I recently had an interesting conversation with a potential client on different types of accounts. She wasn’t clear on what a taxable brokerage account was or why she’d need one, separate from her retirement accounts.
Originally published on the Retirement Daily
She is maxing out her retirement accounts at work, has a few savings accounts in different banks, as well as a 529 account for her kids.
We ended up discussing
What a taxable brokerage account is
Who can open the account
The benefits of the account and what the account can be used for
What to watch out for with the account
The special use case for foreign-born nationals including those on work visas.
The following is a high-level summary of the discussion.
What’s a Taxable Brokerage Account and Who Can Open One?
A taxable brokerage account is also known as an investment account, a securities account or simply a non-retirement taxable account. It can be opened by anyone over the age of 18 if they have a social security number or tax ID number (ITIN) and a US address.
Non-citizens and non-permanent residents are eligible to open the account as long as they meet the requirements above. The account can be opened at an online brokerage like Vanguard, or at a robo-advisor like Betterment. You can open the account on your own or with the help of an advisor.
It takes a very short time to open one of these accounts online. Simply go to the firm’s home page, locate the forms and fill out the new account application form. When starting out, look for firms where the account’s minimum is close to zero, with great customer support, and access to a broad range of investing options.
There are three high-level investing methods, you can use with this account.
Online brokerage account – You are on your own in picking out the investments.
Robo-advisor – You answer a series of questions on your goals, risk profile etc. This allows the algorithm to design a portfolio that fits your described needs.
A managed account – As the name implies, even though it’s a brokerage account, it’s being managed by a financial advisor.
A taxable brokerage account is great for somebody looking to start learning about investing on their own.
There are many ways of funding or adding money to the account. The easiest is a direct transfer from your bank to the newly created account. Linking your bank account means you can move money in both directions. It’s also very easy to set up an automated process, where the money goes from your bank account to the brokerage account on a regular basis.
You can invest in just about anything ranging from individual stocks to mutual funds to ETF’s (We have a future post on the EFTs, Mutual Funds etc. in the pipeline).
The Taxable Brokerage Account and Taxes
The account is taxable. This means that you pay taxes on the gains or the profit when realized. If you hold onto the security (mutual fund, stocks, etc.) for a year plus before selling then you pay capital gains taxes which are lower than ordinary income tax. The capital gains tax is 0%, 15% or 20% depending on your taxable income and filing status.
Another instance where you pay taxes on the account is when you earn money. Two examples of this are dividends or interest. Dividends are taxed the year you get them. They are two types of dividends that is, qualified and non-qualified. Qualified dividends are subject to the lower long term capital gains tax, while the non-qualified are subject to the higher ordinary income tax rate.
Interest income typically from cash and fixed income securities is generally taxed at the higher rate as well.
The taxable brokerage account allows for tax-loss harvesting which is one of the best ways for an investor to reduce taxes. It works like this – you sell one security that’s gone down in value (a loss), to offset the increase of a second security that’s gone up in value, thus eliminating the capital gains tax liability.
The same account is also key if looking to take advantage of tax-gain harvesting. The strategy involves selling assets that have increased in value, then re-buying them again (the 30-day wash-sales rule does not apply here).
The process basically increases your cost basis, leading to a lower capital gain in the future. This works best during the years when you are in an extremely low-income tax bracket, and you have highly appreciated securities in the taxable account.
Mid-Long Term Savings Goals
The brokerage account is the best saving vehicle for mid to long-term goals outside of retirement. Future expenses that are five years out (some advisors choose to go 3 + depending on what’s invested in the account, the goals etc.) are best left to grow in this account.
For example, if you are looking at saving for future health expenses while giving yourself some flexibility, this account is your best option, beyond the Health Savings Account. Another example is, if you looking to save for a house downpayment five years out, this is the perfect account.
When it comes to saving for college, most families will use a 529 plan. The 529 account grows tax-free if the money is used for qualified educational expenses.
If you use the money in the 529 plan for non-qualified expenses, you generally pay taxes on the growth and a 10% penalty.
For families who are not sure they’ll be able to use the money, a taxable brokerage account makes sense.
A specific example applies to foreign-born families in the country, whose kids don’t have social security numbers yet (foreign-born). There is a very good possibility that they’ll never be able to use the 529 plan for them.
Immigrants on work visas can open a 529 plan, but have to keep in mind that they may not be able to use the account as intended. In this two cases the taxable brokerage account is the way to go.
Things to Watch Out for With the Taxable Brokerage Account
When opening the account, you have the option of making it a margin account or a cash account. A margin account allows you to borrow money from the brokerage firm to buy securities. The securities act as the collateral for the loan.
Due to the potential to lose money, this option should only be used by sophisticated investors. So, avoid margin accounts and go with a cash account.
Don’t invest your emergency fund here, as there is a real possibility of losing what you invest in a brokerage account.
Foreign-Born Families Special Use Case
Don’t use it as a retirement vehicle, instead use accounts like 401k, traditional IRAs, Roth IRAs, etc. for retirement saving.
There is one specific case where it may make sense to forgo the traditional retirement accounts and save the money in a brokerage account.
If you are a foreign national, living in the U.S. and you intend to move back to your home country before retirement age, check to see if your home country will recognize the tax preferential treatment of retirement accounts like the Roth IRA. If they won’t, then this might be your best bet for starting to save for retirement.
There are other types of savings and investment accounts, but I think the taxable brokerage account gives you a lot of flexibility, and should be part of your saving/investment strategy.
Happy to discuss the merits of the account anytime. Click here if you’d like to chat more about this account or other financial issues that affect foreign-born families in the US.
If I own foreign rental property, do I have to include the income when I file my US taxes? The answer is yes, although it depends on your tax residency status. Read the rest of the post for the details on how you go about figuring this out and what to do with your foreign rental income.
Filing taxes the first year in the US as an immigrant or as a non-US citizen is not for the faint of heart. You need to figure out your filing status, in addition to understanding different concepts in the tax code. This post discusses what you need to keep in mind as you go through the process.