A brokerage account is the most flexible type of investment account. While there are no tax advantages, investors also have complete freedom to make contributions and take withdrawals without restrictions or penalties.
Using a brokerage account as part of your overall retirement saving strategy can provide a few key benefits including the potential to retire early, leave a tax-efficient legacy to your heirs, and the potential to reduce your tax liability in retirement.
Get closer to an early retirement. If you’re already maxing out contributions to an employer-sponsored retirement plan like a 401(k), you may think you’re already doing everything you can to save for retirement. However, if cash flow permits, it may make sense to consider regular contributions to a brokerage account. The strategy is fairly simple: investors have two options for their surplus cash flow: save it or spend it. As income increases, spending typically follows unless a conscious effort is made to put a meaningful portion toward savings.
[See: 10 Costs You Can Eliminate in Retirement.]
One of the benefits of automatic contributions to a retirement plan at work is that investors don’t have to make a bi-weekly decision as to whether they rather spend the funds on lifestyle expenses or save for retirement. By starting a brokerage account and setting up automatic contributions, you can effectively create the same “set it and forget it” mentality. Over time, with regular savings and investments, you’ll likely be in a much better state for retirement, and could possibly contemplate an earlier retirement or more resources for your desired lifestyle.
Using a brokerage account to systematically save and invest surplus cash flows can also help prevent investors from keeping too much cash on hand in a very low-yielding savings account. In fact, after account for inflation, cash will actually yield a negative return.
Keep in mind that you shouldn’t keep your emergency reserves or funds to cover any short-term needs in a brokerage account.
A brokerage account may also be able to help spendthrift individuals manage their finances. While the funds in a brokerage account are accessible at any time, it isn’t quite as easy as making an electronic transfer from your savings account. You will need to sell securities in order to raise cash and there will be capital gains tax if the position has appreciated.
Leave a tax-efficient legacy to your heirs. If one of your goals is to preserve wealth to leave as a legacy to your loved ones, assets held in a taxable account can be a great vehicle.
For tax purposes, the difference between your cost basis in an investment and the sale price will determine what portion of the gain will be subject to capital gains taxes after it is subsequently sold. When an individual holds highly appreciated securities, there can be a significant tax liability when the position is ultimately liquidated as the spread between the cost basis and the sale price is so large, assuming there are no offsetting losses to recognize.
However, the tax basis rules change when a beneficiary inherits a taxable brokerage account. Taxable assets can pass to a beneficiary on a “stepped-up” cost basis, which values the investment on the date of your death instead of your cost basis in the asset, which is typically much lower, especially if the asset was held for a long time.
Investments receiving step-up treatment will also be considered long-term investments regardless of the actual holding period, and taxed at more favorable long-term capital gains rates when sold. Beneficiaries will not receive a step-up in basis for inherited assets held in tax-deferred retirement accounts like a 401(k), 403(b), or a traditional IRA. Further, your heirs will need to pay ordinary income tax on the entire amount when funds are withdrawn.
[See: 8 Things That Matter More Than Money for a Happy Retirement.]
Regularly funding a brokerage account can help you achieve your legacy goals in three key ways.
First, you can choose to draw down assets in tax-deferred retirement accounts first, preserving the funds in your brokerage account to pass onto heirs so they will receive the favorable tax treatment. Second, unlike inherited assets held in retirement accounts, brokerage accounts do not have any required minimum distributions or other rules governing when distributions can (or must) be made and for what purpose. Brokerage accounts maintain the same flexibility even after they are passed down. And finally, through a dedicated approach to making regular contributions to the brokerage account over the years, the legacy you ultimately pass on is likely to be much more impactful than if the funds were spent or kept in cash.
Tax-efficient withdrawal strategies in retirement. Having a meaningful portion of your net worth held in a taxable brokerage account will help retirees regain some control over their tax liability in retirement. Recall that assets held in tax-deferred accounts, where most Americans have the vast majority of their retirement savings, will be taxed as ordinary income when funds are withdrawn.
Holding a sizeable portion of your portfolio in tax-diversified accounts may open up planning opportunities. But first a quick review of how withdrawals from taxable and tax-free accounts are treated.
Dividends in a brokerage account are taxed as ordinary income when they are received, but when you liquidate assets in a brokerage account you have the ability to target positions that will receive more favorable long-term capital gains rates. If you have a Roth IRA, those assets can be liquidated tax-free, assuming you’ve met the required five-year holding period.
Planning opportunities may be available in retirement as your situation changes. For example, in years where you are in a lower marginal tax bracket, you may wish to draw funds from tax-deferred retirement accounts as they represent the biggest potential tax liability. If you have income needs while you are still working or are in a higher marginal tax bracket in a given year, it may be advantageous to tap a Roth account or your brokerage account.
Developing a strategy for saving and investment and sticking with it over the long term can have a profound impact on an investor’s life. A brokerage account allows individuals to gain exposure to the broad-based stock market while maintaining the flexibility they need to use the funds as they wish and as their needs change. Further, if you are charitably inclined, you may even choose to donate highly appreciated securities to charity later in life. You may receive a tax deduction while supporting a cause you truly care about.
[See: The Best ETFs Retirees Can Buy.]
Brokerage accounts are the only type of investment account that can provide complete flexibility for your goals, lifestyle, and to adapt as your needs change in the future.
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3 Ways a Brokerage Can Help Your Retirement Savings originally appeared on usnews.com
