62% of adults in the U.S. own stocks in some form, whether directly or through funds. Around one third of Americans own a taxable investment account. 

Taxable investment accounts can be a powerful tool for wealth building, but only if you know how to navigate the complexities of how taxes work with your investments. 

But you’re probably not using your taxable investment account to its full potential, which means you’re likely paying more in taxes than you need to.

I’ll guide you through the ins and outs of taxable accounts and help you unlock their flexibility, maximize your returns, all while minimizing your tax burden.

Taxable accounts offer unparalleled flexibility compared to other account types:

• No Contribution Limits: Invest as much as you want, whenever you want.

• No Forced Withdrawals: You have complete control over your investment timeline.

• No Income Limits: No matter your income, you can utilize a taxable account.

• Capital gains taxes are generally lower than income taxes.

But there’s a big catch – you’re subject to tax on your realized gains or losses at the end of each year. Realized means you sold the asset. 

1. Understanding Capital Gains Taxes

If you don’t understand capital gains tax laws, you’ll likely leave a lot of money on the table.

Capital gains taxes are a hugely important aspect when you’re investing in a taxable account. There are two types of capital gains taxes: short-term and long-term.

Short-term capital gains apply to assets held for one year or less and are taxed at your ordinary income tax rate, which can be as high as 37%.

On the other hand, long-term capital gains apply to assets held for more than one year and are taxed at much lower rates – 0%, 15%, or 20%, depending on your taxable income.

Expert Tip: Always aim to hold your investments, whether it’s a stock, bond, REIT, ETF, or mutual fund, for more than a year to benefit from the lower long-term capital gains tax rate. Just this one simple strategy can save you a substantial amount of money in taxes over time.

2. Tax Loss Harvesting

Tax loss harvesting involves selling investments at a loss to offset gains elsewhere in your portfolio, which then reduces your taxable income.

You can deduct up to $3,000 of net capital losses from your ordinary income each year, and any remaining losses can be carried forward indefinitely to offset future gains.

 Example of Stock Loss Harvesting

 Let’s say you have two investments in your portfolio:

 1. Stock A: You purchased 100 shares of Stock A for $50 each, totaling $5,000. Due to market fluctuations, the stock’s value has dropped to $30 per share, making your current investment worth $3,000. If you sell these shares, you would realize a loss of $2,000.

 2. Stock B: You also own 50 shares of Stock B, which you bought for $100 each, totaling $5,000. The stock has performed well and is now valued at $150 per share, giving you a current worth of $7,500. If you sell these shares, you would realize a gain of $2,500.

 You sell both stocks. Here’s how it affects your taxes:

 – Realized Loss: By selling Stock A, you realize a loss of $2,000.

– Realized Gain: By selling Stock B, you realize a gain of $2,500.

The $2,000 loss from Stock A can be used to offset the $2,500 gain from Stock B. This means you will only pay taxes on the net gain of $500 ($2,500 gain – $2,000 loss).

If your long-term capital gains tax rate is 15%, instead of paying taxes on the full $2,500 gain, you will only be taxed on the $500 net gain. You’ll end up saving $300 in capital gains tax.

Expert Tip:

When doing stock loss harvesting, be aware of the wash sale rule. This rule disallows a tax deduction for a loss if you repurchase the same stock (or a substantially identical one) within 30 days before or after the sale. To avoid the wash sale rule, consider investing in a different stock or an exchange-traded fund (ETF) that tracks a similar index.

3. Tax Gain Harvesting

Tax gain harvesting is a strategy that many investors overlook, but it can help you minimize your taxes when you have capital gains. 

Long-term capital gains tax is applied to profits from the sale of assets held for more than one year. The tax rate you pay on these gains depends on your taxable income and filing status.

For the tax year 2024, long-term capital gains are taxed at three rates:

• 0% for lower-income individuals.

• 15% for middle-income earners.

• 20% for high-income earners.

In years when your income is low or nonexistent, you can take advantage of the 0% tax rate on long-term capital gains. By selling investments with gains during these years, you can realize profits tax-free and then immediately repurchase the same investment.

By doing this you keep your investment position but also reset the cost basis to a higher level, which will reduce your potential tax liability in the future. Here are the long-term capital gains tax rates for the year 2024 based on income levels:

Expert Tip:

Keep an eye on your income levels closely or work with a tax advisor to see if you qualify for the 0% long-term capital gains rate in a given year.

4. Direct Indexing

Direct indexing involves creating a portfolio of individual stocks that mirrors an index like the S&P 500. Instead of buying an index fund, you purchase each stock in the index in proportion to its weighting. 

This strategy gives you greater control over tax-loss harvesting and the ability to manage capital gains and dividends.

