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What are taxable investment accounts?
No matter who you open an investment account with, most typically offer the regular taxable investment account. Unlike tax-deferred investment accounts, like traditional IRAs, 401ks, Roth IRAs, and etc., taxable investment accounts count as extra income every year when you sell for a gain or are paid dividends from your investments. This makes them noticeably less tax-efficient than tax-deferred accounts.
Advantages of using a taxable investment account!
There are, however, a few advantages to using a regular taxable investment account along with tax-deferred ones though. The first being that while you might have to pay some taxes on them, unlike the tax-deferred accounts like traditional 401ks/IRAs, you do not have to also pay an extra penalty fee for withdrawing the money before the minimum retirement age of 59 1/2. Another benefit from using taxable accounts is that you are not legally required to take a minimum amount out of them starting at 70 1/2 and with 401ks and IRAs you have to.
Strategies you can use to lower your taxable income when using a taxable investment account!
There are also some strategies you can use to minimize your tax burden. One is to invest in municipal bond funds. Municipal bond funds invest in many individual municipal bonds at once, similar to how ETFs invest in multiple single companies at once. The tax advantage of municipal bonds is that the dividends they pay are free from at least federal income taxes. If you invest with one from the state of your primary residence you also don’t need to pay state income tax on it.
There are also tax advantages for anyone who inherits the money in taxable accounts as well. This tax situation is called step-up in basis. As an example, an investor purchasing a share at $2 and leaving them to an heir when the shares are $15 means the shares receive a step-up in basis, making the cost basis for the shares the current market price of $15.
Any capital gains tax paid in the future will be based on the $15 cost basis, not on the original purchase price of $2. The shares appreciated 7.5 times in value before they were inherited, so after the inheritance, the total savings on capital gains tax would be reflected about that much in the amount of total taxes to be paid pre and post-inheritance. (Source: Nerdwallet.com). This is not an advantage shared by investments held in tax-deferred accounts.
One final strategy to make your taxable investment account more tax efficient is tax-loss harvesting. This is when you minimize your total taxable income by selling some of your investments for up to $3000 in losses for each year. You can only go up to $3000 in one year, but any extra losses on your investments can be carried over to minimize the next year’s total taxable income.
Disclaimer: I am not any sort of investment or financial professional giving any sort of legal advice. I’m just some guy trying to teach other people about how they might navigate the financial world.
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