By Dan Miller, WCI ContributorA Roth IRA is one of the most powerful types of retirement savings accounts under the right circumstances. Roth IRAs can be especially beneficial if they're started early in your career, as you can contribute after-tax money when you are likely in a low tax bracket. You can then let your money grow tax-free and withdraw money in retirement without having to pay any federal income tax.
A Roth IRA can be SO good in the right situations that people have come up with various strategies to mimic some of the advantages of a Roth IRA. In this article, we will look at how a regular taxable brokerage account can be just as good (or maybe even better) as a Roth IRA.
What Is a Roth IRA?
A Roth IRA is a type of Individual Retirement Arrangement that is funded with post-tax money. That is, you’re investing in the account with money that has already been taxed or you’re paying tax on the money when you convert it from tax-deferred to Roth money. Growth in your Roth account and most withdrawals in retirement are not subject to tax as long as you follow the withdrawal rules.
Dividends are not taxed. Earnings are tax-free. Quite simply, once your money is in a Roth account, it will never be taxed again. Sure, the tax laws could change, but any proposal that resulted in double taxation of Roth money would be extremely unpopular and unlikely to gain real traction.
Roth money is so valuable that most people recommend not touching it unless you have no other money sources available. Generally, taxable dollars and tax-deferred dollars should be spent first in retirement, and it can be smart to convert tax-deferred dollars to Roth, depending on your marginal income tax bracket.
More information here:
How I Failed and Then Mastered the Backdoor Roth IRA
What Is a Taxable Account?
When you buy mutual funds, ETFs, or individual stocks or bonds outside of your tax-advantaged retirement accounts with your own hard-earned after-tax dollars, they will reside in a plain old brokerage account. This type of non-qualified (non-tax-advantaged account) is commonly referred to as a taxable account. While specifics may change based on your individual situation, a general rule of thumb is to take advantage of any tax-advantaged accounts before investing money in a taxable account.
How a Taxable Account Can Behave Like a Roth IRA
If we want a taxable account to resemble a Roth IRA, then we have to meet the following criteria:
- No tax on the growth
- No tax on withdrawals
That’s pretty much it. How do we magically make these taxes disappear?
There are a few different ways that you can avoid or even eliminate taxes in a taxable brokerage account. Here are a few to keep in mind:
- Look for growth funds — Growth companies tend to invest most of their profits back into their growing businesses while giving little or no cash back to investors in the form of dividends. Conversely, value companies are more likely to distribute regular dividends from a portion of their profits. Consider investing in growth companies in your taxable account and value companies in your tax-advantaged accounts
- Avoid stocks that pay dividends — One way to accomplish this is by owning growth stocks that do not distribute dividends. Berkshire Hathaway is an excellent example of a diversified individual stock that does not pay out dividends
- Control your taxable income — If your taxable income falls below a certain level, you will pay 0% on your long-term capital gains. This is the linchpin of this strategy, and we'll go into further details in the next section.
More information here:
12 Ways to Simplify Your Taxable Investing Account
The 0% Capital Gains Tax Bracket
As an incentive for investment, the current US tax code gives a break to taxpayers who invest their money. For gains on investments that you've held for at least a year, you won't pay income tax at the same rate as ordinary income. Instead, you will pay the long-term capital gains tax rate, which is currently either 0%, 15%, or 20%, depending on your overall taxable income for the year. So, depending on your income, it's possible to even pay no taxes on capital gains and qualified dividends.
The threshold for paying 0% on capital gains and qualified dividends is fairly reasonable. For the 2024 tax year, a couple filing Married Filing Jointly can have taxable income of up to $94,050 ($47,025 for a single filer) in 2024 and pay 0% on their long-term capital gains. It's also important to note that the 0% bracket is not a cliff. If you end up with $94,051 in taxable income for the year and you realize $50,000 in long-term capital gains, you DO NOT owe 15% capital gains taxes on all $50,000 in realized gains. Only one of those dollars was bumped into the 15% long-term capital gains tax bracket, and the mistake will cost you 15 cents (which will probably be rounded down to $0).
