FI Step by Step: Step 11, Investing in a Taxable Brokerage Account & Alternative Assets

FI Step by Step: Step 11, Investing in a Taxable Brokerage Account & Alternative Assets

Welcome back to my FI Step by Step series of blog posts.  These are the basic steps that I recommend people follow to achieve financial independence (FI).  Of course, there is no one right way to do this, so read through what I have to say and see what you can apply to your own personal finances on your journey towards FI.  

This week I’m going to talk about investing in a taxable brokerage account and alternative assets.  This is meant to be a sister post to Step 10, Paying Off Your Home Mortgage.  Before moving onto these “more advanced” steps, I recommend you have your financial house in order.  As I emphasized in Step 10, make sure you’ve done the following before moving on:

• You have defined the specific reasons why you want to pursue financial independence
• You have calculated and track your net worth
• You are actively tracking your income and expenses
• You have a written financial plan that you review and update regularly
• You are adequately insured against disaster
• You have a liquid cash emergency fund
• You are maximizing your employment benefits
• You have paid off all of your consumer debts including credit cards, auto loans, and student loans
• You are maximizing your contributions to your available tax advantaged accounts

In Step 10, Paying Off Your Home Mortgage I discussed in depth the debate between paying off your home mortgage early vs. investing.  For some, it will make more sense to complete Step 10 and pay off their home mortgage early.  For others it may be better to move to Step 11 and invest in a taxable account and/or other alternative assets first.  And for some, like myself, it might make the most sense to do both simultaneously.  If you are undecided, check out my discussion of this debate in Step 10.

Disclaimer: Please remember that I am not a financial professional. This blog post is for informational and entertainment purposes only.  Please consult a financial planner, financial advisor, certified public accountant, or other financial professional before making decisions regarding your investments, retirement, and finances.

You Are a Financial Beast!

If you arrive at this step in your journey towards FI, way to go, you are a financial beast!.  This essentially means you are debt free (except for possibly your home mortgage), you have a fully funded emergency fund for your situation, and you are contributing the maximum amount to your available tax advantaged accounts.  It also means you have maximized your income such that you still have more money to invest.  Awesome!

This is a very important step on the path to FI, especially if you want to retire early.  Why?  Well, if you are looking to bow out of the working world before age 59 1/2, you are going to need enough money to get you through until you can tap into your tax advantaged retirement accounts without incurring a penalty.  In most circumstances, this will be age 59 1/2.  So if you want to retire at age 45, you will need to have enough invested outside of your retirement accounts to last you for almost 15 years.  Even if you don’t want to retire early, all of your tax advantaged buckets are full at this point and you need to find a place to put your money.  

Because most people in the FIRE community are frugal spenders and super savers, many get to this point where they need to find other places to invest outside of their tax advantaged retirement accounts.  What are the options?  Well, you could just put the money in a high interest savings account, but with current interest rates where they are, you wouldn’t even keep up with inflation.  You want your money to be making more money, not losing its current value.  Put simply, that leaves us with investing in a taxable brokerage account or in alternative assets.  Today we’ll discuss both.  

What is a Taxable Brokerage Account?

First, let’s discuss a little bit more about what a taxable brokerage account is.  Sounds bad, right?  I thought we were supposed to avoid taxes.  

Well, you have already maxed out your available investing accounts that have tax advantages, so that leaves us with an investing account that is subject to taxes.  Other names that mean the same thing include personal brokerage account, standard brokerage account, taxable investment account, or even just individual account.  Most brokerage firms omit the word taxable from the title of the account since it makes it seem less attractive, but in personal finance circles the word taxable is often used because it describes exactly what it is.  

Put simply, a taxable brokerage account is an investing account that is subject to taxes and through which you can buy various investments like stocks, bonds, mutual funds, index funds, ETFs, etc.  Unlike a 401(k) or a traditional IRA, this account is funded with post-tax dollars.  And unlike a Roth 401(k) or Roth IRA, you will owe taxes on the gains your investments make.

Taxable brokerage accounts can be opened with a large number of institutions.  Common examples include Vanguard, Fidelity, Charles Schwab, TD Ameritrade, etc.  An account can easily be opened online within a few minutes.  It can then be connected to your checking account for electronic funding.  Once your account is funded, you can begin purchasing investments right away.  

