In personal finance, people talk a lot about 401(k)’s and IRA’s. I’d say that most people have heard of both these accounts and/or utilize one or both for saving for retirement or for investing purposes. 401(k)’s and IRA’s are like jeans and a favorite T-shirt (or whatevers hip now a days, athleisure?) that most people have in their closet somewhere at some point in time. But many people don’t know what a taxable account is and what role it should have in their financial wardrobe. Personally, I think all high income earners (those in the 25% tax bracket and above) should be investing in a taxable account in addition to their 401(k), 403(b) or equivalent and Roth IRA (and traditional IRA if you have one lingering from the past or because you rolled over a 401(k)). So, let’s get familiar with the often overlooked taxable account, like the slightly too trendy dress or outfit you feel doesn’t warrant a place in your wardrobe but it actually does, and the different pros of investing in one.
Short-term goals: Employer-sponsored retirement plans like the 401(k), 403(b) and similars are generally the ideal place to save for retirement, especially for higher income earners, since 401(k)’s and similars provide tax-sheltered growth, reduction in your tax bill now and probably an employer-match (free money!). If you are self-employed, you have options such as the SEP-IRA, SIMPLE-IRA and solo 401(k), which allows you to generally be able to tax-shelter even more money and provides you with greater investment flexibility. Roth IRA’s and traditional IRA’s can be great adjuncts to saving for retirement and the Roth IRA can offer tax diversity in retirement and it does have some flexibility for other shorter-term goals. For more about Roth IRA, read my post here. However, I would not recommend them as the only place to save for retirement because of their low contribution limits ($5500 for 2016, up to $6500 if you’re 50 year old and older). But none of these accounts are good for any shorter term goals, such as saving for a home down payment or car or world cruise vacation. For financial goals that are still about 5 years away but definitely before you turn 59.5 years old, for most of us the best place to save and invest is in a taxable account. Some of you might wonder what about a CD or high interest savings account? These vehicles are better suited for keeping your emergency cash stash or really short-term goals, generally less than 3-5 years out.
Liquidity: A big pro of taxable accounts is their liquidity. You can for the most part access the money within 24 hours, unlike retirement accounts which with several exceptions, you can not touch without incurring some penalty, until you reach age 59.5 years old.
Investment Flexibility: Taxable accounts, much like IRA’s have incredible investment flexibility with access to many different kinds of investment options from individual stocks and bonds to very low costs index funds/exchange traded funds (ETF) like those offered by Vanguard and Fidelity. Most 401(k)’s and similars have very limited investment options that tend to be of higher costs as well.
Reduced Tax Rates and Tax-Loss Harvesting: Retirement accounts like 401(k) and similars, SEP-IRA and similars, and IRA’s are all considered tax-sheltered accounts and that’s a huge advantage in growing your money. But just because taxable accounts don’t have the same tax-shelter doesn’t mean they don’t get some of their own tax breaks. In a taxable account investors pay lower dividend tax rates (compared to your marginal tax rate i.e. 25%, 28%, 33%) and lower long-term capital gains tax rate (investments held at least one year before being sold). Investors in the federal marginal tax bracket of 25% and above will pay a 15% tax rate on dividends and long-term capital gains, and 0% if your are in the 10% or 15% tax bracket. Additionally, if your investments in a taxable account goes down, you can write off these losses on your taxes up to $3000 in a year. You sell the investment that went down and then proceed to buy a very similar (but not exactly the same one) and this allows you to offset the losses but still remain invested in the market. This is known as tax-loss harvesting. Tax-loss harvesting is not for novice investors though and probably not worth it until you have a significant amount invested in your account. However, over the long-term if can definitely help lessen your tax hit, maybe even cancel out your capital gains taxes and it’s unique to taxable accounts, since you can not tax-loss harvest your losses in a tax-sheltered account. Incidentally, Vanguard’s Advisor Services told me they do not tax-loss harvest. A con of their services in my opinion, since a standard human advisor might be able to do it for you as part of their services.
There’s actually a few more unique aspects of the taxable account that we’ll save for another post, but these are the fundamental things to know about them. You probably should be maxing out your employer-sponsored retirement account and Roth IRA first, then the additional savings you accumulate should be going into a taxable account, this assuming you don’t have any high-interest debt and have at least a 3 month emergency fund in place. Ideally, you own and invest in all 3 accounts and if you don’t, make that #financegoal2016. I still have no idea if I’m using this “#” right.
Did I miss any other pros of a taxable account? Share with us in the comments below!