If you want your taxable account to mimic a Roth IRA in retirement, remaining in or close to the 0% long-term capital gains (and qualified dividend) bracket is key.
0% Capital Gains Tax Scenario
Here's a simple example of how this might look. Sue is a physician who has been contributing to a variety of different accounts over the course of her high-earning years. She has been contributing to a taxable brokerage account with a buy-and-hold strategy. Now, she and her husband are looking to enjoy their retirement.
The couple could sell $140,000 worth of taxable assets purchased long ago that have appreciated 700% and not owe any tax because the assets have been held for over a year. Their capital gains when selling would be $140,000 (value when sold) – $20,000 (cost basis) = $120,000 in long-term capital gains.
A simple tax calculation would be $120,000 long-term capital gains – $29,200 standard deduction in 2024 = taxable income of $90,800. That puts them in the 0% capital gains bracket with no taxes owed on the year. They could have another $3,250 in income from other sources and still owe zero capital gains taxes.
The Bottom Line
While a taxable account is more flexible than a Roth account, there are asset protection benefits offered by a Roth account that the taxable account does not have. That’s all right—you’re not choosing either/or here. Maximizing all tax-advantaged accounts, including annual contributions to a Backdoor Roth IRA can be beneficial as you enter into retirement.
But remember that a “taxable” account can be a great investment account, and it’s not difficult to make it a very low-tax account. And it’s entirely possible, particularly for early retirees with budgets at or below a low six-figure number, to have a tax-free taxable account.
While paying little or no income tax on growth or withdrawals in a taxable account may not work for everyone, it's a strategy you will at least want to know about. The majority of the strategy lies in controlling your net income in any given year to be under (or near) the threshold where you don't pay tax on long-term capital gains. This is a strategy that can be used effectively by many high-net-worth individuals since they often have the flexibility and different income buckets to control their income in any one year.
If you need extra help with planning for retirement or have questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
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Really appreciated this run down! My plan calls for a three way split of my 41% savings rate between debt paydown, maxing out tax advantages accounts and real rate investing. So I don’t have a significant taxable account yet but definitely will in the future and will be using the info here for sure!
Thanks for the article! I did not know about the 80k/no tax rule. That’s very interesting indeed. Making sure we can live on 80k/year or less seems like it will not only help us reach retirement sooner, but also avoid taxes later. Nice!
One correction, NH does not tax capital gains, it taxes dividends and interest at 5%, but not capital gains.
Odd, but a nice little benefit. Live Free!
In reply to Hightower:
And keep in mind that there’s a HUGE difference between having a taxable income of $80k and spending $80k a year.
You could easily live on $120,000 to $150,000 with a taxable income of $80,000 or less. You’ve got the standard deductible of nearly $25,000, probably some Roth accounts to draw from, and the cost basis in your taxable account, which is also not taxable when you sell.
Cheers!
-PoF
Nice summary.
I would not distort my portfolio to get all non-dividend stocks. Dividends are quite low and get favorable tax treatment. I would rather take them and 15-20% plus NIIT than deviate from the market to save, say 30% of 2%.
If you had $100,000 and collected 2% in dividends (VTI is currently at 1.58%, but let’s call it 2.0) that would be $2,000. Assuming the highest federal tax bracket and some state tax on top, call it 30%. Your taxes would be $600. That is 0.6% of your 100k.
Yes, it could be higher if you are in a high bracket in a high tax state. Lower if you avoid the top federal rate, NIIT or live in a no income tax state.
I would rather pay that than try on my own or trust someone to mirror market performance with non dividend stocks.
I’d note that this technique also works to increase the basis of your stocks. That is, this can work in a low/no income year where you can live off of existing after-tax savings. As such, you simply sell your appreciated stock(s) and immediately buy them back. There is no 30-day rule when you are recognizing gains. So you recognize gains to the extent of the $40k/$80k tax break available – and you will have a lower tax bill when you ultimately sell these stocks.
Indeed.
That’s Tax Gain Harvesting. Basically the opposite of Tax Loss Harvesting, but quite valuable when you’re retired and have a low taxable income.
