want to pay extra attention as you rebalance, and it might make sense to have dividends paid in cash so you can use the proceeds for rebalancing.

Another way to keep taxes to a minimum, especially if you have significant assets, is to evaluate ETFs vs. mutual funds in your taxable accounts. ETFs might be slightly more tax-efficient.

Inheriting a Non-Retirement Account

While death may be an unwelcome event, some good news is that you may get favorable tax treatment when inheriting a taxable brokerage account. In many cases, you receive a step-up in cost basis, which can result in little or no tax liability if you decide to sell the inherited assets. However, if the assets gain (or lose) value after the date of death, there may be tax implications.

The loss of a loved one can be complicated and difficult, and money you inherit often comes with emotions attached.

For instance, you might be concerned about using money wisely if you inherit from a beloved family member. On the other hand, some people prefer to liquidate the assets as soon as possible—it just depends.

Taxable Brokerage Account Example

Jane will max out her 401(k) and IRA this year. However, she has additional money that she’d like to save for the future, and she doesn’t expect to spend the funds for at least 10 years. She’d like to keep her options open, and she wants to be able to withdraw the money at any time, if needed.

Jane opens a taxable brokerage account, also known as an individual account, for investing. She decides how much risk she’s comfortable with, and she buys a mixture of ETFs that match the risk level. Over time, she manages the account, occasionally harvesting losses as described above.

What’s the Difference Between a Retirement vs. Non-Retirement Account?

Retirement accounts have tax features designed to promote and enhance retirement savings. Contributions might be deductible, earnings are typically tax-deferred, and it might be possible to withdraw tax-free in retirement.

But retirement accounts also have strings attached. There are often limits on how much you can add to an account each year, and withdrawals might be restricted.

On the other hand, non-retirement accounts allow you to add or withdraw as much as you want without restrictions. But you may owe taxes when you sell holdings, and any earnings in the account are typically reported on your taxes each year.

Types of Non-Retirement Accounts

You can save and invest money in a wide range of non-retirement accounts. The most popular examples are joint or individual brokerage accounts. Bank accounts could also fall into this category. Other account types are also treated as taxable accounts, including living trusts, accounts with a POD or TOD designation, some custodial accounts, and more.

Is a Taxable Account Worth It?

If you want to invest for the long term, a taxable brokerage account can be a valuable tool. It’s wise to research alternatives, such as using retirement accounts. However, if you already max out your retirement accounts, a next step might be a taxable account. These accounts are flexible, and they may be more tax-friendly than you think.

If you want to save and invest—and you’ve already used the most tax-advantageous options to the extent you want—the answer is probably yes. The question is: What else would you do with the money?

Important Information

Triple-check everything with your own tax expert before making decisions. This information does not cover every aspect. There may be opportunities and/or risks that are not discussed in this article. Tax rules are complicated and change over time. This content may have errors and omissions, and this is not sufficient information for making important decisions.