Taxable account

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A taxable account is one where the normal IRS tax rules apply. In a taxable account, you pay taxes on interest, dividends, and capital gains, in the year in which you earn them. Checking accounts, savings accounts, money market accounts, and brokerage accounts are all taxable accounts.

Taxable accounts have none of the special tax rules that tax-advantaged accounts have. 401(k)s, IRAs, 403(b)s, Health Savings Accounts (HSAs), and 529 plans are all tax-advantaged accounts. However, unlike tax-advantaged accounts, taxable accounts do not have restrictions on contributions or withdrawals.

Taxable account basics
The overall tax rules for taxable accounts are:
 * You make taxable investments with after-tax money
 * You pay tax on interest and dividends that your investments generate, and on any capital gains you realize, in the year in which they occur.
 * The tax on these is at either your ordinary income tax rate (for interest, non-qualified dividends, and short-term capital gains), or at a reduced rate for long-term capital gains and qualified dividends.
 * When you sell an investment, you pay tax on the difference between your sale price and your cost basis (effectively, what you paid for the investment).
 * The tax on these is at either a short-term capital gains rate (if held for one year or less) or long-term capital gains rate (if held for longer than one year).
 * Taxable accounts have no contribution or income limitations, and no withdrawal restrictions.

Some cases where you might use a taxable account:
 * Saving for when you need the money sooner than you could take it from your retirement accounts. Examples include emergency funds, and saving for a car, house down payment, or other large purchase.
 * Saving for retirement when you want to save more than the contribution limits for tax-advantaged retirement accounts.
 * Holding investments that are not available in your tax-advantaged accounts.

Details
You pay tax on earnings from a taxable account in the year in which you earn them. This section looks at the tax treatment of different kinds of earnings in a taxable account.

Regardless of the type of earnings, you treat all taxable account earnings as investment income. However, your tax on investment income is different from that for employment income in a few areas:
 * You do not pay payroll taxes (Social Security Tax, Medicare Tax, or the Additional Medicare Tax) on investment income.
 * You may have to pay the Net Investment Income Tax on investment income.

Interest
You pay tax on interest, for example earned from a savings account or money market, as ordinary income in the year you receive it. Interest has no preferential tax treatment.

Payers usually report your interest payments on IRS Form 1099-INT.

Bond interest and coupons
You normally pay tax on bond interest (coupons) as interest, although some types of government-issued bonds pay interest that is exempt from certain taxes:
 * Corporate bond interest is fully taxable.
 * You pay full federal tax on federal government bond interest (Treasury notes, I-Bonds, TIPS, and so on), but this is typically exempt from state income tax.
 * Municipal bond (issued by state and local governments) interest is typically exempt from both federal taxes, and state taxes in the state that issued the bonds; although exceptions exist, so you need to carefully check your state's tax rules.

Dividends
Dividends are payments a business makes to its shareholders (owners). If you hold shares of stock in a taxable account, you will receive dividends when the stock pays out dividends.

You pay tax on dividends that meet the requirements for qualified dividends at long-term capital gains tax rates. These are lower than for ordinary income. Dividends that do not meet these requirements are called non-qualified dividends, and you pay tax on them at ordinary income rates.

Payers report your dividends on IRS Form 1099-DIV.

Capital gains and losses
When you sell an investment for more than its cost basis (typically, what you paid for it, although sometimes the IRS requires you to adjustment this), your profit on the investment is taxable income in the year the investment was sold.

Generally, if you held it for more than one year, you pay tax on the gain at reduced long-term capital gains tax rates. If you held it for one year or less, you pay tax on the gain ordinary income. You only pay tax on the part of the sale price that is your gain. Your do not pay tax on the part of your sale price that is your cost basis (typically the amount you originally invested).

When you sell an investment for less than its cost basis (that is, at a loss), your loss is generally tax-deductible. If you held the investment for more than a year, you first use the loss to offset long-term capital gains on your other investment sales, then offset short-term gains, and finally you can use up to $3,000 of remaining loss to offset earned income. You carry over losses above the $3,000 limit to future years, and you can use them then. This is called capital loss carryover.

