Optimizing Returns: The Power of Stock Funds in Taxable Brokerage Accounts

Read the full blog below to learn more.

This week’s insight aims to underscore the power of owning stock funds in a plain old taxable brokerage account, and not going big into interest-paying bonds and money markets.

We harp on how investing through tax-advantaged retirement accounts, such as Traditional and Roth IRAs, employer-sponsored plans, and even Health Savings Accounts (HSAs), is important to growing your nest egg, but did you know that investing for the long haul in an after-tax account is not a bad deal either?

Consider that many taxpayers who hold a stock or exchange-traded fund (ETF) outside of a retirement account benefit from preferential long-term capital gains tax rates, potentially 0%. Now, individuals and couples in the top tax brackets face a 20% tax on realized gains, but for many retirees, we can craft a plan that includes paying zero tax on investment appreciation. Most taxpayers, though, will find themselves forking over a modest 15% of their gains to the IRS on shares sold after holding for more than one year.

This is not a new strategy, and it’s common practice among financial planners worth a lick, but a new twist has come about all thanks to much higher interest rates today.

You can earn upwards of 5.3% on a money market mutual fund, while certificates of deposit (CDs) offer comparable yields depending on their maturities. Bonds, money markets, and treasury bills might seem like safe bets right now, but investors need to consider the tax implications of these options. Surprisingly, owning low-turnover stock funds can provide a more favorable tax outcome, making them an attractive choice for savvy investors.

As Americans pour more money into higher-yielding fixed-income investments, some will face significant tax bills next spring since interest is often taxed at marginal income tax rates. For investors in the highest tax brackets, the sting will be real. Enough interest income can even push you into a higher bracket, potentially leading to additional tax liabilities.

The beauty of sticking with stocks is that you do not face taxes each year on gains. It’s only when you sell that you pay Uncle Sam his fair share, and that amount is at a relatively low rate. What’s more, many low-turnover stock funds invest in dividend-paying companies, and those yields can come through as “qualified” dividends to you – also at a preferred tax rate compared to taxes levied on bond interest.

The point here is that the safety of Treasuries is more enticing now than at any time in the past 15 years since yields are up big. But that does not mean you should make major portfolio shifts – doing so might throw your financial plan off track, resulting in owing more tax at the same time.