How Specifically Is It Taxed?

First, you are investing post-tax dollars in a taxable brokerage account.  This means you have already taken an initial tax hit on this money.  This doesn’t mean, however, that it is taxed again up front when you put money into the account.  For example, let’s say you make $5,000 every 2 weeks in your job.  But your paycheck is actually $3,750 after taxes have been taken out (Social Security, Medicare, federal income tax, state income tax, etc.).  The $3,750 are post-tax dollars that you could invest in a taxable brokerage account should you so choose, and no additional taxes are due when it is invested.

After your money is invested it is taxed as it earns more money.  In an effort to keep things very simple, here are the three basic ways it is taxed:

• Dividends: when you earn a dividend in a taxable brokerage account, it is taxed.  The rate at which it is taxed is based on the type of dividend:
  • Qualified dividends are taxed at long term capital gains rates of 0%, 15%, or 20% (which is based on your marginal tax rate).  These rates are much lower than your normal ordinary income tax marginal rate.  Most dividends distributed to stockholders by companies in the U.S. (or the mutual funds that hold those stocks) are qualified dividends.  
  • Unqualified dividends are taxed at your ordinary income tax marginal rate.  A common example of this would be dividends earned from a real estate investment trust or REIT.

• Interest: interest earned on bonds or bond funds is generally taxable at your ordinary income tax rate.  This can get complicated and there are exceptions.  For example, state taxes are not due on interest from federal bonds, and federal income taxes are not due on municipal bonds, etc.  But as a general rule, consider interest income from bonds to be taxed at ordinary income tax rates.  

• Capital gains: a capital gain is when you sell an investment and make money.  If you buy a stock for $100 and then sell it later for $150, you have a $50 capital gain.  The rate at which this taxed is based on how long you held the investment:
  • Short term capital gains rates apply if you held the investment for less than 1 year, and the gain is taxed at your ordinary income tax rate.
  • Long term capital gains rates apply if you held the investment for more than 1 year and is 0%, 15%, or 20% based on your marginal tax rate.  

As you can see, not everything is taxed equally in a taxable brokerage account.  Some investments are more tax efficient, while others less so.  As a general rule of thumb, most investors invest in more tax efficient investments in their taxable accounts (likes stocks and mutual funds), and invest in less tax efficient investments in their tax protected retirement accounts (like bond funds and REITs).   

Every year at tax season you will receive form 1099 from your brokerage firm detailing what you have earned in dividends, interest, and capital gains.  This will allow you or your accountant to calculate how much you owe in taxes.  

It’s Not As Bad As You Might Think

I know, all this talk about taxes makes a taxable brokerage account sound pretty unappealing.  However, a taxable brokerage account is not as bad as you might think.  In fact, it’s probably my favorite account to invest in because I feel like I have the most options and freedom with my money.  

Here are some of the advantages of a taxable brokerage account:

Liquidity

I think liquidity is one of the biggest benefits of a taxable brokerage account.  It is very easy to access your money if you need or want it.  Unlike your 401(k) or Roth IRA retirement accounts, there are no early withdrawal penalties for accessing your money.  Furthermore, there are no restrictions on what you spend the money on, like a 529 plan or a Health Savings Account (HSA).  

No Annual Contribution Limits

With a taxable brokerage account, you can invest as much money as you want.  Go crazy!  There are no annual limits like the tax advantaged accounts.  This is especially helpful for those seeking FIRE because 1) they typically need to invest more money than tax advantaged accounts will allow, and 2) they need to be able to access it sooner without a penalty.  

Lots of Investing Options 

A taxable brokerage account offers a plethora of investing options.  Unlike your company’s 401(k) where you may only have access to a limited number of mutual funds and no individual stocks, a taxable brokerage account gives you access to nearly any stock, bond, mutual fund, or ETF you could ever want.

Low or No Trading Commissions

Brokerage firms are all competing for your business these days.  Within the last year or so, most of them have changed to commission free trading.  It used to be normal to have to pay $4-$10 every time you wanted to make a trade online.  But now it typically doesn’t cost you anything.  