Cheers!
-PoF
Thanks PoF, for breaking down the math on the taxes and making it that is easy! I would just say that if one is investing simply, in the 3-fund portfolio or even the one fund portfolio (Total US Stock Market) it’s tax efficient enough to not have to bother with low/no dividend individual stocks or growth funds. Your asset allocation matters more than a little bit in taxes. I would hate to complicate it for someone on the fence.
Best,
PFB
Thank you for this article. I’ve read prior posts here on the taxable account but hadn’t thought of keeping these earnings almost tax-free through life. Thank you for explaining that!
I’m just a few years into practice and just started a taxable account this past year; do you or the audience have recommendations on which funds to place here, and which are close matches for tax-loss harvesting? I use a vanguard brokerage account. Thanks again!
My Vanguard Taxable brokerage accounts includes:
1) Total Stock Market (Primarily Vanguard VTI, but now holding some ITOT since last March. I think I went through Large cap index and 500 index before I got there)
2) Total International Stock Market (Primarily Vanguard VXUS, but now holding some IXUS since last March. I think I went through FTSE and developed market/emerging market index before I got there)
3) Vanguard Intermediate Muni Bond Fund
4) Vanguard International Small (VSS). I tax loss harvested this inot something, then back here. Maybe SCZ.
5) Vanguard Small Value Stocks. Unfortunately as my taxable to tax protected ratio has grown, I’m having to move this asset class into taxable. Haven’t had to tax loss harvest it yet so haven’t spent much time researching it.
Fidelity and Schwab obviously have similar funds, but if you’re at Vanguard I’d stick with the Vanguard funds and ETFs if you can.
Ryan, ” keeping these earnings almost tax-free through life.” If I had the advantage of your youth, that’s exactly the strategy I’d use. Use VUG or VONG to minimize taxes forever. Warren Buffett highlighted the advantages of “internal compounding”. Phil DeMuth in “Overtaxed Investor” advocates the………… growth>>>>value….. strategy in taxable accounts.
Would you please explain this last part for me. I was following everything in this whole article until I got to this paragraph:
It’s also important to note that the 0% bracket is not a cliff. If you end up with $78,751 dollars in taxable income for the year, and you realized $42,750 in long-term capital gains, you DO NOT owe 15% capital gains taxes on all $42,750 in realized gains. Only one of those dollars was bumped into the next bracket, and the mistake will cost you 15 cents (which will probably be rounded down to $0).
I can’t seem to figure out the math.
Thanks
You understand the concept of marginal tax rates? That only the money in the bracket is taxed at that rate? That’s the key point of the paragraph. He’s saying you made $78,51 of which $42,750 is LTCGs. So only one dollar of those LTCGs is being taxed. At 15%. or 15 cents.
Also, those numbers are based on the cutoffs from a couple of years ago. It’s $80,001 in 2020.
Best,
-PoF
I thought he meant that you had $78,751 in taxable income, which is less than $80,000, so why would he owe any taxes on the LTCG’s?
Oh, I think the issue is that the post wasn’t written in 2020 and wasn’t updated prior to republication here. So the $78,750 is the top of the bracket the year the post was written. We try to update those before resharing posts, but it doesn’t always happen.
Thanks.
Most of this post was updated for 2020, but I missed a line. Updated on my end to the following:
“It’s also important to note that the 0% bracket is not a cliff. If you end up with $80,001 dollars in taxable income for the year, and you realized $44,801 in long-term capital gains, you DO NOT owe 15% capital gains taxes on all $44,801 in realized gains.”
My apologies for the confusion,
-PoF
Excellent post! Really helped me understand taxation in retirement, which is a long way off for me. My question is, if I’m investing steadily in the same index fund in a taxable account for decades, how is cost basis determined? i.e. if my goal in retirement is keeping the taxable income under 80k so I’m in the 0% cap gains bracket, and I have a lot of wiggle room left, can I preferentially sell shares with higher capital gain (i.e. “older” shares) such that the net capital gains will bring my taxable income to 80k?
Yes. You can specify which tax lots you sell. The brokerage will keep track of it all.