The Surprising Benefits of Non-Retirement Accounts

The Surprising Benefits of Non-Retirement Accounts

June 05, 2024

When the topic of investing for your retirement comes up, odds are you think of retirement accounts such as 401(k) and IRA. While those account types have obvious tax advantages and were created specifically for the purpose of retirement savings, there is another, often overlooked option. Particularly for those considering an early departure from the workforce, a non-retirement account serves as a flexible and advantageous tool for managing early retirement spending.

Understanding Non-retirement Accounts

A non-retirement account is an investment account where contributions are made with after-tax dollars, and the account holder can buy and sell investments like stocks, bonds, mutual funds, and ETFs. Unlike retirement accounts such as IRAs or 401(k)s, non-retirement accounts do not offer immediate tax deductions on contributions. However, they come with distinct advantages that are particularly beneficial for those targeting early retirement.

One of the primary benefits of a non-retirement account is its accessibility. Unlike traditional retirement accounts, which impose penalties for withdrawals before the age of 59½, non-retirement accounts allow investors to access their funds at any time without incurring early withdrawal penalties. This flexibility is crucial for early retirees who may need to draw from their investments before reaching traditional retirement age.

While contributions to non-retirement accounts do not provide upfront tax benefits, they offer significant opportunities for tax optimization. Investors can employ strategies such as tax-loss harvesting, where losses from certain investments can offset gains from others, thereby reducing the overall tax liability. Additionally, long-term capital gains—profits from investments held for more than a year—are taxed at a lower rate than ordinary income, which can result in substantial tax savings for retirees who plan their withdrawals strategically. Notably, the long-term capital gains tax rate for a married couple who files their taxes jointly is 0% for those couples with a taxable income under $94,051 a year (limit for 2024). Unlike retirement accounts that have contribution limits, non-retirement accounts have no such restrictions, allowing investors to contribute as much as they wish to better position their investment growth.

To clarify, the key difference between retirement accounts and non-retirement accounts is when the investment gains are taxed. In a pre-tax retirement account, all taxes are deferred until withdrawal. This means that the investment gains are not taxed until you begin drawing on the account to supplement your retirement income. When withdrawals are taken, they are taxed at the account holder’s current ordinary income tax rate, whatever that may be based on their income. By contrast, in non-retirement accounts you pay taxes on the investment gains as they are earned. For example, let’s say you purchased a mutual fund 10 years ago and sell it for a $10,000 gain. That gain would appear on your taxes in the year that you sold the fund as opposed to a retirement account where that gain would not be taxed until the funds were withdrawn from your account. As mentioned above, the gain would be taxed at the capital gains tax rates as opposed to ordinary income tax rates.

The Strategic Role of Non-retirement accounts in Early Retirement

For early retirees, funding a non-retirement account can hold the key which allows them to retire before age 59 ½. Early retirees often face a gap between their retirement date and the age at which they can access other retirement funds without penalties. A non-retirement account serves as an ideal bridge during this period. It provides a ready source of funds to cover living expenses and other financial needs without the need for premature withdrawals (and the ensuing IRS penalty) from other retirement accounts. Additionally, as mentioned earlier, the tax rates on long term capital gains can be as low as 0% which makes this a very favorable option from a tax perspective.

Non-retirement accounts can also be a useful tool in mitigating sequence of returns risk in retirement. Sequence of returns risk refers to the danger of receiving poor investment returns early in retirement, which can significantly impact the sustainability of one's retirement portfolio. By having a non-retirement account, retirees can help mitigate this risk by selectively withdrawing funds based on market performance. In years when the market is down, they can avoid selling investments at a loss by drawing from their non-retirement accounts, helping to preserve the value of their tax-advantaged accounts for future growth. For example, many individuals’ largest investment account is their employer-sponsored 401k plan. Using a non-retirement account to supplement income in down years can help preserve your 401k for the future.

Another strategic advantage of non-retirement accounts is their role in facilitating Roth conversions. During the early years of retirement, when income might be lower, retirees can convert traditional IRA funds to Roth IRAs at a lower tax rate. The funds from the non-retirement account can be used to pay the taxes on these conversions, enhancing the tax efficiency of their retirement strategy and helping to ensure tax-free growth and withdrawals from the Roth IRA in later years.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

Strategic Investment Choices

                Since investment gains in a non-retirement account are taxed as they are received, it is important to limit investment income inside of a non-retirement account so as to avoid a potential large tax bill. Many retirement accounts (especially employer retirement plans) utilize mutual funds as their primary investment option. Mutual funds are an option for diversification and long-term growth however, they can pose a problem when used in a non-retirement account. Mutual funds typically pay both dividends (passed on from the companies they invest in) and capital gains distributions which can be substantial. In a non-retirement account, both sources of income would be taxed in the year they are received.

So, what is the alternative? I would suggest taking a look at exchange-traded funds or ETFs. You can read about the differences between mutual funds and ETFs in one of our past blog posts here. For our purposes here, the important difference between mutual funds and ETFs is that the latter rarely produce dividends or capital gains distributions. This means that they grow without producing income until they are eventually sold at which time you would pay capital gains tax. Employing the use of ETFs is yet another way that you can utilize a non-retirement account in a tax-efficient manner.

Funding a non-retirement account offers numerous benefits for those aiming for early retirement. The flexibility, tax optimization opportunities, and potential for diversified growth add another important arrow to your quiver. Investing in a non-retirement account alongside your 401k, IRA, or Roth IRA can give you help make you early retirement goals a reality.

If you have any questions about how to effectively utilize a taxable brokerage account for your early retirement planning or need personalized advice, please don't hesitate to reach out. We are here to help!

Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective. 

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.