A study by Parametric Portfolio Associates found that direct indexing can add up to 1% in after-tax returns annually compared to traditional index funds. This is due to:

• Tax-Loss Harvesting: Selling underperforming stocks to realize tax losses, which can offset gains from other investments and reduce overall tax liability.

• Personalization: Tailoring portfolios to specific needs and preferences, such as focusing on high-performing stocks like the “Magnificent 7” (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla).

• Control Over Capital Gains and Dividends: Managing the timing and realization of capital gains and dividends for better tax planning and cash flow management.

For example, instead of buying an S&P 500 index ETF, you can use direct indexing to focus on specific stocks. During a market downturn, if any of the “Magnificent 7” stocks drop, you can sell those stocks to realize a tax loss, offsetting gains from other investments and reducing your overall tax bill. 

Expert Tip:

You can also adjust your portfolio based on your preferences, such as increasing exposure to AI stocks like NVIDIA or Microsoft. Owning individual stocks gives you the flexibility to decide when to sell shares and manage your dividend income.

5. Dividends: Qualified vs. Ordinary

Dividends are payments made by companies. Dividends are classified as either qualified or ordinary. Qualified dividends are taxed at the lower long-term capital gains tax rate, while ordinary dividends are taxed at your regular income tax rate.

Since dividends are considered realized gains, they can increase your tax liability if not managed well.

Not all dividends are created equal when it comes to taxes. Understanding the differences in dividends can help you manage your investments more effectively and minimize your tax bill.

Qualified dividends benefit from lower long-term capital gains tax rates. To qualify, dividends must meet specific criteria, including being paid by U.S. corporations or qualified foreign corporations and held for a minimum period.

To receive the lower long-term capital gains tax rates on qualified dividends, you need to hold the stock for more than 60 days during a 121 day period.

Popular stocks such as AAPL, MSFT, and KO are typically “qualified” if the holding period is met. 

For Ordinary (or “Non-Qualified”) dividends – these are taxed at your regular income tax rate, which can range from 10% to 37%, depending on your tax bracket.

This is much higher than the capital gains rate, which ranges from 0% to 20%. Non-Qualified dividends include Real Estate Investment Trusts (REITs).

Dividends from REITs are automatically considered non-qualified and taxed at ordinary income tax rates, regardless of the holding period.

Master Limited Partnerships (MLPs) dividends are also non-qualified.

Expert Tip: 

Manage the taxes of your dividends by owning high-dividend paying stocks in your tax-advantaged accounts like IRAs or Roth 401(k) plans. This can help minimize your tax impact while still allowing you to benefit from the income these stocks generate. 

6. Use Tax-Efficient Funds

Not all funds are created equal when it comes to taxes. Some mutual funds and ETFs are designed specifically to minimize taxable distributions. 

These tax-efficient funds typically avoid high-turnover strategies and focus on long-term growth. 

Look for index funds or ETFs with low turnover rates and a history of minimal taxable distributions.  This means they buy and hold investments for extended periods rather than frequently trading, which can generate short-term capital gains that are taxed at higher rates. 

Many tax-efficient funds use an indexing strategy, which has lower turnover than actively managed funds. Some tax-efficient funds may also use tax-loss harvesting strategies, where they sell losing investments to offset gains from winning investments.

Some examples of tax-efficient funds:

• Vanguard Tax-Managed Capital Appreciation Fund (VTCLX) aims to provide long-term capital appreciation while minimizing taxable distributions. 

• Schwab U.S. Broad Market ETF (SCHB) seeks to track the performance of the entire U.S. stock market while maintaining a low expense ratio and turnover rate. 

• iShares Core S&P 500 ETF (IVV) is a tax-efficient fund that tracks the S&P 500 Index and is known for its low turnover rate.

Investing in these types of funds within your taxable account can help you keep more of your returns.

7. The Bond Tax Trap

Bonds can be a solid addition to an investment portfolio since they provide a steady income and diversification. The problem is, taxes on your bond investments can be a big drawback, especially when held in a taxable account.

Bonds typically pay interest regularly, usually monthly or semi-annually. This interest income is considered a realized gain each year and is taxed at your ordinary income tax rate, which can be as high as 37% for high-income earners. 

This tax treatment is different compared with the preferential long-term capital gains rates applied to assets held for more than a year, which range from 0% to 20%.

The taxes on bond interest can be substantial, especially if you’re in a higher tax bracket.

For example, if you hold a corporate bond that pays 5% interest annually in a taxable account, and you’re in the 32% tax bracket, you would owe $1,600 in taxes on the $5,000 in interest earned, leaving you with only $3,400 in after-tax income.

And that’s not counting any state income tax you’ll owe.

