Introduction:

Many investors focus solely on tax-advantaged retirement accounts like 401(k)s and IRAs when building their portfolios. However, non-qualified brokerage accounts can also provide significant, often overlooked tax benefits. This post explores the key tax advantages of using a taxable brokerage account as part of your overall investment strategy. While appreciated investments in taxable accounts may incur taxes on dividends and capital gains when sold, savvy tax planning and management can legally minimize or eliminate these taxes completely.

Tax-Deferred Growth

One benefit of non-qualified accounts is tax-deferred growth on investments. While you might eventually pay taxes on capital gains when you sell, you can delay paying those taxes if you buy and hold rather than sell an appreciated investment. By avoiding counterproductive buying and selling, your money can compound tax-deferred over time, leading to faster growth.

Avoiding the 3.8% Net Investment Income Tax and Increased Medicare Premiums

For high earners, avoiding the 3.8% Net Investment Income Tax (NIIT) on capital gains and dividends is another advantage of tax-deferred growth. Keeping income low enough to stay under the NIIT thresholds by deferring taxes can mean thousands in tax savings each year. Additionally, controlling capital gains can help avoid increased Medicare Part B and Part D premiums, which are tied to your taxable income.

Tax Loss Harvesting

Tax loss harvesting is a strategy of selling investments at a loss to offset capital gains tax. This technique can only be used in taxable accounts, as you cannot claim losses in an IRA or 401(k). By harvesting losses in a down market, you can use those losses to offset gains from other investments you sell in the same or later tax year. This reduces your tax bill while letting you reinvest the proceeds for future growth. Also, there is a $3,000 net loss write-off against ordinary income available without itemizing.

Long-Term Capital Gains Treatment

One of the most significant advantages of long-term investing in a non-qualified brokerage account is the favorable long-term capital gains tax rate. If you hold assets for over one year before selling, you qualify for a lower long-term capital gains tax rate of 0%, 15%, or 20%, depending on your income. This is substantially lower than short-term capital gains and ordinary income tax rates.

The Policy Behind Long-Term Capital Gains Treatment

Preferential tax rates on long-term capital gains have historically been justified as beneficial for promoting capital formation, entrepreneurship, and investments. Lower rates incentivize investors to take risks and realize gains that can be redeployed into building businesses and funding innovation. Without this incentive, capital would be locked into existing assets. Lower rates also help avoid double taxation – corporate income is taxed when earned, and then capital gains taxes apply on the appreciation when investors sell their stake. Reasonable capital gains rates prevent excessive taxation that would discourage equity investments, which is vital for economic growth.

The Added Benefit of Reduced Transaction Costs

Choosing ETFs and reducing the number of buy and sell-transactions can help maximize after-tax returns in taxable accounts. Lower turnover reduces other transaction costs, not just capital gains taxes.

Step-Up in Basis Savings Can be Huge

When you inherit assets in a taxable account, you receive a step-up-in-basis to the current market value. This means your cost basis is reset to the value on the date of death, eliminating any built-in capital gains on appreciated investments. This can save you and your heirs a tremendous amount of taxes compared to inheriting an IRA or 401(k).

Gifting Appreciated Securities

Another tax strategy is gifting appreciated investments held for over a year. By giving the securities directly rather than liquidating and gifting cash, the recipient can sell without paying capital gains taxes. The donor also avoids taxes on the appreciation. This can be an efficient way to transfer assets to your children or charity while maximizing tax benefits.

Borrowing Against Appreciated Assets

Opening a margin account with your brokerage allows you to borrow against the value of appreciated assets rather than selling them. This will enable you to access funds while avoiding capital gains taxes. Borrowed funds in a margin account incur lower interest rates, making this an efficient option compared to liquidating positions and losing the tax deferral benefit. While you can borrow against some insurance products like whole life insurance, this option is unavailable for annuities, IRAs, or other tax-deferred vehicles without triggering taxes and penalties. Margin accounts offer more flexibility and lower risk for borrowing against your portfolio.

Conclusion:

In summary, non-qualified brokerage accounts offer unique tax advantages that shouldn’t be overlooked. By utilizing tax-deferred growth, avoiding NIIT, tax loss harvesting, long-term capital gains rates, reduced transaction costs, step-up-in-basis, gifting appreciated securities, and strategic borrowing, you can maximize after-tax returns and create more tax-efficient income in retirement. Consult with a financial advisor or tax professional to implement appropriate tax-minimization strategies for your portfolio.