Understanding Taxable account in layman terms

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loss
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Understanding Taxable account in layman terms

Post by loss »

Hi guys,

Before I open a taxable account I wanted to make sure I know what I'm doing :) Would you guys mind answering some questions for me? I am planning to open an after-tax brokerage account with Vanguard building a 3-Fund lazy portfolio and invest 10K in it. I will afterwards be investing around 1K every month in this portfolio.

1. I guess this is a silly question but Is there a difference between taxable and brokerage account? I have heard both terms used interchangeably but don't know if there's a difference. Is there specific terminology that I need to use when calling up Vanguard's representative so they know what I'm asking for?

2. How are taxes paid on taxable accounts? Do I pay taxes only on money that I made from investing or is there more taxation happening that I should be aware of? Will I be taxed again when I choose to withdraw a lump sum X years from now?

3. Should I choose to automatically reinvest money that I am making like I am doing in 401k?

4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?

Sorry for stupid questions and thanks a lot! :)
sport
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Re: Understanding Taxable account in layman terms

Post by sport »

loss wrote:Hi guys,

Before I open a taxable account I wanted to make sure I know what I'm doing :) Would you guys mind answering some questions for me? I am planning to open an after-tax brokerage account with Vanguard building a 3-Fund lazy portfolio and invest 10K in it. I will afterwards be investing around 1K every month in this portfolio.

1. I guess this is a silly question but Is there a difference between taxable and brokerage account? I have heard both terms used interchangeably but don't know if there's a difference. Is there specific terminology that I need to use when calling up Vanguard's representative so they know what I'm asking for?

2. How are taxes paid on taxable accounts? Do I pay taxes only on money that I made from investing or is there more taxation happening that I should be aware of? Will I be taxed again when I choose to withdraw a lump sum X years from now?

3. Should I choose to automatically reinvest money that I am making like I am doing in 401k?

4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?

Sorry for stupid questions and thanks a lot! :)
1. The mechanics and terminology are the same for taxable or an IRA.
2. There are three taxable events in a taxable account.
a. Dividends may be paid monthly, quarterly or annually. They are taxable in the year paid, whether or not you reinvest them.
b. Capital gains distributions. They are taxable the same as dividends.
c. Unrealized capital gains. They are taxable (or might be a tax credit if you sell at a loss) only when you sell.
3. Sure, why not.
4. It makes no difference.
livesoft
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Re: Understanding Taxable account in layman terms

Post by livesoft »

loss wrote:Hi guys,

Before I open a taxable account I wanted to make sure I know what I'm doing :) Would you guys mind answering some questions for me? I am planning to open an after-tax brokerage account with Vanguard building a 3-Fund lazy portfolio and invest 10K in it. I will afterwards be investing around 1K every month in this portfolio.

1. I guess this is a silly question but Is there a difference between taxable and brokerage account? I have heard both terms used interchangeably but don't know if there's a difference. Is there specific terminology that I need to use when calling up Vanguard's representative so they know what I'm asking for?
A brokerage account can be an IRA, a Roth IRA, a 401(k), a 403(b), or a taxable account. A brokerage account just holds investments that can be purchased at a brokerage. A taxable account is just an account that does not have the typical tax advantages of tax-deferral or non-taxed income or gains.
2. How are taxes paid on taxable accounts? Do I pay taxes only on money that I made from investing or is there more taxation happening that I should be aware of? Will I be taxed again when I choose to withdraw a lump sum X years from now?
A US investor would pay the taxes that they were liable for when they filed their tax return. A taxable account may have taxes on the yearly, quarterly, monthly distributions and on sales that realize gains. The account will get a tax break on sales that realize losses. Unrealized gains are not taxed. Tax-exempt income from tax-exempt municipal bonds are not taxed, but will affect the taxes on social security income. Also the federal government and the individual states will tax different things differently.

3. Should I choose to automatically reinvest money that I am making like I am doing in 401k?
It depends.
4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?
It probably makes no significant difference. If you do open one in 2015, then you will get tax information for 2015 very soon that will help you in the future and focus your attention on taxes while your investments are not large which can teach you an important lesson.

Sorry for stupid questions and thanks a lot! :)
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retiredjg
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Re: Understanding Taxable account in layman terms

Post by retiredjg »

1. I guess this is a silly question but Is there a difference between taxable and brokerage account? I have heard both terms used interchangeably but don't know if there's a difference. Is there specific terminology that I need to use when calling up Vanguard's representative so they know what I'm asking for?
A taxable account is an account that does not offer you some kind of tax advantage.

