If you have extra cash to invest after maxing out a 401(k) or other retirement plan at work, it’s wise to consider your options. Most investors will have three options: a Traditional IRA, a Roth IRA, or a taxable brokerage account. Though there are important pros and cons to know about each type of account, for high-earning individuals with a significant capacity to save, the taxable investment account offers the most flexibility.
Using a brokerage account to save after maxing out a 401(k)
The main reason a taxable brokerage account is a popular choice after a 401(k) or 403(b) is quite simple: flexibility. There are no income limits precluding wealthier individuals from opening an account and there aren’t any annual funding limitations. And unlike retirement accounts, the assets in a brokerage account can be used for any purpose at any time.
How a brokerage account works
A brokerage account can be opened at the financial institution of your choosing. To fund the account, you may choose a lump sum or schedule recurring automatic contributions from a bank. Unlike 401(k)s or IRAs, there are no limits on how much you can save annually. You pick your investments and are only limited to the options available at the institution where you opened the account, so you’ll want to investigate this ahead of time. When funds are needed down the road, select which positions to sell and pay any tax due on your investment gains.
Tax treatment
As the name suggests, a taxable account is funded with after-tax dollars, so there is no tax deduction for your contributions. The account is subject to tax annually for dividends, interest, or capital gains distributions (for mutual funds and ETFs) received during the year, even if you did not sell an investment and reinvested the proceeds. When you liquidate a portion of your account, you will incur a capital gain (or loss) depending on your purchase price and cost basis. If you’ve held the stock, bond, ETF or mutual fund for a year or more, any gain will be taxed at more favorable long-term capital gains rates.
Why you should consider a brokerage account
A savings account isn’t the best choice for medium to long-term goals as interest won’t keep pace with inflation. Especially for high-income individuals, maxing out annual 401(k) contributions likely won’t be enough to maintain the same lifestyle in retirement. Further, if you wish to retire early, before penalty-free distributions from 401(k)s or IRAs begin at age 59 ½, you’ll need other assets to bridge the gap.
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Another reason to consider investing in a brokerage account is tax diversification in retirement. If you only have assets in tax-deferred vehicles like a 401(k), 403(b), or Traditional IRA, you may have fewer tax planning options each year. When you contribute to one of these retirement accounts it is typically tax-deductible, so when you later make withdrawals in retirement, it’s taxed as ordinary income.
Assuming you also held assets in a brokerage account, you could consider other planning opportunities as your situation changes; blending withdrawals from both types of accounts or tapping tax-deferred assets in years where you’re in a lower marginal tax bracket. The tax code is always subject to change and diversification can provide flexibility and reduce the risk that unfavorable legislative changes to one type of account will impact your whole financial plan.
Investing Outside of a 401(k): Comparing Investment Options
Other unique features of brokerage accounts
Invest for non-retirement goals. With a 401(k), IRA, or Roth IRA, there are limits as to when you can use the funds–and for what purpose–without incurring a penalty. With a brokerage account, there are no such restrictions (which is also why there aren’t any tax advantages). Any money you need access to in the short-term (usually five years or less) should be kept in a high-yield savings account, but for goals with an intermediate or long-term time frame (e.g. supplemental college savings, major purchase, funding an early retirement, etc.) a brokerage account can be a great solution.
Avoid required minimum distributions. Just as there are no rules on how early you can access the funds, there are also no regulations on when you must begin tapping the account, as with Traditional IRAs, 401(k)s, pension plans, and so forth. This is important as retirees who don’t need the income can avoid unnecessary tax consequences, fees, and the disruption to their portfolio by staying invested.
Tax-efficient way to leave a legacy. The tax rules change when a beneficiary inherits a taxable brokerage account. If the original account owner sells a position during their life, the difference between their cost basis in the investment and the sale price will determine the gain that’s subject to capital gains taxes (at either short or long-term rates). When an investor has highly appreciated securities in a taxable account, there may be a significant tax liability if the position is sold. However, if your spouse or heirs inherit a taxable brokerage account, the assets can pass on a “stepped-up” cost basis, which ‘steps-up’ their inherited cost basis in the asset to the value on the date of your death.
Here’s a simplified example:
In 2010, May purchased 100 shares of ABC ETF for $20/share. The ETF is currently trading at $150/share. If May sold all 100 shares today, she’d have a long-term capital gain of $130/share or $13,000. If May is in the 15% tax bracket for long-term capital gains, her tax due would be $1,950. If May died today, her heirs would have a stepped-up cost basis of $150/share and could sell all 100 shares with no capital gain and no tax due.
Other types of investment accounts
Aside from a brokerage account, investors may also want to consider a Traditional IRA or a Roth IRA.
Traditional IRA
Anyone can make contributions to a Traditional IRA up to the lesser of their earned income or $6,000 per year in 2019 if under age 50, plus an additional $1,000 for those older. Whether the contribution will be tax deductible or not will depend on whether you’re covered by a retirement plan at work, your income, and tax filing status (see 2019 limits).
Tax-deferred growth is powerful due to the nature of compounding, but if you’re not only looking for ways to save for retirement, an IRA may not be the right choice due to early withdrawal penalties. There are some exceptions, but flexibility can be a valuable thing.
For high-earners who are unable to make a tax-deductible contribution, consider the drawbacks before funding an IRA with after-tax dollars. For example, in retirement, you must calculate the percentage of each withdrawal that will be tax-free due, called the pro-rata rule. Also, the taxpayer is responsible for tracking non-deductible contributions, not the IRS or your financial institution. If you’re unable to maintain adequate records over time (often decades) you could risk paying tax twice.
Roth IRA
A Roth IRA shares some features of a brokerage account and an IRA: funds are invested after-tax and there are no required minimum distributions (RMDs) for the account owner in retirement like a brokerage account, and like an IRA, investments grow tax-deferred and early withdrawal penalties may apply before age 59 ½. It’s worth noting that non-spouse beneficiaries of a Roth IRA will be subject to required distributions.
The most unique feature of a Roth IRA is that provided a five-year holding period is met since your first contribution and you’re age 59 ½ or older, withdrawals will be completely tax-free. There are several penalty exceptions to the age and five-year holding period requirements, and it’s important to note that only the investment growth portion of the account is subject to taxes or penalties, but you will still want to check with current IRS regulations before investing.
The main drawback of a Roth IRA is that income limitations apply which prevent wealthier individuals from making regular contributions. In 2019, the income phase-out range for single filers is between $122,000 - $137,000 and between $193,000 - $203,000 for married couples filing jointly. As taxpayers enter the phase-out range their contribution limit decreases until the upper end of the range when they become disqualified.
Traditional vs. Roth IRA considerations are also important as a Roth is most advantageous when a taxpayer expects to be in a higher tax bracket in the future, which is why they’re willing to pay tax on their contributions today. With either IRA, the relatively low annual contribution limits may require the implementation of more than one savings strategy. The annual IRA funding limits (lesser of earned income or $6,000 per year in 2019 if under age 50, plus an additional $1,000 for those older) applies to any Roth and/or Traditional IRA contributions in aggregate.
Weighing your options
There are various pros and cons with each type of investment account. Depending on your situation, goals, and the amount you’re looking to invest, you may be able to utilize more than one. For most investors, the flexibility of a brokerage account make it a preferred option.