Typically, payers report your capital gains and losses on IRS Form 1099-B.

Distributions
If you hold a mutual fund or Exchange-traded fund (ETF) in a taxable account, the fund pays you any interest, dividends, and capital gains earned inside it. You may see capital gains reported on a 1099 form at the end of the year, even if you did not sell any shares of the mutual fund or ETF.

Step-up in basis
The cost basis of investments "steps up" to equal the value of the security when inherited after the owner's death. For example, if your uncle owned shares of a stock worth $100,000 with a basis of $20,000 (what he originally paid for it, plus any reinvested dividends), and you inherit these when he dies, your basis becomes $100,000 on the day you inherit the stock. If you sell the stock immediately for $100,000, you receive the full value and pay no tax. If your uncle had sold the stock the day before he died, he would pay capital gains tax on the $80,000 gain.

It is possible to gift taxable investments while alive. In this case, the recipient "inherits" the same basis as you had for purposes of gains. So if you receive a gift of investments with unrealized capital gains, selling them will mean you have to pay capital gains tax. If you sell for a loss, your cost basis for tax is the lower of your basis or the fair market value at the time of the gift. (This rule stops you from giving property with a loss to a relative who would get a larger tax benefit from the loss than you would.)

Foreign tax credit
International investments sometimes have to pay taxes in foreign countries, and when they do, Form 1099-DIV will show you the amount. Although there are some limitations, to avoid double tax you can take either a credit or deduction for foreign taxes. A tax credit is usually the better choice.

Taxable account investing strategy
In Traditional and Roth retirement accounts, your results depend only on the return from the investments you hold in them. Investing in a taxable account is considerably more difficult. Complex tax rules, the yield (returns that are paid out from the investment as opposed to retained as an increase in value), and tracking your the basis all cause complications.

Tax efficiency means minimizing your taxes over your entire portfolio by optimizing around tax laws. This section describes various strategies that minimize taxes and maximize your returns in taxable accounts.

Tax-efficient funds and fund placement
Prefer minimal yield on taxable investments, for a given level of return. Lower yield improves your investment performance in several ways:
 * Taxes that you would pay on dividends and capital gains stay in the investment, and this helps with compound growth.
 * Growth in the form of price appreciation, rather than as yield, gives you control over when to realize this gain. For example, you could sell appreciated investments in low-income years to reduce your tax. You pay taxes on yield in the year you earn it, even if your tax rate is high in that year.
 * You pay taxes on investments you hold for longer than one year at lower long-term capital gains rates, but you pay tax on yield at higher ordinary income tax rates.

Passive stock funds, such as index funds have an inbuilt tax efficiency that gives them an enormous advantage over actively-managed stock funds inside a taxable account. By design, passive funds buy and hold a set of stocks, and trades within the fund are rare (for example, to track the index as the market capitalization of the constituent stocks fluctuates). This means that a passive fund generates far lower capital gains than an active fund, and that any capital gain tends to be long-term. If the stocks pay dividends, those dividends are unavoidably passed to the fund owners, but even then, dividends are far more likely to meet the holding period requirement for qualified dividends and receive preferential tax treatment.

Exchange-traded funds are often more tax-efficient than mutual funds (see also: ETFs vs mutual funds), although passive funds are already more tax-efficient than active funds, so the difference is smaller. Vanguard is a special case; both their ETFs and mutual funds have the same tax efficiency.

Several investment companies, including Vanguard, offer tax-managed funds specifically for taxable accounts. They design these for maximum tax efficiency, although at the cost of slightly higher expenses. Compared to low-expense non-tax-managed passive funds, which are already very efficient, the difference is small. If you have a very high marginal tax rate, tax-managed funds can offer an advantage in after-tax performance. However if you are in a lower bracket, the lower expenses of the normal funds will probably outweigh the tax efficiency of tax-managed funds, making normal funds the better choice.

Bonds and bond mutual funds are inherently tax in-efficient investments, because much of their return is interest, and you pay tax on this as ordinary income in the year in which you earn it. For best tax efficiency you might want to locate bonds inside tax-advantaged accounts. However, bonds tend to be lower-return assets in most portfolios, and by putting those assets inside tax-advantaged accounts, you reduce your future tax-advantaged space.

