Taxable Accounts vs IRAs

Compare Taxable Accounts With Traditional IRAs and Roth IRAs

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Should you use taxable accounts, IRAs, or both?. Getty Images

Should you park all of your long-term savings in your IRAs? When is it best to use taxable accounts? Or is it an advantage to use several different account types?

Finding the best account type for your savings and investing goals need not be complex. Here's a basic breakdown on when and why you should certain account types over others:

When Is It Best to Use Taxable Accounts?

Taxable accounts don't get much love from the media.

Just the idea of "taxable" puts anxiety, frustration and resentment into the minds of investors everywhere. But tax-deferred accounts, such as traditional IRAs and Roth IRAs are also taxable, although only upon withdrawal.

There are several good reasons to use taxable accounts. For example, if you are saving for retirement and you think you may need some of your long-term savings prior to age 59 1/2, you can avoid the 10% "early withdrawal penalty" and keep your IRAs growing if you tap into your taxable accounts instead.

Also, withdrawals from taxable accounts are only taxed on the gains of the investments, rather than the entire withdrawal amount like with the traditional IRA or on non-qualified withdrawals from Roth IRAs. Long-term gains on taxable accounts are taxed at a 15% rate.

In this regard, taxable accounts provide what is called tax diversification, which is a reduction in risk by spreading savings and investment assets among different types of accounts.

For example, the "risk" here is that no one can predict with accuracy what tax rates or tax laws will do 10, 20 and 30 years from now.

Taxable Accounts vs Traditional IRAs and Roth IRAs

Another reason to use taxable accounts is because you may not qualify to invest in an IRA. Generally, you must have earned income to save money in an IRA.

Therefore, if you don't have a job, you don't get to contribute. This is why 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).

Some people have the fortunate problem of not being able to contribute to an IRA because they make too much money or they may have more money to save beyond the annual contribution limits of 401(k)s and IRAs. 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.

Returning to the benefits of tax diversification, a young person or young couple today saving for retirement that is 20 or 30 years from today would choose a traditional IRA (pre-tax savings) because they assume that they will be in a lower tax bracket in retirement than they are during their accumulation years. The idea is to defer taxes now at a higher rate and pay them later at a lower rate. But due to a combination of increasing income, inflation and the great possibility of higher federal tax rates 20 or 30 years from now, the young person or couple could end up in a HIGHER tax bracket during retirement!

When Using More Than One Savings or Investment Account Type Is Smart

This is why I have wondered if the traditional IRA is deadand is why this tax conundrum is part of the attraction of using a Roth IRA and/or a taxable account or both. Unless you know with certainty that you will be in a lower tax bracket in retirement than you are during your savings years, you should use savings and investment vehicles other than 401(k)s and traditional IRAs.

A smart long-term savings strategy is to first contribute to a 401(k) only up to the amount your employer matches. For example, if they match 50 cents for every dollar you contribute up to 6% of compensation, then contribute only 6% to get that valuable benefit.

Next, contribute up to the maximum amount in a Roth IRA, which is $5,500 in 2015 or $6,500 for people ages 50 or higher.

If you are able to save more, open a taxable brokerage account or joint brokerage account and save as much as possible. Once you are within about 10 or 15 years from retirement, you may think of decreasing the Roth contributions and increasing the taxable account contributions, especially if you think you can retire early (before age 59 1/2).

Now all you need to do is know which are the best investment types for taxable accounts and which are the best investment types for IRAs.

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.