Tax-advantaged accounts include 401k, 403b, 457b, IRA, Roth IRA, HSA and FSA accounts and probably a few other things. Each of these offers some kind of advantage in taxes - the most common advantage is putting taxes off till a later date. Another example is how you can sell an investment in one of these accounts and buy another without paying taxes on the gains.

So everything that is in an "ordinary" account is in a taxable account. This could be your savings account or checking account. Or it could be located at a "brokerage" (a place that brokers the sale of things like stocks, bonds or mutual funds).

Many people do say "brokerage" account when they should say "taxable" account. I'm not sure why.
2. How are taxes paid on taxable accounts? Do I pay taxes only on money that I made from investing or is there more taxation happening that I should be aware of? Will I be taxed again when I choose to withdraw a lump sum X years from now?
There might be some annual tax and there will probably be tax later if you sell something for more than you paid for it.

An example of an annual tax might be your savings account. You probably get $10 or $15 these days in interest each year. You add that to your taxable income even if that interest was reinvested. Stocks and bonds in a taxable account might pay out some dividends or capital gains distributions - these should be relatively modest each year. Then when you actually sell your stocks or bonds, you might have a capital gain - the shares may be worth more than you paid for them (including the reinvested dividends). When you sell some shares, you will pay tax on these capital gains. The tax rate is lower than your ordinary tax rate.

You do not get taxed twice on the same dollar.
3. Should I choose to automatically reinvest money that I am making like I am doing in 401k?
I would not. Here's a Wiki article on that subject. https://www.bogleheads.org/wiki/Reinves ... le_account

4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?
It does not matter.


Regarding holding a three fund portfolio in taxable, you need to choose your bonds in a different way from what you would hold in a 401k. In the 25% or higher bracket, you should consider using a tax-exempt bond fund rather than the Total Bond Market. Or consider not holding your bonds in the taxable account at all.
Topic Author
loss
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Re: Understanding Taxable account in layman terms

Post by loss »

Thanks a lot, guys!

So, just to repeat..I only pay taxes when I sell the stocks. As long as there's no withdrawal happening I only pay taxes on dividends and capital gain distributions (and annual tax).

It might be better to collect the gains as cash, and invest them next month?

I can just call Vanguard and say that I would like to open a taxable account.

Is it possible to calculate the tax on capital gains when I withdraw if it's lower than my ordinary tax rate?

Sorry if I'm misunderstanding something :)
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Yesterdaysnews
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Re: Understanding Taxable account in layman terms

Post by Yesterdaysnews »

I would use ETFs of Vanguard index funds in taxable for maximum tax efficiency and broad diversification. They are perfect investment vehicles for taxable accounts.

Hold bonds and ALT products in tax-protected account.
retiredjg
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Re: Understanding Taxable account in layman terms

Post by retiredjg »

loss wrote:So, just to repeat..I only pay taxes when I sell the stocks. As long as there's no withdrawal happening I only pay taxes on dividends and capital gain distributions (and annual tax).
The taxes on the dividends and capital gains distributions ARE the annual tax that occurs even if you don't sell anything. They (the dividends and the capital gains distributions) get added to your "basis" which is money that has already been taxed. That is why you don't get taxed again on those things.

It might be better to collect the gains as cash, and invest them next month?
Opinions vary and neither approach is wrong. Most people probably reinvest.

I can just call Vanguard and say that I would like to open a taxable account.
Vanguard calls this a "personal account". You can call them or do it online in about 15 mintues.

Is it possible to calculate the tax on capital gains when I withdraw if it's lower than my ordinary tax rate?
Yes, if you are asking what I think.

Once you get into the 25% tax bracket, the capital gains tax rate on long term gains (shares held longer than 1 year) is 15%. The tax on short term gains (shares held less than 1 year) will be 25%. I don't remember which side of the line day 365 falls on.


Just to reiterate, if you have a plan at work like a 401k or 403b or SIMPLE IRA, you would want to contribute to that and an IRA or Roth IRA before using a taxable account for long term investing.
Last edited by retiredjg on Sat Nov 28, 2015 4:39 pm, edited 1 time in total.
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ruralavalon
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Re: Understanding Taxable account in layman terms

Post by ruralavalon »

First, do you have a work-based account offered at your job, like a 401k, 403b, etc.? If so how much are you contributing annually?