For more on where to hold bonds, see Tax-efficient fund placement.

Tax-free investments
Some investments, such as municipal bonds, are exempt from federal tax, or state tax, or both. For investments in a taxable account, your after-tax return is what matters. If you have a high marginal tax rate, you could see a significant benefit to your after-tax returns if you choose tax-free investments.

However, tax-free investments tend to deliver lower returns, so if you are in a lower tax bracket, you may see higher after-tax returns with fully taxable investments such as corporate bonds, despite the higher tax cost. Also, for this reason it is usually not a good idea to use tax-free investments in tax-deferred or tax-free accounts such as 401(k)s and IRAs.

While you do not directly pay tax on returns from tax-free investments, they are taken into account when phasing in taxation of Social Security benefits, and so they can have substantial tax consequences.

Tax loss harvesting
Tax loss harvesting means selling investments that have lost value relative to their basis, specifically so that you reduce your taxes. There are three ways that selling investments at a loss can save you tax:
 * When you deduct the loss now and receive a tax deduction from the IRS, you effectively get an interest-free loan from the government. You can invest the taxes you save saved to generate future returns. The ability to deduct up to $3,000 of losses annually from earned income adds to your tax saving.
 * Long-term capital gains tax rates are lower than ordinary income tax rates, so that you effectively swap a higher tax rate for a lower one if your losses offset short-term gains or ordinary income, but you can realize these as long-term gains.
 * If you later donate appreciated assets to charity, or leave them to heirs, they avoid capital gains taxes entirely.

In most cases, harvesting losses improves long-term performance, so consider harvesting your losses as soon as they occur. In rare cases, it may not be a good idea to harvest losses, for example if you know that your future tax rates will be much higher than today, or if your losses would offset gains that you would otherwise not pay tax on anyway.

When you harvest losses you need to pay attention to the wash sale rule. This disallows a tax deduction for your losses if you buy a "substantially identical" security within 30 days of the sale.

Frustratingly, the IRS has never defined "substantially identical", but it may include different mutual funds that track the same index, and different share classes of the same mutual fund or ETF. It would not include funds that track different sets of stocks, for example the Vanguard Total Stock Market Index Fund (VTSAX) and the Vanguard S&P 500 Index Fund (VFIAX), even though these two funds might have very high market correlation.

Tax gain harvesting
Generally, keeping your investment gains give you better long-term performance, because the tax that you would otherwise pay compounds in your account, and because you might later donate to charity or get a step-up in basis at death. tax gain harvesting is a much less common strategy than tax loss harvesting.

However, harvesting gains can make sense in some cases, perhaps if you are confident that your tax rates will be higher in the future, and you know you will want to sell the investment. Harvesting gains at a rate of 0% is usually a good idea, as long as the additional taxable income does not cause you unwanted tax consequences. There is no wash sale rule for tax gain harvesting.

Low-basis investments
Investors commonly have to deal with investments with a low cost basis (large unrealized capital gains). A large unrealized capital gain in an investment creates a large disincentive to sell.

This commonly happens when someone learns more about the Bogleheads investment philosophy and decides they no longer want to hold individual stocks in their taxable account, but these stocks have large unrealized gains. For any low-basis investment, there are three ways to dispose of it:
 * Liquidate it and pay the tax cost. You could spread the sale across multiple years if the capital gains tax on the lump-sum would push you into a higher marginal tax rate than for smaller gains, for example by triggering the Net Investment Income Tax (NIIT).
 * Continue to hold it, and plan to either sell it at a future time when the taxes may be lower, or leave it as part of your estate.
 * Donate it to a charity, avoiding the tax cost for both you and the charity and allowing you to deduct the full value of the investment.

