A brokerage account is the second of the Phippen Tax & Financial Services Accounts You Want because it allows you to invest beyond the limits of your 401(k),* IRA, and HSA. You should open a brokerage once you maximize contributions to your other retirement accounts because you want to:
Bolster your retirement or other long-term investments, particularly if you plan to retire early, to solidify your financial future. Brokerage accounts allow you to invest for maximum growth, and you can enjoy the returns from that growth at a lower tax rate than when you work for money.
Why are my retirement accounts not enough?
They are, if you do not want to retire until age 65. That is why a brokerage account is an account you want rather than an account you need. However, if you want to eliminate risk and reach enough money that you could retire early, whether or not you actually do, brokerage accounts offer another avenue to expand your investing without limits.
If you are pursuing FIRE (financial independence, retire early) and do not plan to live so frugally that you can pull only the basis of your Roth IRA to cover your expenses from the time you retire to age 59.5, you need a brokerage account to support you during at least some of those years. The farther away you are from age 59.5 and the larger amount of money you need each year, the more important your brokerage account is to your early retirement plan.
For those content on working until age 59.5 or later, a brokerage account is a want rather than a need, but it carries a lot of benefits. First, investing money outside of your retirement accounts provides another safety net since you can use that money, including any growth, at any time for any reason. While you can withdraw your contributions from a Roth account at any time, you will incur both tax and a penalty if you make an early withdrawal of any of the accumulated growth. To withdraw any of the growth without tax or penalties, you must be at least age 59.5 and have held your Roth account for at least five years. Traditional Roth and 401(k) withdrawals will also subject you to a penalty if made before age 59.5 (and you will be taxed on the total withdrawal, contributions or growth, at any age). Brokerage accounts do not have a five-year wait, a minimum withdrawal age, or a penalty.
Additionally, brokerage accounts do not have to be used for retirement. You can invest in a diverse range of assets and open brokerage accounts to invest money for future investments or life goals. Just do so with the understanding that investing in the market is best over the long term, like for the lake house you want to buy in 20 years, so any short-term goals are better suited for a high-yield savings account or a certificate of deposit (which we will discuss next week).
Not Tax-Free, but Tax-Advantaged
One of my favorite reasons to encourage folks to consider investing aggressively and retiring early is that the growth from investments in your brokerage account (or retirement accounts, when withdrawn after age 59.5) is taxed at a lower rate than your salary. To repeat, your salary is taxed at a higher rate than when your money grows from compound interest to magically make more money. You receive a greater portion of the returns from doing nothing than from working!
A regular brokerage is not tax-advantaged to the extent of an IRA, Roth IRA, 401(k), Roth 401(k), or HSA. But the fact that you can lower your tax bracket by living off of the money your money grew instead of the hours of your life you traded away to receive money is remarkable.
The growth in value of your investments are called capital gains. If you buy shares of a mutual fund for $40,000, and sell those shares when its value has increased to $50,000, you have $10,000 in capital gains. Like ordinary income (such as your salary), capital gains are subject to tax, but at a much lower rate. Assuming you held your investment for more than one year, these are the capital gains brackets for single filers in 2023:
The cut points for the three levels are slightly less favorable for married filing separate, and more favorable for head of household or married filing joint.
That means, if you withdraw $40,000 of gains to live off of in 2023 – an amount of money that could provide a decent standard of living – and that is your only income for the year, you pay no taxes! If you want to live a luxurious lifestyle by withdrawing any amount up to nearly $500k, your capital gains beyond $44,625 will still only be taxed at 15%.
If you are not shocked by this, let me remind you of the 2023 income tax brackets for filing single:
In other words, the one-billionth dollar you withdraw from your brokerage account is taxed less than the 45,000th dollar in your salary. At Phippen Tax, we love less taxing tricks, and it is far less taxing to live off the money your money made than the money you made.
In summary, if you are living off of the gains from your investments and you are withdrawing less than $492K annually, you will not pay more than 15% in capital gains taxes on a single dollar. That is magical.
The net investment income tax will also apply in addition to ordinary income tax or capital gains tax if you have net investment income (such as capital gains or a passive partnership interest) and modified adjusted gross income above certain levels depending on your filing status:
Married filing jointly: $250,000
Married filing separately: $125,000
Single: $200,000
Head of household: $200,000
Qualifying widow(er): $250,000
This tax is the lesser of (1) your income above these levels or (2) your net investment income.
If your only income is capital gains, then the computation is simple. You will only be subject to the net investment income tax on your capital gains that exceed these levels. A single taxpayer living entirely on capital gains will not be subject to the net investment income tax if their gains are below $200,000.
Remember that only the gains count towards your income. If you sell an investment for $250,000 that you purchased for $85,000, you are only taxed on the $165,000 growth (i.e., $250,000 minus $85,000). Assuming that is your entire income for the year, you only have a 15% capital gains tax on $120,375 (since the first $44,625 of your capital gains has a 0% rate), and no net investment income tax!
Retire Earlier and/or Richer
Brokerage accounts provide a location to experience the full potential of compound growth in a non-retirement account. If you want to retire early, this is where you can invest money and withdraw it before age 59.5, including any gains. Cobble together a plan where you withdraw money from your brokerage account until age 59.5, enjoying those low capital gains taxes, and then switch over to retirement accounts when you reach traditional retirement age.
If you want to keep working, this is how you get extremely wealthy. On average, invested money will double every 7-10 years, depending on your investments. Particularly if you self-manage your accounts rather than hire a financial advisor with high fees, even the smallest amount of money will be huge by the time you plan to use it.
Regardless of your individual path, compound growth and lower taxes are the most fun things we can offer as a tax and financial services business. Go open a brokerage account so you can avoid taxes (legally!), like the billionaires do.
*We use “401(k)” to discuss factors that are true for all of the employer-sponsored retirement accounts, including a 401(k), 457, 403(b), or TSP. The specific type of account available to you is based on your employer type. For example, only federal government employees can participate in the Thrift Savings Plan.
About the Financial Accounts Series: The Financial Accounts Series is a four-part series discussing financial accounts that can improve the health of your finances. The Phippen Tax & Financial Services team will provide a deep dive on each of the accounts listed in Part 3, Accounts You Want, before releasing Part 4, “Accounts to Have for Fun.” If you missed Part 1, Accounts You Need First and Part 2, Accounts You Need Next start there! If you would like to seek additional guidance about your personal finances or the specific organization and composition of your financial accounts, please contact Patrick Phippen or complete a new client form if you have not worked with Patrick in the past.
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