How does a taxable brokerage account work?

You transfer money you have already been taxed on, and buy investments. Nothing about the deposit affects your tax return. There is no deduction, no form, and no limit.

From then on the account generates two kinds of taxable event. Income, meaning dividends and interest, is taxed in the year you receive it, whether or not you reinvest it. And capital gains, which arise only when you sell something for more than you paid.

Holding an investment that has doubled produces no tax. The gain is unrealized, and unrealized gains are invisible to the IRS. Your broker reports the year's activity on a 1099 each January.

What you give up is the tax shelter. In a 401(k) or IRA, dividends compound untouched. In a taxable account, a slice is removed every year, and over decades that drag is real.

What you get is the absence of every restriction. No contribution cap, so you can invest $200,000 in a year if you have it. No income limit, unlike a Roth IRA. No withdrawal age, no penalty, no required distributions. No restriction on what you hold. And you can move the account between brokers without tax consequences.

Money you may need before 59 and a half. A house deposit, a career break, a business. Locking that money into a retirement account and paying a penalty to get it back is worse than paying tax as you go.

Anything beyond the annual limits. Once you have deferred $24,500 into a 401(k) and $7,500 into an IRA, a taxable account is where the rest goes.

When you are locked out. High earners barred from direct Roth contributions, or people without earned income, can always use a taxable account.

Tax-loss harvesting. Realized losses can offset gains and, up to a limit, ordinary income. This only works in a taxable account: losses inside an IRA are not deductible.

Cost basis is what you paid, including commissions. Your gain is the sale price minus the basis.

The detail people get wrong is reinvested dividends. Every reinvested dividend was already taxed as income in the year you received it, and it bought more shares. Those purchases add to your basis.

Ignore that and you will count the same money as income once and as capital gain again. Brokers now track basis for most holdings, but the figure can be wrong for shares transferred in from elsewhere, so it is worth checking before a large sale.

Hold for more than a year before selling and the gain is long-term, taxed at preferential rates. Sell within a year and it is short-term, taxed as ordinary income at your marginal rate.

The gap is large enough that the holding period is often worth more than the trade. Selling a week before the one-year mark can cost considerably more tax than waiting.

A brokerage account is not an investment. Opening and funding it does nothing. Cash sits as cash until you buy something, and uninvested cash sitting for years is one of the most common and least visible mistakes.

Where you hold what matters. Tax-inefficient assets, like bonds and REITs that throw off ordinary income, generally belong in tax-advantaged accounts. Broad equity index funds, which distribute little, sit more comfortably in a taxable account. Placing assets deliberately is worth real money and costs nothing.

Capital gains treatment and holding periods are set out in IRS Topic 409, and cost basis reporting in IRS Publication 550. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.