As a fee-only financial advisor who is always looking at the tax impact of investing, I often write about the importance of pre-tax investing. Whether it is in a 401k/403b, SEP, SoloK, or a traditional IRA, creating a tax deduction by investing for your future is certainly a home run. In September of 2011, I penned the article titled 401k: Still the Best Game in Town! The post was an example of my belief in the power of pre-tax investing.
Unfortunately, we often are limited to the amount we can invest on a pre-tax basis. The tax code limits how much and who can make contributions to certain retirement accounts. Often, these limitations can impact an investors ability to reach their retirement goals.
The good news is there is an answer when pre-tax investing is not an option. If you can’t invest on a pre-tax basis, a taxable investment strategy can be a great option. It allows for lots of flexibility and can work quite well for most folks. Here are some of the benefits of taxable investing:
Flexibility of contributions and distributions
When investing in a taxable account there are no limitations to the investing or distribution schedules. While I typically don’t count taxable investments as emergency funds, funds can be withdrawn at anytime…..therefore can be used for emergency purposes. With no distribution limitations (other than tax planning strategies)these investments can be used for any purpose: college, retirement, automobile purchases, home remodels…etc.
The timing of when the contributions are made is just as flexible. With all retirement plans there are limitations as to when the contributions are to be made. In a taxable account, the contributions have no timing limitation…..contribute when you want.
Capital Gain Treatment
Another benefit to taxable investing is the treatment of long term capital gains. Even with the increase in capital gain rates this year (for those with higher incomes), distributions are still taxed at a lower rate than that of earned income. The tax code allows for another wonderful retirement strategy. If capital gains are used to fill up the 15% tax bracket as income on your personal tax return, the capital gain tax is zero. Essentially, some people can take up to $72,500 in capital gains and pay no tax! This requires a good deal of planning, but it’s obviously worth it. What a deal, right! This illuminates the importance of taking a look at the tax consequences of distributions prior to pulling the trigger.
Capital Loss Harvesting
Another great tool for taxable investments is the ability to harvest capital losses. Most folks understand that a capital loss may be used to reduce taxable income, but they often feel that taking a loss is an emotional defeat….and therefore choose not to.
There is another way to approach this. The key is to harvest the loss and immediately reinvest into another investment that avoids the wash sale rules. In effect, the investment is not “out of the market”, but we’re able to harvest the loss while the investment has the opportunity to rebound…..essentially, we get to reduce our taxable income.
Dollar Cost Averaging
One of my favorite strategies for taxable investing is the use of dollar cost averaging. Automatic investing helps smooth out the bumps along the investment highway and can be a great way to buy into the market during volatile times.
Don’t forget current taxation
One important note should be addressed when discussing this method of investing. It’s important to understand that all income produced by the underlying investment( except muni- bond interest) will be currently taxed, so it’s very important to invest is a tax-efficient investment….one that doesn’t produce a lot of dividends, capital gains, or other income. This means that bonds and bond funds are certainly not a good choice for this type of investing. Passive investing with index funds is usually the best fit.
There are many benefits to investing in a taxable account. While it is often overlooked, it is a great strategy to invest for the future with flexibility. The next time you find yourself out of options for pre-tax investing don’t throw in the towel….simply look to set up a taxable investment strategy.