Taxable Brokerage Accounts: Pros & Cons to Consider
Most people look for options with higher returns when investing for the long term. These goals can include building a nest egg or saving for college.
A taxable brokerage account is the most flexible investment account type you can open.
These accounts don’t have the restrictions or contribution rules that disqualify some people from taking advantage of certain retirement accounts.
Here’s what you should know about taxable brokerage accounts and the pros and cons of using one.
What is a Taxable Brokerage Account?
A taxable brokerage account is a type of nonretirement financial account -- offered by many institutions -- that allows you to buy, sell, and hold investments.
Commonly offered investment types may include:
- Mutual funds
- Exchange-traded funds (ETFs)
The specific options for investment will depend on the brokerage firm you open your account with.
You may have to meet certain qualifications in order to open the account with the brokerage. There are no limits based on your income as you may find with retirement accounts.
Brokerage accounts have many benefits that make them worth considering.
Can be opened with a brokerage of your choice
Unfortunately, some account types are limited to where they can be opened.
You can’t choose your 401(k) provider at your workplace.
Similarly, you can’t choose the provider for your state’s 529 plan.
Thankfully, brokerage accounts can be opened anywhere that offers them.
This is a huge advantage.
It essentially allows you to shop for the best deal.
You can find a firm that offers the investments you want.
You can also price shop to find a brokerage account that doesn’t charge commissions.
If you prefer ETFs, you can look for one that offers ETFs with low expense ratios.
More investment options
Workplace retirement accounts, such as 401(k)s and SIMPLE IRAs, often have a limited selection of investments to choose from.
This makes sense.
Employers may aim to keep the plans relatively simple--this can help keep plan costs low.
While this works well for employers, it isn’t always a benefit for employees.
If you want a highly customized investment portfolio, your 401(k) may not offer the options you want to invest in. Brokerage accounts offer a much wider variety of investment options.
Many allow you to purchase thousands of investments, including stocks, mutual funds, or ETFs. Some of these investments charge fees, but they’re an option.
You can even carefully choose your brokerage account to find one that offers the investments you want at the lowest fees you can find.
No contribution limits
Retirement plans have contribution limits.
You’re limited to how much you can put in these accounts each year.
Some accounts may have a limit of $20,500. Others may be $6,000.
No matter what the amount is, you can’t contribute an unlimited amount to these accounts.
Retirement accounts have tax benefits.
Some offer tax-deductible contributions. This lowers your taxable income and results in paying less in taxes.
If you could contribute an unlimited amount of money to these accounts, the government wouldn’t be able to collect taxes.
Other retirement accounts allow tax-free withdrawals if you pay taxes on the amounts you contribute.
For example, when you contribute to a Roth IRA, you do so with after-tax money.
The benefit is you get to withdraw the money tax-free in retirement if you follow the rules.
This also reduces government income taxes collected because the earnings are never taxed.
Taxable brokerage accounts do not have contribution limits. Many people may max out their retirement accounts or simply don’t want to deal with the restrictions they come with.
In these cases, you can contribute as much as you want to your taxable brokerage account.
No income limits
Some types of retirement accounts have income limits.
These exist for several reasons and help the government control who can contribute to these accounts.
If your income exceeds those limits, your contribution limit to a retirement account may be reduced.
If it exceeds the limit by a certain amount, you may not be able to contribute to that type of account at all.
Brokerage accounts do not have these income limitations.
May qualify for long-term capital gains tax rates
While taxable brokerage accounts don’t offer retirement account-like tax benefits, they do have one benefit.
If you hold your investments for more than a year, the gains on the sale are taxed at long-term capital gains tax rates.
These are lower than ordinary income tax rates, giving you a break on your tax bill.
When you pay capital gains taxes at the long-term rates, you could save significant money.
No required minimum distributions
Some types of retirement accounts force you to start taking distributions at age 72.
If you don’t, you face steep penalties.
This is a way the government can make sure that you have to pay taxes on the retirement account money you stashed away.
Taxable brokerage accounts do not have these forced distributions.
No early withdrawal penalties
Withdrawing money from a retirement account before the designated age can result in a 10% early withdrawal penalty.
This penalty exists to discourage people from withdrawing the money they save for retirement.
There are no government-mandated early withdrawal penalties on brokerage accounts.
Your investments may have penalties if you sell them before you hold them for a specific period, though.
The lack of penalties allows you to use a taxable investment account for shorter-term goals than retirement.
Can participate in tax-loss harvesting
When you sell investments, you either have a capital gain or capital loss.
You must pay taxes on the gains.
The tax code allows you to offset your capital gains against your capital losses. For this reason, a tax strategy called tax-loss harvesting exists.
Essentially, you sell investments with losses to offset the gains you’ve earned.
This reduces the amount of taxes you owe at tax time.
You cannot do this in retirement accounts, partially because earnings are generally not taxable.
It does provide a tax benefit for taxable investment accounts, though.
Unfortunately, there are some benefits brokerage accounts can not offer.
This results in some pretty significant drawbacks for this account type.
No tax breaks
Other than tax-loss harvesting and long-term capital gains tax rates, taxable brokerage accounts don’t have significant tax breaks.
While some tax breaks technically exist, they don’t reach the same level as those offered by retirement accounts.
May raid account early
You may be tempted to raid the account early since taxable brokerage accounts don’t have early withdrawal penalties.
This can result in less than optimal returns.
If you need an early withdrawal penalty to help you stay invested for your retirement goals, a retirement account may be a better fit.
How Taxable Brokerage Accounts Differ from IRAs and 401(k)s
Taxable brokerage accounts differ from IRAs and 401(k)s in many ways.
Taxable brokerage accounts don’t have:
- As beneficial tax breaks
- Early withdrawal penalties
- Income limits
- Contribution limits
- Required minimum distributions
Like an IRA, you can choose where you open your taxable brokerage account.
This is not the same for a 401(k).
IRAs and taxable brokerage accounts usually have more investment options than a 401(k), too.
When Should You Consider a Taxable Brokerage Account
Deciding when to use a taxable brokerage account can be tricky.
Generally, retirement accounts offer more tax benefits.
You may get an employer match from your workplace retirement plan.
It almost always makes sense to get the match before contribution to a taxable brokerage account.
Beyond that, it depends on your goals.
A taxable brokerage account makes sense if you want to put away money for a goal before retirement age.
If you want to retire before the traditional retirement age, you may want some of your money to be invested in a taxable brokerage account.
However, most people saving for retirement at the traditional retirement age may want to max out their retirement accounts first.
Once those accounts are maxed out, a taxable brokerage account usually makes the most sense.
A taxable brokerage account may also be a consideration if you want to invest in something you can’t do in a retirement account.
For instance, margin trading is usually not allowed in retirement accounts.
Consult an Expert
Deciding where to invest can have huge impacts on your financial life and tax situation.
If you don’t feel comfortable deciding on your own, it makes sense to consult an expert.
A fiduciary fee-only financial advisor can examine your entire financial situation. Then, they can recommend an investment plan to help you reach your goals. These advisors do not accept commissions, so you don’t have a conflict of interest.
That said, they do charge for their time.
Even so, the fee may be worth the peace of mind you get that you didn’t accidentally overlook or misunderstand something when setting up your investment plan.