Over the past 10 years working in financial services, creating financial freedom or the ability to retire as early as possible is a common goal I hear. In fact, there is a whole movement around this goal called the FIRE movement: Financial Independence Retire Early. However, I think many people involved in this movement have the wrong mindset. They are skimping on enjoying many things in life today with the aim of retiring at the earliest possible age and never having to work again.
It doesn’t matter the age at which “retirement” comes, people still have a very hard time shifting from a saving to a spending mentality if they have been skimping every penny along the way. Once you develop that muscle memory, it’s hard to change. This is why I believe many in the FIRE movement will fail. In fact, research from the National Institute of Health shows the prevalence of depression among retirees is substantially higher than that over the overall adult population. Research also shows that most retirees never spend down their entire nest egg, and the higher the net worth at retirement, the less likely they are to actually spend down the money. As they say, the proof is in the pudding (or the spending in this case).
A Different View of the fire movement
My view of the FIRE movement is a little different.
I call it Financial Independence Rest Easy. My version of this is based more off of the economic theory of consumption smoothing – trying to maintain a more consistent lifestyle through the different phases of life with a healthy balance between spending and saving over time. My aim is to work as long as possible doing what I enjoy, and strike a better rhythm between work and other important areas of my life. Hopefully this allows me to avoid burnout, and continue my work well past traditional “retirement” age.
Whether your goal is to fully retire someday or just rest easy as you pursue work you enjoy, it is still important to build flexibility into your finances because financial goals often shift over time, voluntarily or involuntarily.
Many are already investing through a 401k, which is great for traditional retirement, or saving through a bank account, which works well to cover short term emergencies, but most are missing the in between layer.
Creating Financial Flexibility
So, what is the most common piece of the investing puzzle I see missing from people who want to build financial flexibility into their plans?
Consistent investing into a taxable brokerage account. I think people avoid the taxable brokerage account for a few reasons:
- It sounds boring
- Taxable brokerage account is anything but a sexy name. Perhaps reframing it as your Financial Freedom Account or Financial Flexibility Account will draw you in more.
- People think the stock market is too risky
- Many people have been burned by speculating in brokerage accounts rather than sticking to a consistent long term investing plan. Recent quarterly data by Robinhood shows they are down about $10 million monthly active accounts since their peak in 2021. This shows that many who dabbling in the meme stock craze in 2021, weren’t truly in it for the long haul.
- They don’t automate or budget for it
- Research shows that over 90% of employees stick with a 401k plan if they are automatically enrolled in it. Consider making a line item in your budget for a taxable brokerage account and have it automatically deducted from your checking/savings account before you consider it part of your monthly income to spend. You don’t need to sacrifice everything, but it needs to become part of your plan.
The Advantages of a Taxable Brokerage Account
If you’ve decided to take the leap to begin investing in a brokerage account, here are five ways this underappreciated and underutilized account may help you create more flexibility in your financial plan.
- 0% Capital Gains Rate
One of the most compelling advantages of a taxable brokerage account is the potential to benefit from a 0% capital gains tax rate. Those in the 10% or 12% ordinary income tax bracket may pay no taxes on their long-term capital gains. This also applies to qualified dividend income. Even capital gains for higher earners are taxed at lower rates than ordinary income of 15 or 20% depending on your tax bracket. Keep in mind, short term capital gains are taxed as ordinary income. This is another benefit of taking a long term approach to investing.
- No limitations on withdrawals or contribution limits
401ks are capped at $22,500 for those under age 50 and IRAs at $6,500. 401ks are a great tool, but despite the contribution limit many times I see people over contributing to them with no real plan for managing the withdrawals down the road. Pre-tax 401ks have required minimum distributions, which are taxed as ordinary income. They are also still taxable when inherited upon death. On the other hand, a taxable brokerage account has no contribution limits and the funds can be withdrawn at any time without penalty regardless of your age.
- Investment flexibility and ability to deduct losses
Unlike your employer 401k, which can be restricted in terms of investment options available, a taxable brokerage has much broader investment choices. Taxes can be a concern in a brokerage account since investors must pay tax on any capital gains realized or distributed during the year. However, investments in ETFs (exchange traded funds) or individual stocks can give investors much better control of the timing of when they realize any capital gains on those investments. On the flip side, investors in a 401k or IRA cannot deduct losses. Within a taxable brokerage account losses on investments like individual stocks can be used to offset other capital gains and then deducted against ordinary income up to $3,000 per year. Any additional losses can be carried forward to offset future gains.
- Gifting strategies and step-up in cost basis
Taxable brokerage accounts offer gifting strategies that can be employed to benefit both the account holder and their heirs. When you gift highly appreciated stock to a family member or loved one, they inherit your cost basis, potentially allowing them to sell the stock with little to no capital gains taxes. Shares gifted to a qualified charity may also receive a tax deduction for the full amount of the shares gifted, subject to AGI limitations and carryover rules. This can make gifting highly appreciated shares to your favorite charity or to a Donor Advised Fund another great strategy. Furthermore, upon your death, the recipient may benefit from a “step-up” in cost basis, which means that the value of the assets at the time of your passing becomes the new cost basis for the heir. This can result in significant tax savings and is a strategic way to pass on wealth to future generations. Most investors are under the federal estate tax exemption, so this is a simple strategy to pass wealth tax-free to heirs.
- Premium tax credits if taking a work sabbatical or early retirement
Health insurance is an important consideration for those who are considering taking a sabbatical from work or early retirement. Having funds in a taxable brokerage account can help you maintain a steady income level to maximize Premium Tax Credits when applying for private health insurance through the exchange prior to medicare age. If managed properly, Premium Tax Credits can allow for several thousand dollars a year in savings on health insurance for early retirees or self-employed individuals.
Learning to Embrace Change
The only real constant in life is that life will change constantly. This may include our own wants and desires. Building a nest egg in a taxable brokerage account is a great way to create the financial margin to prepare for this. To me, this is what financial independence is really all about – the ability to let us rest easier as we navigate the many curveballs that life throws at us.