What We Do

We have a taxable brokerage account with TD Ameritrade.  I opened the account when I opened up our traditional IRA and Roth IRA accounts with them in 2018.  I chose TD Ameritrade primarily because I liked the user interface of their web-based platform, as well as their mobile app.  As many of you probably know, Charles Schwab recently bought out TD Ameritrade, so we’ll see how that pans out with the merger amidst the coronavirus pandemic.  

We regularly invest in our taxable brokerage account.  I have set up automatic transfers from our checking account every 2 weeks after I get paid to invest in the taxable brokerage account.  It’s hasn’t been much since we’ve been working on other financial goals, but I wanted to get in the habit of regularly investing in our taxable account, as well as reap the benefits of dollar cost averaging.  

What do we invest in?  As I’ve mentioned before, I tend to follow the Boglehead 3 fund portfolio philosophy of a U.S. total stock market index fund, an international total stock market index fund, and a bond fund.  For the stock funds we invest in the Vanguard Total Stock ETF (VTI) and the Vanguard Total International Stock ETF (VXUS).  Since most bond funds are tax inefficient, as described above, we invest in the Vanguard Tax-Exempt Bond ETF (VTEB), which is a tax exempt bond fund composed primarily of municipal bonds for which no federal income tax is due.

What Are Alternative Assets?

Once you’ve maxed out your tax advantaged accounts, another way to invest your money is in alternative assets.  Alternative assets are assets that don’t fall under the standard umbrella of cash or cash equivalents, stocks, or bonds.  This is obviously a broad category.  Here is a list of some examples that are considered alternative assets.  Within each asset class there is also a significant amount of variation.  Please note that just because I am listing an alternative asset class here does NOT mean in any way that I invest in it or endorse it.  

Real Estate

Real estate is real property that consists of land and anything on it or under it.  This includes any buildings or permanent structures on the land, as well as any resources on the land or that it may produce.  Real estate is one of the most common alternative assets that people invest in.  There are so many variations and strategies of real estate investing.  These include residential properties, commercial properties, long term buy and hold strategies, fix and flip strategies, vacation rentals, wholesaling, hard money lending, REITS, etc.  The list cold go on and on.  

Commodities

Commodities are basic goods used in commerce, often to produce other goods and services.  One key aspect of commodities is that they are considered interchangeable, meaning it doesn’t matter who the producer is, the value is the same for the same grade and quantity of the good.  Examples of commodities include gold and other precious metals, wheat, corn, beef, cotton, and oil.  Commodities are typically traded via futures contracts (future agreements to buy a quantity of the commodity) on an exchange.  Investors can buy these contracts directly, or they can purchase shares of an ETF that holds these contracts.  

Collectibles

Do you have a Mickey Mantle rookie card, or perhaps Superman’s first comic book?  These would be examples of collectibles, which are items that are worth far more than their original value due to their rarity or popularity.  Other examples include original works of art, stamps, coins, classic cars, etc.  

Private Equity

Private equity is ownership or interest in a company or entity that is not publicly traded on the stock market.  Most investors access private equity investments through a private equity firm that pools the resources of multiple investors to purchase a private business or businesses.  The firm then uses its resources to increase the profitability, and thus the valuation, of the private business before selling it for a profit several years later.  

Venture Capital

Venture capital is a subset of private equity where investors finance startup companies they believe have a strong probability of long term growth.  Since these companies are yet to be proven, venture capital is considered more risky than other forms of private equity investments.  

Hedge Funds

Hedge funds are funds that pool the capital of multiple investors to invest in any assortment of traditional or alternative investments.  They are usually set up as a limited partnership.  The fund manager (who is the general partner) invests the capital from the investors (who are the limited partners) according to the strategy of the hedge fund.  It is called a hedge fund because the first fund of this type was structured to hold stocks both long and short to “hedge” against risk, allowing investors to make money whether the market went up or down.  Hedge funds today cover the full spectrum of investing philosophies, are usually only available to accredited investors and very high net worth individuals, and often have very high associated fees.  

Life Insurance Products

Life insurance companies market some of their products as an alternative investment asset class.  This class includes permanent cash value life insurance policies, such as whole life insurance, universal life insurance, and variable universal life insurance.  It also Includes annuities in all of their various forms.  

Other

There are many other alternative asset classes that include foreign currencies, derivatives, intellectual property, distressed securities, equipment leasing, peer to peer lending, tax lien certificates, and more.

Why Invest in Alternative Assets?

