I work with a lot of mid-career professionals. One trend I’ve noticed is a common desire to create freedom and flexibility with their money today. They want to go beyond simply saving for a retirement decades in the future. Semi-retiring, or the “work-optional” life, is much more appealing. They want to be in a financial position to take a lower-paying, but less stressful job or to take extended time off. The ability to travel and spend more time with family are markers of success.
Today’s mid-career professionals view their careers differently than previous generations. Baby boomers could slowly climb the corporate ladder and retire in their 60s with a comfortable pension. However, 401ks have largely replaced the corporate pension plan. Investors today know they will likely need to rely on themselves for funding retirement. They may as well control the “when” and the “how”. Reinforcing this trend is the emergence of the gig economy and the reality of how insecure our jobs really are. The Global Financial Crisis and the COVID pandemic were stark reminders that a salary can quickly disappear.
The problem is that our retirement system is built around retiring in your 60s. Withdrawing money from your retirement accounts before age 59 ½ is rarely a good idea. Those withdrawals get hit with a 10% penalty, with a few exceptions, on top of the tax liability. So you can have millions in your retirement accounts, but still have a liquidity issue if you want to take some time off work in your 40s or 50s. If financial flexibility is a goal, the traditional advice of maxing out your retirement accounts may not be optimal.
The Account You Need To Retire Early
Enter the taxable brokerage account. This account allows you to invest in the same types of securities that you have in your IRAs and 401ks. You can open a taxable account at just about any major financial institution. You will have access to the broadest range of investments giving you the ability to create a fully diversified portfolio. However, the big advantage of a taxable account over those retirement accounts is that you can access it at any time without penalties.
This added flexibility creates all kinds of use-cases for taxable accounts. You can use it to fund an early retirement, a sabbatical, a down payment, home renovations, or a new business venture. A taxable account provides these options in your pre-retirement years, while a retirement account does not.
If your plan is to retire, semi-retire, or just take time off of work before 60, then you will almost certainly need a taxable account to fund the gap.
The Tax Treatment of Taxable Accounts
The drawback, or price you pay for that flexibility, is that it’s usually not as tax efficient as those retirement accounts. While your retirement accounts get a tax break on the front-end (pre-tax 401ks and IRAs) or back-end (Roth accounts), taxable accounts get neither. Also, as long as the money stays inside your retirement accounts, you aren’t taxed while it’s growing. Taxable accounts, on the other hand, are taxed along the way.
There are a couple of events that trigger taxes in a taxable account.
First, you’ll pay taxes on the dividends and/or distributions paid by a stock/bond/fund in the year those distributions are paid. The tax could be treated as ordinary income or capital gains depending on the distribution.
Second, when you sell a holding, even if you reinvest in something else, it creates a taxable event. If you had a gain on that holding, you’ll owe capital gains taxes. If you held the security for more than a year, you could qualify for reduced “long-term capital gain” tax rates. This means you’ll want to pay attention to how long you’ve held a position before selling or rebalancing.
The Tax Advantages of Taxable Accounts
Taxable accounts are much more tax-efficient than they appear at first glance.
There is a 0% long-term capital gains tax bracket (for 2022, the upper limit for 0% is $41,675 for single filers and $83,350 for married filing jointly). If your income falls under the limit in a particular year, you could realize gains up to the limit and pay no taxes on those gains. Sabbatical years or early retirement years often have lower-than-normal income where you could utilize this strategy.
Also, there is a big tax benefit for charitably-inclined individuals. With taxable accounts, you can donate appreciated securities directly to the charities you want to support. Depending on your income and other deductions, you could receive a tax deduction for the full amount of the appreciated security AND pay no taxes on the gain.
How to Maintain Balance
I think advisors tend to overemphasize retirement accounts and underemphasize taxable accounts. However, I am not arguing that we should ignore retirement accounts completely. For spending beyond age 59 ½, retirement accounts are still the preferred savings vehicle.
So how do we balance the two? Ultimately it depends on your plan and your goals, but there are a couple of rules of thumb.
- Make sure you take full advantage of any 401k matching that’s available before investing in a taxable account
- You want to have a basic level of financial security in place, meaning an adequate emergency fund, no high-interest debt, and you’re on track to retire at a normal retirement age
If you’ve checked those boxes, then you can split additional savings according to your goals. A percentage goes to tax-advantaged retirement accounts and a percentage towards more flexible taxable accounts.
The point is, in a world where we desire more flexibility and freedom with our time, a taxable account is an indispensable tool in the financial toolbelt.