When discussing saving strategies with clients, one topic that often comes up is personal investment accounts. Many people are so focused on saving for retirement, and the tax benefits of retirement accounts, that they overlook personal investment accounts. But personal accounts (also known as taxable accounts) have one big advantage over retirement accounts: flexibility. They also have some big tax advantages.
Yet many people are unclear on what personal investment accounts are, how they work, and when to use them.
What are personal investment accounts?
A personal investment account, also called taxable account, is an account at a financial institution that is owned by one or more people. Most people are familiar with savings accounts, but they may not realize they can also have a personal investment account.
The only difference between a savings account and a personal investment account is that one is at a bank and the other is at an investment institution (“custodian”) like Vanguard or Charles Schwab. If an account is owned by one person, it is called an individual account and will be titled in the name of the owner (Jane Doe). If owned by more than one person, it will be titled in some other form (Joint, Tenants In Common, etc.)
How do personal investment accounts work?
A personal account is typically funded with cash. Then the cash is used to purchase investments like stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), etc.
Unlike IRAs, 401(k)s, and Roth accounts, there are no limits to how much you can contribute in one year. There are also no limits on distributions; you can withdraw funds for whatever you need, whenever you want.
If you want to withdraw money from your account and do not have enough cash, you will need to sell one of your investments. When you do this, a gain or loss will be generated.
While personal investment accounts do not have taxes on withdrawals, they are subject to capital gains taxes. When you sell an investment at a gain, you will have to pay tax on the gain. For example, if you buy XYZ stock for $10 and then sell it at a later point for $100, you will have a $90 gain on the sale.
If you held the position for more than one year, the gain will be considered long-term, and long-term capital gains tax will apply. This tax can vary from 0% to more than 20%, depending on your income. Most people are in the 15% capital gains bracket, which means they would pay 15% x $90 = $13.50 on the sale.
If you sell something you held for less than a year, the gain will be considered a short-term capital gain. Short-term gains are taxed at your marginal tax rate.
What happens if you sell something at a loss? This is one of the ways people can make lemonade out of lemons!
Let’s assume you buy ABC stock for $100 but, after you buy the stock, the price falls to $20. If you sell at $20, you will realize a capital loss of $100 – $20 = $80.
While nobody likes to sell at a loss, one advantage of personal accounts is that, at the end of the year, when taxes are prepared, gains and losses are netted against each other. Losses can then be used to offset gains.
Using the examples above, if you have a $90 gain from selling XYZ and a $80 loss from selling ABC, your net gain is $10. Assuming you held both stocks for more than one year and are in the 15% gains bracket, your tax would be $10 x 15% = $1.50.
Not only do losses count against gains, but if you have more losses than gains in a year, you can count up to $3,000 in losses against other income on your tax return. Finally, unused losses can be carried forward to future years to offset gains in future years. (The details are a little more complicated. Talk to your financial advisor or tax professional for more information.)
Some types of investments may create income that can have tax implications, so it is important to pay attention to the types of investments you buy in your account. For example, the interest paid on bonds is considered taxable income. Depending on your circumstances, it may be better to buy municipal bonds in a taxable investment account.
Taxes related to personal accounts are higher than Roth accounts (distributions from Roth accounts are tax-free) but lower than retirement accounts (distributions from retirement accounts are taxable income).
When to use a personal (taxable) account?
Personal investment accounts offer more flexibility than any other type of account. They are the ideal vehicle for saving for long-term goals like buying a vacation home or starting a business. They can also be a good option for supplemental retirement or college savings.
Retirement accounts should be used for retirement savings, but, if you have contributed the maximum and have extra money to save, consider using a personal investment account.
One mistake some people make is that they focus so much on saving for retirement that they forget or dismiss other goals. They save all of their money to 401(k)s and Roth accounts and then, when life changes and they decide to make a career change, or want to buy a bigger home, they don’t have the funds to do so. While Roth accounts have some flexibility around withdrawals, there are limits. Taxable accounts allow you to save for long-term goals while preserving flexibility with your money.
What a taxable account is not
A personal investment account is not an emergency fund. While the cash in an account can be part of an emergency fund, stocks, bonds, etc. can be quite volatile and may lose value. Do not invest money you may need in less than three years.
If you have goals that you would like to fund but would be willing to delay in the event of a market decline (such as a backyard swimming pool), then go ahead and invest. If not, keep the money in liquid reserves.
In summary, a personal (taxable) investment account can be a great option for just about anyone. They offer flexibility and tax advantages that aren’t available in retirement accounts and can be a great way to save for your future.