So why would someone want to invest in alternative assets?  

First, I think it is important to point out that you certainly don’t need to invest in alternative assets in order to be a successful investor and reach financial independence.  Many people have become wealthy and reached FI sticking to cash, stocks, and bonds.  

However, there are a number of possible advantages to investing in alternative assets.  Likewise, there are also some possible downsides.  Let’s discuss some of the pros and cons.  

Pros of Alternative Assets

• Investing in alternative assets can give you more diversification in your portfolio, which can potentially decrease your overall risk profile
• Alternative assets often have low correlation with traditional asset classes
• There may be less efficient markets in alternative assets, as opposed to the efficiency of the stock market, allowing for the possibility of larger investment gains
• There are possible tax advantages, e.g. real estate has many tax advantages not available in other asset classes like depreciation and 1031 exchanges
• Investing in a hard asset like real estate or a commodity can be a hedge against inflation

Cons of Alternative Assets

• Many alternative asset investments have high barriers to entry requiring you to be an accredited investor and/or require a high minimum investment
• Alternative assets are often not regulated by the Securities and Exchange Commission (SEC) and may have limited transparency
• May be more risky and complicated than the standard asset classes
• Alternative assets such as collectibles may be very difficult to value
• Some alternative assets may have more tax liabilities than traditional assets
• Investments in alternative assets are often highly illiquid

What We’re Doing

I’m not going to pretend to know a lot about alternative assets.  I will be the first to admit that I am still learning about this area of investing.  The only alternative asset I have really studied in depth is real estate.  If you haven’t read my posts about why I am so interested in investing in real estate, you can find them here and here.  

As I mentioned in my post My Path to FI: Part 7, Moving Forward With Intensity, we have revised our asset allocation to invest 25% of our portfolio in real estate.  This will take some time to achieve.  We aren’t going to sell our current stock and bond assets to meet this goal.  Rather, we are going to save and invest disproportionately in real estate until we meat this 25% goal.  We haven’t made a final decision about how we will invest in real estate.  I’ve heavily researched buy and hold strategies with renting out single family homes, as well as owning commercial real estate.  Lately, I have also been seriously looking at private equity real estate funds.  We will likely pull the trigger on our first major real estate investment in the Spring of 2021.     

At the current time, I am not particularly interested in investing in other alternative assets.  I am trying to keep our portfolio relatively simple and limit our investments to things I understand.  I completely agree with Warren Buffett’s advice to never invest in something that you don’t really understand.  This may change in the future, but for now I am pretty happy with our financial plan.  

Despite my limited knowledge of alternative assets, I do have a couple of recommendations.  

First, if you want to invest in an alternative asset, learn everything you can about it.  Do your own research.  Do your due diligence.  Don’t blindly trust the advice of others, especially if they are trying to sell you something.  You don’t have to invest in everything that comes along.  One of my favorite quotes from the White Coat Investor is that there are no called strikes in investing (that may not make sense if you aren’t a baseball fan).  

Second, given the potentially increased risk, limited regulation, and illiquidity of alternative assets, only invest an amount of money that, if you lost it completely, it would not financially devastate you.  Of course, none of us wants to lose money.  But what I’m basically saying is don’t invest your entire future in any one place, especially an alternative asset.  This should be a facet of your portfolio, not the cornerstone.  

Conclusion

On the road to financial independence, you will likely spend a significant amount of time on this step, investing in a taxable brokerage account and possibly in alternative assets.  Here are some take home points to consider:

• In order to achieve financial independence, most people need to invest more money than their available tax advantaged retirement accounts will allow.  Furthermore, if they want to retire early, they need to invest somewhere that they aren’t penalized for pulling out their money early.  Investing in a taxable brokerage account and/or in alternative assets can help meet these needs.  

• A taxable brokerage account is not as bad as it sounds.  You have more liquidity, no limits on annual contributions, no restrictions on withdrawals, and nearly unlimited investing options.  Just make sure you understand how your investments are taxed, which will allow you to place more tax efficient investments in this type of account.  

• Alternative asset investments can help you diversify your portfolio and potentially achieve higher returns.  However, these investments may be associated with increased risk, be less regulated, and be highly illiquid.  Make sure you completely understand anything you are investing your money in, and only use them to compliment your portfolio, not be the foundation.  

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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