Taxable account

A taxable account is an account for which the default IRS tax rules apply, meaning that you pay taxes in the year the interest is earned. Taxable accounts include checking accounts, savings accounts, money market accounts, and brokerage accounts.

This is different than a tax-advantaged account, which has special tax rules that the IRS assumes are better for the investor. Examples of tax-advantaged accounts are 401(k)s, IRAs, 403(b)s, Health Savings Accounts (HSAs), and 529 plans.

Taxable account basics
The tax rules for taxable investments are as follows:


 * Taxable investments are made with after-tax money
 * Interest, dividends, and capital gains generated by taxable investments are taxed as income in the year they are earned, either as ordinary income (for interest, ordinary dividends, and short-term capital gains), or at a reduced rate for long-term capital gains and qualified dividends
 * When the investment is sold, the difference between the sale price and the cost basis is taxed as either short-term (if held for <=1 year) or long-term (if held for >1 year) capital gains.
 * Taxable accounts have no contribution or income limitations, and no withdrawal restrictions

Appropriate uses for taxable accounts include:


 * Saving for goals on a shorter time horizon than permitted by retirement accounts, including emergency funds, or saving for a car, house down payment, or other purchases
 * Saving for retirement when the amount being saved is above the contribution limits for available tax-advantaged retirement accounts
 * Investing in investments not available inside tax-advantaged accounts

Details
Earnings from a taxable account are taxed as income in the year they are earned. This section discusses the tax treatment of specific kinds of earnings from a taxable account. Regardless of the type of earnings, all taxable account earnings are treated as investment income, and so have the following tax treatments:


 * Earnings do not result in payroll taxes (Social Security Tax, Medicare Tax, or the Additional Medicare Tax)
 * Earnings may be subject to the Net Investment Income Tax
 * Earnings are not eligible for deduction as Qualified Business Income under Section 199A, even if they are earned within a business.

Interest
Interest, for example, earned from a savings account or money market, is taxable as ordinary income in the year it is received. Interest receives no preferential tax treatment. Interest payments are usually reported to investors on IRS form 1099-DIV.

Bond Interest/Coupons
Bond interest (coupons) are generally treated as interest, although certain types of government-issued bonds pay interest that is exempt from certain taxes:


 * Corporate bond interest is fully taxable
 * Federal government bond interest (Treasury notes, I-Bonds, TIPS, etc.) is taxable by the federal government, but typically exempt from state income tax
 * Municipal bond (issued by state and local governments) interest is typically exempt from both federal and state taxes, although exceptions exist, so consult your specific state's tax rules

Dividends
Dividends are payments made from a business to its shareholders (owners). Holding shares of stock in a taxable account means you will receive dividends when the stock pays out dividends. Dividends that meet the requirements for qualified dividends are subject to long-term capital gains tax rates, which are lower than for ordinary income. Dividends that do not meet these requirements are called ordinary dividends, and are taxed at ordinary income rates. Dividends are reported to investors on IRS Form 1099-DIV.

Capital gains and losses
When an investment is sold for more than its cost basis (typically, what you paid for it; sometimes the IRS requires adjustments to this number), the profit on the investment becomes taxable income in the year the investment was sold. Generally, if the investment was held for more than one year, the gains are taxed at reduced long-term capital gains tax rates. If the investment was held for one year or less, the gain is taxed as ordinary income.

When an investment is sold for less than its cost basis (at a loss), the losses are generally tax-deductible. If the investment was held for more than a year, the loss will first offset long-term capital gains on other investment sales, then offset short-term gains, and up to $3,000 of remaining losses can offset earned income.

Step-up in basis
One feature of Taxable accounts is that 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 bequeaths these securities to you 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 are required to pay no tax. Conversely, if your uncle sold the stock the day before he died, he would be required to pay capital gains tax on the $80,000 gain.

It is possible to gift taxable investments while you're still alive. In this case, the recipient "inherits" the same basis as you had, so receiving a gift of investments with unrealized capital gains will cause you to incur capital gains tax in order to liquidate the investments. Likewise, gifting someone a security with an unrealized loss will allow them to deduct the loss on their taxes when the investment is sold.