Second, do you have an IRA anywhere? If so how much are you contributing annually?

In general it's best to make the maximum contributions to these accounts before starting to invest in a taxable account. Wiki article, "Prioritizing investments".

loss wrote:Thanks a lot, guys!

So, just to repeat..I only pay taxes when I sell the stocks. As long as there's no withdrawal happening I only pay taxes on dividends and capital gain distributions (and annual tax). You pay tax each year on any dividendsr and paid out capital gains, even if you reinvest them. When you sell shares you pay tax only on the amount of the capital gains, but not on the amount that you initially invested or reinvested.

It might be better to collect the gains as cash, and invest them next month? I would have automatic reinvestment just for simplicity and hands-off management, but either way could work.

I can just call Vanguard and say that I would like to open a taxable account. Yes, they will set this up for you and help with any questions that you have.

Is it possible to calculate the tax on capital gains when I withdraw if it's lower than my ordinary tax rate? If you stay in the 15% bracket, the tax rate for long-term capital gains is currently zero. moneychimp.com, "Capital Gains Calculator".

Sorry if I'm misunderstanding something :)
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Longdog
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Re: Understanding Taxable account in layman terms

Post by Longdog »

To everyone else's good advice, I will add that if you haven't already, you should start doing your own taxes. You will learn quite a bit about how investments are taxed, which will help you make wise financial decisions in the future!
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loss
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Re: Understanding Taxable account in layman terms

Post by loss »

Thanks again everyone for the replies! You are truly awesome :)

Currently I am putting 15% of my paycheck into 401K and maximizing ROTH IRA. I am investing in Vanguard Target Retirement Fund 2050 (VFIFX) in both accounts.

According to my calculations using Bankrate.com website, and assuming an optimistic annual rate of return of 7%, I will have 2mil by the time I am 59, which should be more than sufficient for me to retire.

What I am planning to put in the taxable account is essentially what is left after all of my expenses. I expect to be able to invest up to 10K/year. This in theory would be an account for major expenses like a down payment for a first home or a car purchase, etc.

I realize that it is suggested to maximize 401K before contributing to a taxable account but it seems unnecessary if I'm on track on meeting my goal (2 mil). I also feel that hopefully investing in a home and having the mortgage paid off before retiring will be a good financial decision as well.
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yangtui
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Re: Understanding Taxable account in layman terms

Post by yangtui »

When do you think you will be buying a house or new car? Money needed within 5 years should probably be in a risk free vehicle like a CD or high yield savings account.
retiredjg
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Re: Understanding Taxable account in layman terms

Post by retiredjg »

It is OK not to max your 401k if you are saving for another goal such as a house. Many people can't max every account during the years they are saving for a down-payment. I would encourage you to go back to maxing the retirement accounts when the house and car money are saved.

You should consider that a downpayment is something to save for, not something to invest for. If you want the money to be available at a certain time, it cannot be invested in stocks. If your time frame is very flexible, you can use stocks - if there is a market crash, the house just gets postponed by several years. Understand this could be 5 years or longer.

Many people would say that you should not even put house money (needed at a certain time) into bond funds because bond funds can lose value. Personally, I think it is probably OK to use short term bonds for this goal, knowing that the value could bobble a little.
goGators
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Re: Understanding Taxable account in layman terms

Post by goGators »

4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?
Purchase mutual funds in January to avoid tax on distributions: https://personal.vanguard.com/us/insigh ... tual-funds
livesoft
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Re: Understanding Taxable account in layman terms

Post by livesoft »

goGators wrote:
4. This year I am in 15% bracket, but I expect to be in 25% bracket starting in 2016. Is it a good idea to open a taxable account in December or is it wiser to wait until January?
Purchase mutual funds in January to avoid tax on distributions: https://personal.vanguard.com/us/insigh ... tual-funds
While it is true that one can avoid any December distributions by waiting until January to buy, that just delays the learning process about taxes by a year. That's one reason why I suggest one get started now. December distributions will be relatively minor and the tax consequences will also be minor to non-existent, but one will get 1099-DIVs and be able to do things on their Form 1040 Schedule B that will teach them some things. It will be more fun, too.
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Lafder
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Re: Understanding Taxable account in layman terms

Post by Lafder »

Regarding this "I realize that it is suggested to maximize 401K before contributing to a taxable account but it seems unnecessary"

I would think about the idea that by investing in pretax 401k your entire paycheck pretax dollar is being invested to grow over time, and the income tax is not being taken out. In retirement you may be in a lower income tax rate and pay less tax on the larger amount that has grown over the years.

