Note: This article is part of Morningstar's February 2015 Tax Relief Week special report. An earlier version of this article appeared Nov. 6, 2014.
Investors are often schooled in the virtues of stashing money in tax-sheltered savings vehicles, whether IRAs, company retirement plans, 529s, or health-savings accounts.
At a minimum, these savings wrappers all offer tax-deferred compounding--meaning you won't pay any taxes on a year-to-year basis as long as you don't withdraw any assets. And depending on the vehicle, you may also receive a tax break on your contributions and/or withdrawals, too. Those tax breaks can help enhance your take-home return--and that's nothing to sneeze at in an environment when future returns could be muted.
With all the attention paid to plowing money into those tax-sheltered accounts, many investors see saving in a taxable account as a last resort--something to be considered only after they've fully funded their tax-sheltered wrappers.
But investing via a taxable account can be a sensible maneuver, and not just if you're running out of tax-sheltered receptacles for your money. In fact, I'd argue that most investors should simultaneously fund their taxable and tax-sheltered accounts, and the current tax and interest-rate environment make saving in a taxable account particularly sensible. Here are six key reasons why.
Reason 1: Extreme flexibility. Investing via a taxable account carries two key advantages, both of which make the taxable wrapper more flexible than any other.
First, liquidity: If you have near-term income needs or are simply building an emergency fund, a taxable account will allow you access to your money without any strings attached (though you may owe taxes if your investments have appreciated over your holding period). True, a Roth IRA allows you to tap your contributions (not your investment earnings) at any time and for any reason, which is one reason it's such a great vehicle for younger investors who are conflicted between saving for near-term financial goals and retirement. But for higher-income folks who need to use their tax-advantaged retirement options for retirement savings, putting money for liquidity needs into a taxable account is the way to go.
The other reason investing in a taxable account is so flexible is that you can invest in literally anything. You'll have to choose from a preset menu if you're investing in a company retirement plan, health savings account, or 529. And while you'll have more leeway when investing in an IRA, there are a few investment types that are off limits, including collectibles such as artwork or coins. A taxable account is the one account type that gives you carte blanche. (Of course, it also gives you more opportunity to make mistakes!)
Reason 2: Near-tax-free compounding if you plan carefully. One additional, under-discussed aspect of investing inside of a taxable account is that it's not all that difficult to simulate the tax-deferred compounding you get with many tax-sheltered vehicles. The key is to choose investments that kick off limited taxable income and capital gains distributions. For equities, broad-market exchange-traded funds or index funds fit the bill nicely; the former, in particular, tend to deliver few capital gains payouts, but both are pretty tax-efficient. Meanwhile, income from municipal bonds is exempt from federal and in some cases state income taxes. Tax-efficient equities and munis make it possible to buy and hold a basket of securities for years inside a taxable account while owing very little in taxes on that portfolio during your holding period.
It's also worth noting that income is low on an absolute basis right now, so the tax hit associated with owning securities that produce income that is taxed at your ordinary income tax rate--whether bonds or cash--is also going to be pretty low, at least in dollar terms. (That will change if yields go up, though.)
Reason 3: You can use tax losses to reduce your tax bill. In addition to the ability to have your assets grow without owing a lot in taxes, investing in a taxable account also gives you the ability to harvest losses--something that is impossible (or at least quite cumbersome, in the case of IRAs) to do with investments you're holding inside your tax-sheltered accounts. You can sell securities that are trading below your purchase price and use your loss (the difference between your purchase price and your sale price) to offset capital gains or, if you still have excess losses, up to $3,000 in ordinary income. In a year like 2008, when stocks were badly in the dumps, the ability to engage in tax-loss selling was a rare silver lining. Investors who use the specific-share identification method of tracking their cost basis give themselves the greatest leeway to harvest tax losses; while their average purchase price on a security may be above the current share price, they may have specific lots of securities they picked up when prices were higher.
Reason 4: You may be able to enjoy no- or low-tax withdrawals. In addition to being able to keep your tax costs down while you own the securities in a taxable account, currently low capital gains rates also help you limit your tax costs when you eventually sell them. As recently as the late 1990s, a 20% long-term capital gains rate applied to investors in the 28% income tax bracket and above. Now, only investors in the very highest income tax bracket (39.6%) pay a 20% long-term capital gains rate; investors in the 25% to 35% brackets pay 15% and investors in the 10% and 15% brackets currently owe no taxes on long-term capital gains. Investors paying a 0% rate for long-term capital gains can also engage in tax-gain harvesting--essentially, selling appreciated securities and rebuying them immediately thereafter. In so doing, they reset their cost basis to a new, higher level, thereby reducing the capital gains tax they'll pay if they eventually sell the security when their tax rate is higher.
Reason 5: You'll have more control over your tax bill in retirement. The ability to pull your money out with limited tax liability (because capital gains rates are pretty benign right now) can prove particularly beneficial when you begin taking money out of your accounts during retirement. You'll owe ordinary income tax on distributions from Traditional IRAs and 401(k)s during retirement, and the timing and size of those distributions will be out of your control once you have to begin taking required minimum distributions (RMDs). By diversifying your asset mix across taxable and Roth accounts, you'll help ensure that at least some of your distributions will come out with low or no tax ramifications. I explored the virtues of tax diversification in this article.
Holding taxable assets in addition to tax-deferred and Roth also helps ensure that, if you determine that you want to convert some of your Traditional IRA or 401(k) assets to Roth, you'll be able to pay the conversion-related taxes without having to dip into your IRA/401(k) funds, thereby sidestepping further taxes.
Reason 6: Your heirs will receive a step-up in basis. Another key advantage to investing inside of a taxable wrapper is that your heirs will be able to take advantage of a step-up in cost basis, essentially wiping out any capital gains tax liability that you racked up over your own holding period. That means that when they inherit assets from you, the taxes they'll eventually owe when they sell will be calculated by looking not at your purchase price but what they were worth at the time of your death. Even if your heirs end up selling the inherited assets shortly thereafter, you've still reduced the drag of taxes on your overall estate.
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