Taxable account investing strategy
In Traditional and Roth accounts, investment performance is solely a function of the overall return. Investing in a taxable account is considerably more complex, due to the more complex tax rules, additional dimension of yield (returns that are paid out from the investment as opposed to retained as an increase in value), and tracking of the basis. Tax efficiency describes the concept of minimizing taxes over one's entire portfolio by optimizing around tax laws. This section describes various strategies that are useful for minimizing taxes and maximizing returns when investing in Taxable accounts.

Tax-efficient funds and fund placement
Ideally, an investor should prefer minimal yield on

Performance
Because the tax rules for taxable accounts are more complex than for retirement accounts, so is calculating the performance. The following is a derivation of the formulas that can be used to calculate future taxable account values, given a rate of return and other parameters. Variables are defined as follows:

$$ \begin{align} t & = \text{time} \\ V(t) & = \text{investment value at time t} \\ V(0) & = \text{initial investment value} \\ B(t) & = \text{investment basis at time t} \\ B(0) & = \text{initial investment basis} \\ r & = \text{overall rate of return} \\ y & = \text{investment yield} \\ tr_{div} & = \text{tax rate on dividends} \\ tr_{cg} & = \text{tax rate on capital gains} \\ \end{align} $$

For simplicity and clarity, this derivation will assume continuous compounding, but the formula may be modified for period compounding as desired. Continuous compounding formulas use exponentials of base e $$\approx$$ 2.71828. The value of the investment at any future time t can be written as follows:

$$ \begin{align} V(t) & = V(0) \cdot e^{(r-y \cdot tr_{div})t} \end{align} $$

Calculating the basis at any time t requires integration. The rate of change of the basis at any time t is equal to the value at t, multiplied by the yield, multiplied by (1 - $$tr_{div}$$). The product of $$V(t) \cdot y \cdot tr_{div}$$ is the rate of loss to dividend taxes, and the remainder is added to the cost basis:

$$ \begin{align} \frac{dB(t)}{dt} & = V(t) \cdot y \cdot (1-tr_{div}) = V(0) \cdot y \cdot (1-tr_{div}) \cdot e^{(r-y \cdot tr_{div})t} \end{align} $$

Integrating this formula from 0 to t and setting $$B(0) = V(0)$$gives:

$$ \begin{align} B(t) & = \int_{0}^{t}\ V(0) \cdot y \cdot (1-tr_{div}) \cdot e^{(r-y \cdot tr_{div})\tau}d\tau = V(0) + \left ( \frac{V(0) \cdot y \cdot (1-tr_{div})}{r-y \cdot tr_{div}} \right ) \left ( e^{(r-y \cdot tr_{div})t}-1 \right ) \end{align} $$

Finally, the after-tax value after the investment is sold is given by:

$$ \begin{align} \text{after-tax value} & = V(t) - \left ( V(t) - B(t) \right ) \cdot tr_{cg} \end{align} $$

For periodic (eg. annual) compounding instead of continuous compounding, $$(1+r-y \cdot tr_{div})^t$$ may be substituted for $$e^{(r-y \cdot tr_{div})t}$$. Summary:

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 don't itemize your state income taxes on your federal return. You plan to move to a tax-free state and 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 ordinary 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:

$$ \begin{align} \text{after-tax value} & = $76,796.81 - \left ( $76,796.81 - $21,761.77 \right ) \cdot 15% = $68,541.55 \end{align} $$

Comparison to retirement accounts
In almost all cases, the taxes will be lower for investments inside retirement accounts (401(k)'s, IRAs, etc.) then for taxable accounts. A Roth retirement account has the same performance as a taxable account with no dividend and capital gains tax, and so its performance will always be equal to or higher than a taxable account. A Traditional retirement account is similar to a Roth, except that taxes are paid when the funds are withdrawn rather than when they are invested as after-tax income. For these reasons, almost all investors should contribute retirement savings to retirement accounts first, and use taxable accounts only if the amount they wish to invest exceeds the contribution limits. They should also check less widely known retirement account options, such as catch-up contributions, the Backdoor Roth IRA, and the Spousal IRA, before saving retirement funds in a taxable account. When using a taxable account for retirement savings, the use of low-cost tax-efficient investments is critical for achieving good long-term performance.