Contributing to 401(k)s and IRAs is always prudent. But you should also consider some taxable investments, especially if you've already contributed the annual maximum to your tax-advantaged accounts. You may even find that the tax hits of taxable accounts are outweighed by the tax advantages.
Taxable investments are those on which you can earn taxable dividends or profits when you sell them. Examples include:
Dividends generally are taxed either at ordinary income rates or a lower rate for "qualified" dividends. Short-term capital gains (on investments held one year or less) also are taxed at ordinary income rates. Gains on long-term investments are taxed at lower capital gains rates.
By contrast, when you invest in traditional 401(k)s or IRAs, you won't pay taxes until you withdraw funds (usually in retirement) and your contributions are immediately deductible. Contributions to Roth accounts aren't deductible, but they grow tax-free and you aren't taxed on qualified distributions.
Taxable investments may make sense in a variety of scenarios. For example, if you reach your tax-advantaged accounts' annual contribution limits, you can turn to taxable investments. Such investments also appeal to taxpayers who want greater control over their investments. In addition, with taxable investments, you can avoid the annual required minimum distributions (RMDs) that come with some tax-advantaged accounts and are taxed at ordinary income rates.
Taxable investments provide greater liquidity, too. You won't incur early withdrawal penalties if you need to tap them before you reach retirement age. And they can complement college savings plans, which restrict their tax-free distributions to qualified educational expenses.
Estate planning priorities might weigh in favor of taxable investments, as well. Because of RMDs, inheriting tax-advantaged accounts can push beneficiaries into higher tax brackets. By using the assets in your tax-advantaged accounts while you're living, you can pass on taxable investments, which have no withdrawal deadlines, to your heirs. They'll also benefit from stepped-up basis, meaning heirs receive any appreciation that occurred before your death tax-free. As a result, they will only owe capital gains tax on appreciation after they receive the investments.
Other strategies are available to reduce tax bills for taxable investments. For example:
Tax-exempt bonds. You might invest in municipal bonds. These are exempt from federal income tax and also may be exempt from state and local income taxes.
Asset location. Placing different assets in different investment accounts based on their tax treatment is known as asset location — not to be confused with asset allocation. Consider putting your tax-inefficient investments in tax-advantaged accounts and tax-efficient assets in your taxable accounts, as shown in the table:
Pay close attention to the holding periods for taxable investments. You'll pay less in capital gains taxes if you hold your investments past the short-term holding period.
Loss harvesting. This involves selling off investments that have dropped in value to offset any capital gains. In years when your capital losses exceed your capital gains, you can deduct up to $3,000 ($1,500 for married couples filing separately) from your ordinary income. Any remaining excess losses can be carried forward indefinitely. But watch out for the "wash-sale" rule. It prohibits you from deducting a loss when you acquire "substantially identical" investments within 30 days of the date of the sale, before or after.
For many taxpayers, the ideal investment portfolio includes both taxable and tax-advantaged accounts. Sometimes non-tax-related reasons might dictate otherwise, though. So discuss your options and potential strategies with your financial advisor.
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