What is a taxable account?

 

A taxable account is one in which typical IRS tax rules apply. Some examples of taxable accounts include:

• Checking accounts
• Savings accounts
• Money market accounts
• Brokerage accounts

For these types of accounts, you are expected to pay taxes on any interest, dividends, or capital gains that your investments generate, in the year in which you earn them.

 

What are capital gains?

Capital gains are profits earned from the sale of an asset such as a stock, a bond, or something tangible like a house. The taxes levied on capital gains vary, depending on how long you hold the asset prior to selling, with “short-term” capital gains applying to assets held for less than a year and “long-term” capital gains applying to assets held for a year or more.

For interest, nonqualified dividends, and short-term capital gains, you are typically charged your normal income tax rate. Long-term capital gains and some qualified dividends typically have a lower tax rate. The government does this to encourage long-term investment, so it's usually in your best interest to carefully choose your investments and hold on to them.

 

Here are some scenarios in which you might use a taxable account:

• Short-term savings account that you may add to, or take from, on a regular basis—such as an emergency fund, or if you’re saving for a car, etc.
• Saving for retirement if you’ve exceeded contribution limits for nontaxable retirement accounts.

 

What is a tax-deferred account?

A tax-deferred account is one in which taxation on any investment growth is deferred until money is taken out of the account. Some accounts allow contributions that are deductible in the current tax year. In that case, the entire withdrawal is subject to taxes. In some accounts, the contribution is made with after-tax money and only the growth portion of the withdrawal is subject to taxes. Some examples of tax-deferred accounts include:

• Individual retirement accounts  (traditional and Roth IRAs)
• Deferred annuities
• 401(k) plans

 

What does tax-deferred mean?

Tax-deferred status refers to investment earnings—such as interest, dividends, or capital gains—that accumulate tax free until the investor takes constructive receipt of the profits. Accounts with tax-deferred status are also commonly referred to as being tax-advantaged.

 

Taxable vs. tax-advantaged

While the returns on your investments are important, what’s perhaps more relevant is how much you get to keep after taxes. Small amounts can add up over time, so choosing the right asset allocation to maximize your returns is a strategy in and of itself. Diversifying your investments across different tax treatments also helps to give you more flexibility when you start drawing from your savings in retirement since you don’t know what the tax rate will be in the future.

To give you some idea, here are some common investments associated with taxable or tax-advantaged accounts.

Taxable brokerage accounts are typically taxed at a normal rate, but provide greater flexibility and liquidity^* (i.e., fewer restrictions), and are commonly used to invest in:

• Stocks
• Index funds
• Exchange-traded funds (ETFs)
• Mutual funds that pay qualified dividends
• Surplus retirement savings (if you’ve maxed out your tax-advantaged retirement savings accounts)

Tax-advantaged accounts typically have more restrictions, but provide greater tax advantages and are ideal for:

• 401(k) plans
• IRAs

However, if all your money is in your 401(k) or IRA and you do not hold investments in both types of accounts, you can simply focus on choosing the appropriate investments for your needs. Ideally, you’d want to work with a financial professional who can help you determine the right asset allocations according to your goals, risk tolerance, and time frame.