Your best strategy depends on several factors, such as your current and expected tax rates, your need for cash, plans for charitable giving, your age and health, performance and risk level of the investment in question, and how well or poorly the investment fits into your investing plan. See also: Paying a tax cost to switch funds

Low-basis investments makes rebalancing challenging. Trading in a taxable account creates added tax drag and lowers long-term performance, so avoid it when possible. One way to rebalance is to trade only in tax-advantaged accounts, such as 401(k)s and IRAs, balancing these against your taxable account. You can trade without any tax consequences in both Traditional and Roth retirement account. This means that you can often rebalancing without selling low-basis investments using a combination of new investments and trading within tax-advantaged accounts.

To restructure larger investments, you need to compare the benefit of selling low-basis investments with the tax cost, using the various factors described above.

Tax lots
Buying shares of a security at different times, and reinvesting dividends, give you different tax lots of shares, each with a different cost basis. You have a choice about how you handle multiple tax lots:
 * First-in-first-out (FIFO) method: Oldest shares are always sold first.
 * Specific identification of shares: The brokerage identifies each tax lot of shares with its own cost basis.
 * Average cost method: The IRS allows you to use an average cost method, where each sale has the average cost basis of all tax lots. Once you start using the average cost method, you have use it for all future transactions of that security, until you have sold all of its shares.

There is no single best cost basis method. Specific identification of shares gives you the most control, but can mean you have to track a large number of tax lots, particularly if your provider automatically reinvests your dividends.

Depending on your goals, it may be worthwhile to sell older or lower-basis investments first, for the lower tax rates on long-term capital gains. Or, it may be best to sell more recently-purchased higher-basis shares, to minimize realized capital gains and preserve lower-basis shares.

Some brokerages offer more complex cost basis methods that try to optimize around tax laws. These tools may streamline trading, but make sure you understand the procedure before you use them, to make sure you are using the methods that work best for your situation.

Performance
Because the tax rules for taxable accounts are more complex than for retirement accounts, so is calculating the performance. You can use following formulas if you want to calculate future taxable account values from rate of return and other parameters.

This analysis assumes that all dividends are reinvested and all taxes are paid from the dividends. While dividend reinvestment is not always desirable, it makes it possible to directly compare performance in taxable accounts to the performance of tax-advantaged accounts.

Evaluating the performance of investments that have dividends periodically removed from the value, or that have dividend taxes paid from external sources, is more difficult than the method shown below, and would require discounted cash flow analysis.

The following table summarizes the formulas for the future pre-tax value $$V(t)$$, future basis $$B(t)$$, and future after-tax value $$V_{at}(t)$$, for periodic (for example, annual) or continuous compounding:

These formulas are derived here. When analyzing a periodic compounding investment, make sure the period on the rates of growth matches the compounding period. For example, a monthly compounding investment with an annual rate of return of 8% and a yield of 2% would have a periodic return of ~0.667% (8% / 12) and a periodic yield of ~0.167% (2% / 12). Time should also have the units of number of compounding periods, for example, number of months.

Example
You invest $10,000 in a mutual fund in a taxable account and plan to sell it after 25 years. Your federal tax rates are 24% on ordinary income and 15% on qualified dividends on long-term capital gains. In addition, your state charges a 9.3% tax on all forms of income, and you do not itemize your state income taxes on your federal return.

You plan to move to a tax-free state, and you will pay a 15% long-term capital gains tax rate when the investment is sold. The mutual fund has an expected return of 9% and a yield of 2%, compounding annually. The yield is comprised of 90% long-term capital gains (paid within the fund and passed to you) and qualified dividends, and 10% short-term capital gains and non-qualified dividends.

What is your expected after-tax value when the mutual fund is sold? Your effective tax rates are:

$$ \begin{align} tr_{div} & = (15%+9.3%) \cdot 90% + (24%+9.3%) \cdot 10% = 25.2% \\ tr_{cg} & = 15% \\ \end{align} $$

Your future balance is:

$$ \begin{align} V(25) & = $10,000 \cdot (1+9%-(2% \cdot 25.2%))^{25} = $76,796.81 \end{align} $$

Your future basis is:

$$ \begin{align} B(25) & = $10,000 + \left ( \frac{$10,000 \cdot 2% \cdot (1-25.2%)}{9%-(2% \cdot 25.2%)} \right ) \left ( (1+9%-(2% \cdot 25.2%))^{25}-1 \right ) = $21,761.77 \end{align} $$

