Reasons to Use a Taxable Account

Advantages of Investing in Taxable Accounts and Who Should Use Them

Don't overlook the benefits of using taxable brokerage accounts. Getty Images

401(k) plans and IRAs get most of the media attention and attract the bulk of savings dollars, but it is important to put some money inside of taxable accounts.

There are many overlooked advantages of using taxable accounts. Here are 5 of them:

1. Taxable Accounts Are the Best Resource for Pre- and Early-Retirement Years

If you need money prior to retirement, you don't want to get hit by the 10% early retirement penalty tax if withdrawals are made prior to age 59 1/2.

And what if you find a way to retire early or if you want to shift into "semi-retirement" in your 50s? Having a taxable brokerage account can be beneficial. Long-term capital gains are only 15% and you won't pay tax on the entire account assets, whereas the income tax plus early withdrawal penalties can add up to more than 35% and tax-deferred accounts, such as 401(k) and IRAs must pay these taxes on 100% of the money withdrawn.

2. Taxable Accounts Add Another Layer of Tax-Diversification

Tax diversification with investing is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.

Why tax diversification? Because you don't know exactly where your life, your finances or your tax circumstances will be in 10, 20, 30 or 40 years from now.

For example, as I write this, federal income tax rates are at 40-year lows with almost no foreseeable means of getting any lower and more chances of going higher in most people's lifetimes.

The idea of saving in a traditional IRA today is that the pre-tax savings will make sense if the investor expects to be in a lower tax bracket in retirement than in the savings years.

But if federal tax rates go up, or if your income needs rise over time and you end up in a higher tax bracket anyway, the traditional IRA loses its primary tax-saving advantage.

For this reason, other account types, such as taxable accounts and Roth IRAs are a good idea.

3. Taxable Accounts Don't Have the Same Barriers as 401(k) and IRAs

If you don't have a job or any kind of earned income, you generally can't contribute to a 401(k) or IRA. Also, even if you do qualify to contribute to a tax-deferred account, there are limits on contributions.

With taxable accounts, there are no such barriers to entry and no maximum contribution amounts. This is especially beneficial for people, such as minors or highly-compensated individuals, that would like to invest but may not qualify for tax-deferred accounts.

For example, adults can open a custodial brokerage account for a minor child, usually for the purpose of college savings, under the Uniform Transfer to Minors Act (UTMA).

And for a high-income saver--say, someone earning over $250,000 a year--the combined $23,500 they can put into 401(k)s and IRAs is not even 10% of their income. That's assuming they qualify for the IRA and they are under the age of 50.

Bottom Line: The conventional wisdom of saving in a 401(k) if the employer offers a match is good advice. But don't contribute more than necessary to receive the maximum match. If you qualify to save in a Roth IRA, max out those dollars. But at some point, it is a good idea to invest money in a taxable brokerage account. This will give you full tax diversification.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent tax advice or a recommendation to buy or sell securities.