To avoid the tax trap of bond interest, it’s more tax-efficient to hold bonds in tax-deferred accounts like a Roth or traditional IRA or a Roth 401(k) plan.

In these accounts, your investments grow tax-deferred, and you only pay taxes upon withdrawal, typically in retirement when your tax rate is lower.

For example, if you hold a $100,000 bond portfolio in a traditional IRA and it generates 5% interest annually, the $5,000 in interest won’t be taxed until you withdraw the funds in retirement. 

This means that your bond interest can compound without being eroded by taxes each year.

Expert Tip:

If you still decide to hold bonds in a taxable account, consider investing in municipal bonds, which are often exempt from federal and sometimes state income taxes.

The interest earned on municipal bonds is generally exempt from federal income tax and may also be exempt from state and local taxes if you live in the issuing state.

For instance, if you live in California and hold a California municipal bond that pays 4% interest, you won’t owe any federal or state income taxes on the $4,000 in interest earned annually. This can boost your after-tax returns compared to holding a taxable bond with the same yield.

9. Step-Up in Basis

One of the most powerful yet often overlooked strategies in wealth preservation and estate planning is holding onto appreciated assets, such as stocks, until death.

By doing this, you can take advantage of the “stepped-up basis” provision in the tax code.

With a stepped-up basis, the taxable gain is calculated based on the asset’s value at the time of inheritance, not when you originally purchased it. 

This means your heirs only pay taxes on any appreciation that occurs after they inherit the asset. If they sell the stock immediately, they pay no capital gains tax.

This strategy can seriously reduce the tax burden on your heirs and help create a lasting legacy of wealth for your family. 

For example, if you bought Apple stock for $10,000 and it’s worth $50,000 at the time of your death, the cost basis for your heirs would be “stepped up” from $10,000 to $50,000. 

This means that if your heirs sell the stock immediately after inheriting it, they would owe no capital gains taxes, as there would be no gain based on the stepped-up basis.

But without the stepped-up basis rule, your heirs would inherit your original cost basis, which in this case is $10,000. If they later sell the stock for $50,000, they would face capital gains taxes on $40,000 of profit. 

 This strategy effectively allows wealth accumulated during your lifetime to be passed on to your children with minimal tax consequences.

10. Rebalancing Without Triggering Taxes

As your investment portfolio grows, certain stocks or asset classes can become overweighted due to the movement in asset prices. 

For example, if your stock allocation increases from 60% to 70% of your portfolio due to a strong bull market, you’d need to sell some stocks to bring it back to your target 60% weighting. 

But there’s a problem when you do rebalancing in a taxable account – it can lead to capital gains taxes. And these capital gains taxes can be significant, especially if you’ve held stocks for a long time or have large unrealized gains.

One way to rebalance without selling is to invest any new money or dividends received in your taxable account toward those underweighted assets. 

Let’s say your target asset allocation is 60% stocks, 30% bonds, and 10% real estate investment trusts (REITs). Over time, your portfolio shifts to 70% stocks, 25% bonds, and 5% REITs due to asset price movements.

To rebalance without triggering taxes, you could:

1. Direct your next $1,000 contribution to buy more bonds and bring your bond allocation closer to the 30% target.

2. When your stocks pays a dividend, reinvest these into your REITs. 

11. Double the Tax Benefits with Charitable Giving 

Donating appreciated assets, such as stocks or funds, can provide significant tax benefits compared to cash donations. As a donor, this allows you to maximize charitable contributions while minimizing tax liabilities. 

When you donate appreciated stocks instead of cash, you get to enjoy two main tax advantages:

1. If you sell appreciated stock, you trigger capital gains tax on the profit. By donating the stock directly to a qualified charity, you avoid this tax. 

For instance, if you bought Microsoft for $3,000 and it is now worth $10,000, selling it would result in a $7,000 gain which is subject to capital gains tax. But donating the stock allows you to bypass this tax entirely.

2. You can claim a deduction for the full market value of your Microsoft stock at the time of the donation. The value of your Microsoft shares valued at $10,000 gets deducted from your taxable income, which can mean a substantial tax saving, especially for high-income earners.

Let’s look at the couple who own a portfolio stocks worth $450,000 that they purchased for $300,000. If they sold these shares, they would face a capital gains tax of around $35,700.

Their capital gains tax would reduce the amount they could donate to their favorite charity to $414,300. Instead, they could their stocks directly, and then claim a full deduction of $450,000. 

The Key Takeaway

If you’re not being strategic with your taxable investment account, you’re likely losing money to taxes needlessly.

Taxable investment accounts can be a powerful tool for building and growing wealth. The reason the wealthy continue to accumulate wealth is that they strategically invest in appreciating assets and hold them for long periods before selling. Are you willing to do the same?