Bridging Your Income Gaps with a Taxable Investment Account

Proof that investing is highly dependent on behavioral systems: We have no problem contributing 4% of our paycheck to our company’s retirement plan automatically over decades, but when it comes to investing in a taxable, non-retirement account, it is difficult to be consistent.

We are more likely to make a decision if we can actually visualize the end goal, and if we see other people doing the same. I have heard the question: “Why should I invest if there is no ‘goal’ or specific purpose for the money?”

Although compounding growth in an investment account can start out slow, there are many reasons why beginning to invest in an account other than your retirement or education planning accounts (IRA, Roth IRA, 401k, 529 plan, etc.) can be beneficial. One of these reasons has to do with income gaps.

Throughout our lives, most people experience two major income gaps:

Mid-Career Income Loss: You get fired, laid-off, can’t find a tenant for your income-producing rental real estate, or maybe you take an extended sabbatical. Depending on the circumstances, it may be difficult to find a new job/tenant immediately, causing stress on your current lifestyle expenses until you can replace your income.   

Retiring before Social Security or Pension payments begin: Pensions may start at a certain age and delaying social security benefits could be highly beneficial to someone’s long term planning. So, there is a gap period where you need to cover your “golden” retirement years.

Let’s take a look at how a built-up taxable investment account can bridge these two gaps.

First, what is a taxable investment account?

This is an account (a brokerage or advisory account) that may not be tied to a specific event (like retirement or education). Taxwise, the money that you invest has already been taxed when you received it from employment income. Once invested, as long as investments inside are held for longer than 1 year, the gains are taxed at your long-term capital gains rate (usually much lower than your income tax rate).

This money can compound (earning growth on your growth), and if you continue to contribute and wait, it can be built into a sizeable money-earning factory. Imagine having a $200,000 taxable account that earns an average 8% a year. That is $16,000 of growth in the first year, $17,280 in the second, $18,662 in the third, and so on.  You can plug in your own numbers. The point is, without having to lift a finger, your money is working overtime in a "career" of its own.

How the Gap Can be Filled

Many people get it stuck in their brain that they are never allowed to actually touch their investment money. With certain retirement and education accounts, this can be true to an extent, unless you want to pay penalties. But with non-retirement, taxable accounts, your money is fair game regardless of your age or circumstance!

So back to our examples...   

Let’s say you lose your job, or your rental tenant breaks contract and you cannot find a replacement. You can easily set up automatic withdrawals from a taxable investment account to mimic your usual paycheck until you are able to replace your income. Meanwhile, the account continues earning in the background.   

Or you want to retire at 65 but want to delay locking in social security payments until age 70 (for that automatic 8% increase in guaranteed lifetime income for every year you wait after your full retirement age). You can use your taxable account money to send you money every month into your bank account.  

Ok, but if I am already in my 60’s, why can’t I just withdraw money from my retirement accounts?

Great question…and herein lies the biggest perk of using a taxable account to close income gaps.

The growth on your taxable account is only taxed at your long-term (if held for longer than 1 year) capital gains rate. In 2021, if your Adjusted Gross Income is less than $40,400 (single), or less than $80,800 (married), your tax rate on that growth is…drumroll…0%. If you earn less than $445,850 (single), or less than $501,600 (married), your tax rate is 15%. This is, most likely, much lower than the rate you would pay if you were to begin withdrawing from your 401k or IRA (tax-deferred accounts).  

For those younger than 72, this could give you a substantial amount of time where your tax bracket is the lowest it will ever be, thus giving you the opportunity to convert traditional IRA or 401k money into Roth IRA money, among other things. This has two benefits...  

1. It reduces the amount of Required Minimum Distributions on traditional retirement money that you will be forced to take starting at age 72 for the remainder of your life, thus reducing the amount of tax you must pay on that money.
2. If your children inherit a non-Roth retirement account, they will have 10 years to take the entire amount as income, which could be burdensome on their own bracket. If they inherit a Roth retirement account, the same timeframe applies, but the money will be tax-free, and will not impact their tax liability.     

So you see, just because there is no tangible “goal” in view doesn’t mean you should not invest money from your cash flow. Building up a taxable investment account over many years can also be used to bridge the income gaps we all inevitably face at some point in our lives. And you are able to do this in a tax-favorable way. Having different buckets of income available (taxable, tax-deferred, and tax-free) is a wise approach to weathering the ups and downs of life.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply