Understanding Taxable Accounts

The taxable status of an account refers to whether or not the income and gains are taxable when realized (when the holdings in your account are sold). There are numerous types of taxable and tax-advantaged accounts to select from, but this week we’ll be concentrating specifically on taxable accounts. 

Taxable accounts are funded with after-tax dollars, meaning you have already paid taxes on the money you are investing into the account.

Let’s assume you fund a taxable account with $10,000. Since it’s assumed taxes have already been paid on the $10,000 prior to funding, this will also be considered your cost basis (the original value / purchase price of your investment for tax purposes). When you sell a holding, you may end up incurring a capital gain (or loss) based on the market value of the holding at the time of sale and the original cost basis. The sale price minus your cost basis equals your capital gain (or loss).

Taxable accounts require you to pay capital gains taxes each year when you sell a holding and realize a profit. You are also required to pay taxes each year on any income received, such as dividends, bond interest, etc. 

For example, assume the account that you put $10,000 into is now worth $12,000. The $10,000 is your cost basis and it’s assumed you’ve already paid taxes on this amount. However, you have not paid taxes on the additional $2,000 received in capital appreciation. The $2,000 is considered a capital gain and is taxed as a short-term or long-term gain, depending on how long the investment was held (12 months or longer would be considered a long-term capital gain). 

This can also work the other way. Assume your account is now worth only $8,000 when you sell your holdings. Since the cost basis is $10,000, you now have a capital loss of $2,000. You can use this loss to offset other gains or possibly other income when you file taxes.

Here are some of the most common taxable account types:

Individual Accounts are simply accounts owned by one individual. The account owner has sole authority over all assets and must claim any income and gains/losses on their individual tax return. Individual accounts are beneficial if you want to transfer ownership to a beneficiary upon your death with no restrictions, but you want to keep full control and ownership of the account until your death (just make sure to include the “transfer on death” registration to the account).

Joint Accounts are accounts owned by two or more individuals. Any individual that is a partial owner of the account can withdraw from and deposit into the account as control is shared by the owners. Joint accounts are most common for spouses, close relatives, or business partners. The major benefits of this account type are the ease of access and ability to transfer assets easily. A joint account allows all owners access to the funds, so if the “primary owner” is unavailable the funds are still accessible to others. Also, if two individuals open a joint account and one of them passes away, the surviving individual receives the entire balance of the account and can avoid the probate process which can be long and expensive. 

Trust Accounts are accounts that are managed for the benefit of a beneficiary by an outside fiduciary. The beneficiary can be either the account owner or another person/entity. Trusts are great for estate planning as they avoid probate and allow you to specify exactly how and when the assets will pass to the beneficiary. You can set restrictions on when distributions can be made and rules on allowable investments within the account. There are many types of trusts, but a major factor is whether they are revocable or irrevocable:

• Revocable Trusts (Living Trust) allow you to retain control of the assets during your lifetime. This type of trust is flexible and can be changed at any time if your intentions or circumstances change (ex: you can change the beneficiary of the account). Although  there’s benefits with flexibility, revocable trusts are still subject to estate taxes at the grantor’s demise. The grantor is also liable for any current taxes since they still retain control of the assets.

• Irrevocable Trusts transfer your assets to the trust and out of your personal estate. This relieves you personally of any tax liabilities and transfers them to the trust since you no longer control the assets. Irrevocable trusts are generally preferred if your goal is estate tax minimization, but you cannot change the terms of the trust once it is created. Once the trust is created you can never alter it, even if your intentions or circumstances change.

It’s important to understand how different accounts can be used for different goals. A lot of tax-advantaged accounts are designed for long-term investing. For example, besides a few exceptions, an investor must be age 59 ½ to withdraw money from a 401(k), otherwise they will incur a 10% penalty. 

A benefit to taxable accounts is their flexibility / liquidity. Individual taxable accounts can be used for any goal at any time with no early withdrawal penalty. Specifically, they can be used for short-term goals unlike a lot of tax-deferred accounts. Whether you’re saving for a new car, house, family vacation, etc. a taxable account may make a better savings vehicle than a tax-deferred account. 

Taxable accounts can be a great fit as a part of your larger financial plan. Be sure to work closely with an advisor to understand the value-add they can bring to your situation. 

Check out our blog next week as we’ll dive into tax-advantaged accounts.

Ben Webster, CFP® and Derek Prusa, CFA, CFP®

Co-Founders and Owners of Aspire Wealth