By investing the post tax income in taxable accounts, you are "losing" the compounding power of the entire amount. Do you want to invest a dollar in your 401k or 75 cents in your post tax investment account in 2016? That 25% really adds up over all of the years between now and retirement.

How much more would you have to invest in a pretax 401k to max the 18k employee contribution limit? Maybe you can have the best of both worlds and invest the max pretax now and still have a solid chunk to invest in your post tax account.

I prefer to make the most of tax breaks now :)

As far as optimizing taxes, it is usually rec to hold bonds in your retirement accounts or to use tax advantaged bonds if you do hold them in your taxable account.

lafder
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ruralavalon
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Re: Understanding Taxable account in layman terms

Post by ruralavalon »

loss wrote:What I am planning to put in the taxable account is essentially what is left after all of my expenses. I expect to be able to invest up to 10K/year. This in theory would be an account for major expenses like a down payment for a first home or a car purchase, etc.
It's OK to use a taxable account for short-term goals even if you are not maxing contributions to your retirement accounts.

Don't invest this in the stock market, it's too risky. When saving for short-term goals (5 years less) like a down-payment use safe investments like federally insured short-term or intermediate-term CDs, and good credit quality short-term or intermediate-term bond funds.
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heyyou
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Re: Understanding Taxable account in layman terms

Post by heyyou »

A little tax info:

Your taxable income is reduced by the amount that you can put into your 401k. So max it out first, then max out your Roth IRA (RIRA), putting just equity mutual funds in it for the potential of the most growth. Then add your remaining savings into your taxable account, putting only equity mutual funds in it. No sense in paying tax on low returns from bond investments. Thus you need to boost your bond holdings in your 401k to balance with the equity amounts in the RIRA and the taxable account. You could do that by just buying some stable value fund once a year, after you see what you have in RIRA and taxable accounts.

In the 15% tax bracket, cap gains are not taxed, and in the 25% tax bracket, cap gains are taxed at 15%. When figuring taxes, your wage income goes in first, then the cap gains and interest are added on top.

Only the portion of your wages that overflows into the 25% bracket is taxed at 25%, but then the cap gains are added on. They too are only taxed at 15% on the portion that overflows into the 25% bracket. That is the reason to put equity funds in the taxable account and boost your bond holdings in the tax-sheltered 401k, no sense in paying tax on the interest now. You will pay tax when withdrawing from the 401k (rolled over into a traditional IRA (tIRA)) in retirement, when your income may be less than now. Tax brackets rise each year so your inflation adjusted retirement income might be taxed similar to your current income.

Your "taxable income" is your remaining income after your personal exemption and standard deduction are subtracted. Scroll here for those
http://fairmark.com/general-taxation/re ... inflation/
Many just look at tax brackets without subtracting their exemption and standard deduction, then squeal about their tax rate. At the top of the 15% bracket, your tax is only 10.8% of your total income, not the 15% marginal rate, because you pay zero on exemption and deduction, then 10% on some income, then 15% on the next portion.
http://fairmark.com/general-taxation/your-tax-bracket/
Above are the brackets, but you have to scroll to get the one that fits you, either single or married.
Miriam2
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Re: Understanding Taxable account in layman terms

Post by Miriam2 »

heyyou wrote:A little tax info: . . . .
Heyyou -
I hope you realize that your explanation of taxes - which I'm sure took some time to post - helped many more of us than just the OP :happy
Thank you for the post! And the Fairmark.com references.
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Topic Author
loss
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Re: Understanding Taxable account in layman terms

Post by loss »

Thanks a lot guys! I will shop around for a high yield saving account or a CD or just keep money in my current savings account. My current savings account yields 0.75% and I was just looking for a better investment.

The main reason I wanted to start the taxable account is to grow my down-payment money but since I would like to have it short term (5 years or so) I see that investing in stocks might be too dangerous.

One reason I don't want to invest in 401K more than I feel I need to is because it is so far away. Who knows what may happen in the next 25-30 years, chances are I won't make it. Meanwhile I can use the extra money for personal goals such as a home or to be able to go on vacations.

I wonder if there's a number of how much percent of one's paycheck one may want to contribute to a retirement account like a 401K. I feel like it's overdoing it if you are forcing yourself to live paycheck to paycheck and unable to enjoy life to the fullest just so that you can max out retirement accounts.
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