Photo credit: jb
I’ve written about this topic a few times in the past, such as in this article on tax diversification of your investment accounts. It’s an important topic, but probably the most important subtopic is having a significant portion of your investments not only in tax-deferred accounts, like 401(k) or IRA, but also in regularly-taxed accounts. Roth-type accounts are also critically important, but given the limited availability and costly nature of getting assets into a Roth-type account, I’ll focus for now on the importance of the taxable investment account.
With a taxable investment account, you have the opportunity to use the tax code to your advantage, even though it may seem counter to your initial thoughts on the topic.
Granted, in a taxable investment account you don’t get the complete tax-deferral that is available from an IRA or the tax-avoidance in a Roth IRA. Plus, you know that you won’t get to deduct your investments from your taxable income – but at the same time, when you take distributions from the account, any growth that occurred will be taxable.
But the taxability isn’t the same with a taxable account as it is with your IRA. For example, if you invested $10,000 in a taxable account and it grew to $15,000, you would owe tax only on the growth, $5,000. In addition, the tax rate being used is the capital gains rate, which currently tops out at 20%, for total tax on the distribution of $1,000. The net result for your account is a withdrawal worth $14,000.
On the other hand, if you invested $10,000 in an IRA you’d receive a tax deduction for the contributions (over a couple of years, due to limitations), which might amount to $2,500 if you’re in the 25% bracket. After the growth of $5,000 occurred, you are now able to take distribution of the $15,000 – which is fully taxed at your 25% ordinary income tax rate. The total tax is $3,750 – and now your net result for this account works out to $13,750. This is your total IRA account ($15,0000), minus the ordinary income tax ($3,750), plus the tax deduction credit from your original contributions ($2,500).
A Different Outcome
So the taxable account actually is better in the long run, as the example only dealt with a single distribution. And it actually could get even better, depending upon the circumstances of how the $5,000 growth occurred. Let’s say that the investments were in two different asset classes, for example international stock and domestic stock. Over the years, these two asset classes experienced some rather wild swings in returns, for example let’s say that the international stock experienced returns of 15%, -10%, 20%, 20%, 15%, 10%, and 20%. The domestic stock (for the purposes of our example) had returns of -10%, 5%, -15%, -5%, 10%, -5%, and -7.5%.
If each year when there were offsetting losses and gains in each of the asset classes you used the capital gain and loss rules to your advantage, you’d owe tax only on the difference of taxable gain. And when there’s a net loss, you can write off up to $3,000 per year against your ordinary income. Here’s how it works out:
| Year | Int’l Stock | Domestic Stock | Net Gain/(Loss) | Tax Impact |
| 1 | $5,750 | $4,500 | $250 | $50 |
| 2 | $5,175 | $4,725 | ($350) | ($88) |
| 3 | $6,210 | $4,016 | $326 | $65 |
| 4 | $7,452 | $3,815 | $1,041 | $208 |
| 5 | $8,570 | $4,197 | $1,500 | $300 |
| 6 | $9,427 | $3,987 | $647 | $129 |
| 7 | $11,312 | $3,688 | $1,586 | $317 |
| Totals | Both accounts | $15,000 | $981 |
So, as you can see, you wind up with the same net investment account balance, but by netting your gains and losses annually you wind up paying $29 less in taxes. It should be noted that the Year 2 tax impact includes using the excess loss of $350 against ordinary income, which results in a larger tax reduction in that year since ordinary income is taxed at 25% in our example.
This example is simplified to illustrate the affect. The true benefit occurs as this plays out over many years. The tax benefit of $29 from the example works out to a 4.6% reduction in the tax over just 7 years. Even if you don’t work the gains/losses rules in your favor – perhaps all of your investments increase in value so you have no losses to utilize – the difference between the taxable account’s tax impact and the IRA’s impact is significant enough to make the case. Use a taxable account – the results can be a windfall to you!