After the fund is sold, your after-tax value will be:

$$ \begin{align} V_{at}(25) & = $76,796.81 - \left ( $76,796.81 - $21,761.77 \right ) \cdot 15% = $68,541.55 \end{align} $$

Comparison to traditional and Roth accounts
In almost all cases, your taxes will be lower for investments inside traditional and Roth retirement accounts (401(k)'s, IRAs, and so on) than for taxable accounts. A Roth retirement account has the same performance as a taxable account, but with no dividend and capital gains tax, and so its performance will always be equal to or higher than a taxable account.

Under the same conditions as the above example, an investment in a Roth account would be worth $86,230.81 ($10,000 * (1 + 9%)^25), about 26% more than the same investment in a taxable account. A traditional retirement account is similar to a Roth, except that you pay taxes when you withdraw the funds rather than when you invest them as after-tax income.

For these reasons, almost everybody should contribute retirement savings to traditional and Roth retirement accounts first. Use taxable accounts for retirement savings only if you want to invest more than the contribution limits on retirement accounts. Also, consider less widely known retirement account options, such as catch-up contributions, the Backdoor Roth IRA, the Mega-backdoor Roth, and the Spousal IRA, before saving retirement funds in a taxable account.

If you do use a taxable account for retirement savings, for good long-term performance it is critical that you hold low-cost tax-efficient investments.

Comparison to non-deductible IRAs and variable annuities
Non-deductible traditional IRAs and variable annuities have a similar tax structure: you contribute after-tax money, tax is deferred on your investment growth, and you pay tax on the growth when you withdraw it, as ordinary income.

For tax efficient investments, taxable accounts tend to outperform these accounts. The future value of the same investment in the above example inside a non-deductible IRA or variable annuity would be $86,230.81 ($10,000 * (1 + 9%)^25) before taxes, and $67,935.41 ($86,230.81 - ($86,230.81 - $10,000) * 24%) after taxes.

For tax in-efficient investments, non-deductible IRAs and variable annuities may have a significant advantage over a taxable account.

Consider the above example, but with an investment that returns 6% that is all fully taxable yield. The future taxable balance is:

$$ \begin{align} V(25) & = $10,000 \cdot (1+6%-(6% \cdot 25.2%))^{25} = $29,968.18 \end{align} $$

The future taxable basis will be:

$$ \begin{align} B(25) & = $10,000 + \left ( \frac{$10,000 \cdot 6% \cdot (1-25.2%)}{6%-(6% \cdot 25.2%)} \right ) \left ( (1+6%-(6% \cdot 25.2%))^{25}-1 \right ) = $29,968.18 \end{align} $$

This makes sense. Because the growth is entirely due to yield, the future value and future basis are equal. This also means there is no capital gains tax to pay, so the future value is after-tax. The future value of a non-deductible IRA or variable annuity is:

$$ \begin{align} $10,000 \cdot (1+6%)^{25} = $42,918.71 \end{align} $$

After taxes, the value will be:

$$ \begin{align} V_{at}(25) & = $42,918.71 - \left ( $42,918.71 - $10,000 \right ) \cdot 24% = $35,018.22 \end{align} $$

However, if you hold variable annuities, you need to compare the fees and liquidity issues against the tax advantages. Variable annuities typically have fees of 0.5-1%+ per year, and when subtracting these fees from the returns, the annuity performance is not nearly as good.

In the above example, the annuity would slightly outperform the taxable account with a fee of 0.5%, but under-perform with a fee of 1%. Annuities also typically have surrender fees for early withdrawal, and the IRS also applies an early withdrawal penalty for withdrawals before age 59.5.

Non-deductible traditional IRAs also have early withdrawal penalties and contribution limits, although low-fee IRAs are much easier to find. However, almost everybody should have access to a Roth IRA (which is strictly better than a non-deductible traditional IRA) due to the Backdoor Roth IRA. For rare cases where a non-deductible traditional IRA make sense, see Appropriate uses.