When a Taxable Brokerage Account Is Best

Investing experts typically recommend prioritizing tax advantaged accounts like a 401(k) or Roth IRA. One common concern I hear, especially from Gen-Z and Millennial peers, is what if I want to use the money before retirement?

While there are some loopholes to access money in a tax-advantaged retirement account early and without penalty, the easiest investing account to withdraw money from is the taxable brokerage account. This account is the one that gives you the investor the most control and the most options. 

The only catch is you will have to pay taxes. But how big of a deal is this? Investing experts make this extra tax seem like the end of the world as it’s not the optimal path to maximize your wealth. 

That said, while it may not be the most optimal path, for some it may be the most practical. If you are hesitant to put your money in withdrawal restricted retirement accounts, this is for you. You will discover the trade off of optimization in exchange for complete control. 

Please note: I am NOT a licensed financial advisor or tax expert. This information is for educational purposes only and is not advice. Every individual has a unique situation. Accordingly, do your own due diligence before making any financial decision. 

How various investments accounts are taxed

A Roth retirement account contribution is taxed as income when you contribute the money to the account. You can withdraw the contributions, and gains, tax free, assuming you follow the withdrawal requirements. 

A traditional retirement account is NOT taxed when you contribute the money to the account. Instead your withdrawals, including original contributions and investing gains, will be taxed as income when you withdraw it. 

A taxable brokerage retirement is taxed based on the investments you own and when you sell them. The tax rules may vary for bonds, ETFs, mutual funds, etc. 

In general, there are short and long term capital gains taxes. Typically you owe these taxes when you sell an investment. 

If you sell an investment that you’ve owned for less than a year, it’s a short term capital gain which is typically taxed as income. 

If you sell an investment that you’ve owned for longer than a year, it’s a long term capital gain which is taxed at a capital gains tax rate. 

In general, long term capital gains are usually taxed more favorably than short term capital gains. 

Impact of Taxes and Investment Account Type

TLDR; a taxable brokerage account will never beat a Roth investment account. If you are making high six figures, then a brokerage account may be better than a traditional investment account.

Honestly, bottom line, you will probably come out ahead if you are making long-term investments in any investment account. But if you’re here and reading this, you probably already knew that, so let’s jump into the key findings.

• The taxable brokerage account cannot beat the Roth investment accounts in terms of tax savings.
• The more you invest, the more tax-advantaged accounts have an impact. (When you earn higher gains, tax advantages reduce your bill and maximize your profit.)
• If your income is less than $40,400 in 2022, you will owe $0 on long term capital gains. This can make a taxable brokerage account more favorable than a traditional investment account, where you could owe up to $3,000.
• Unless you’re in a high tax bracket (32%+ making over $200,000), tax-advantaged accounts will be your best bet to maximize your profit. However, if you’re raking in the high six-figures, capital gains taxes may be more favorable than a traditional investment account (taxed at 15-20%). 
• If you are younger (30+ years away from retirement), tax advantaged accounts make a greater positive impact. That’s because the more time your money is invested, the more it grows, and the more you owe in taxes.
• The longer you are retired, the tax difference between a traditional retirement account and a taxable brokerage account widens.

How Taxes Are Calculated

I wanted to include specific numbers and say investing in a taxable brokerage account can save/cost you $X over your lifetime. I had the same assumptions for every account type, so the only variable I changed was how these accounts were taxed. The problem is it depends so much on your unique financial situation, that I’ve instead just summarized the key findings in the analysis above. The factors that impact this include

• Time invested
• Income
• Amount invested
• Duration of retirement
• Rate of return
• Capital gains

Because all the factors will be unique to your financial situation, it’s impossible to write a prescriptive statement on what’s optimal. 

If you want to dive deeper than the key findings from the analysis in the section above, this next part will explain how taxes are calculated. If this does not interest you, you can skip straight to the conclusion here. 

Income Taxes

There are a lot of misconceptions with how income taxes work. At a high level, there is a tax bracket to guide what % of your income (after pre-tax deductions) is taxed at various income thresholds. 

Here’s the tax bracket with an example of how much you’d pay if your income was $75,000. Everyone gets the standard deduction, so you’d take your salary – the standard deduction – any other deductions to get the total you owe taxes on. (75000-12950=62050)

Roth Taxes

If you invest in a Roth investment account, you can only contribute up to $6000 of your income each year. Effectively, that means anything you contribute to a Roth investment account has already been taxed through income taxes. (You would pay taxes on that money anyway if you just kept it and spent it, so this is a great way to take advantage of building future tax-free wealth.)

Traditional Taxes

If you were to invest in a traditional retirement account, you would subtract the amount you invested from your income. So if you contributed $10000 to your 401(k), this is how your taxes would look. ($75,000-$12950-$10000=$52050)

Then when you are withdrawing the money, your withdrawals would be counted as income and taxed like the income taxes example. 

Long term capital gains taxes

Long term capital gains are taxed at a specific % based on your income. A capital gain means investing profit. If you invested $10,000 and had a total ended balance of $50,000, you’d have a $40,000 capital gain. The entire amount of your capital gain ($40,000) is taxed at the same %, depending on your income. 

Here’s an example assuming you had a $40,000 capital gain and your income was $75,000. 

Conclusion

For the average person, tax advantaged retirement accounts win for maximizing your investing profits. HOWEVER, that doesn’t mean they may be the best decision for you.

Instead, consider what you need to feel confident investing for your unique personal finance situation. Perhaps you don’t need to maximize profits. Maybe you want the flexibility to be able to withdraw your investing profits within the next 10 years for whatever your heart may desire.

Maybe you hate commitment and cannot imagine locking up your money until your 59 ish. If you only remember one thing from this, it’s that the right decision is the one that lets you sleep peacefully at night, even if it’s not the one that is the most likely to maximize your profits.

There’s so much uncertainty anyway, the only thing you can influence is setting up your finances in a way that brings you as much peace as possible. Taxable brokerage accounts can be the best for you when they help you achieve your goals and bring you peace of mind.