For most people, saving for retirement is best done through accounts specifically designated for retirement, like 401(k)s or Traditional or Roth IRAs. By design, these accounts offer preferential tax treatment — you either get a tax break now, or later in retirement.
For example, most contributions in Traditional IRAs and 401(k) accounts reduce taxable income today, but the money is taxed later when it is taken out of the account. Conversely, Roth IRA and designated Roth contributions in a 401(k) plan do not provide a tax break today, but do potentially provide tax-free withdrawals in retirement.
A good rule of thumb is to save 15% or more (including any employer contributions) of your household gross income for retirement. There are a few situations where you may want to supplement your retirement savings with a taxable account. Here are four:
1. You don’t have access to a 401(k) plan at work. Your workplace may not offer a retirement plan at all. Some employers have a waiting period (e.g., 90 days or one year) before someone is eligible to participate. Or, the plan might only be available to full-time workers.
If this is your situation and the only retirement account option is in an IRA, contributions are limited to $6,000 per year ($7,000 if over 50). For many workers, an IRA by itself, will not get you to that 15% savings rate. Making additional contributions to a taxable account can help you meet this savings target.
2. You want accessibility to your long-term investments. Some households may want to start investing beyond what they’ve saved as their emergency reserve. Other households may not want to tie up all their long-term investment savings in retirement accounts. A taxable account provides the flexibility to add money and take money out without limits, penalties or restrictions. There are also no required distributions. You can save more towards retirement, or any other future goal
3. You have maxed out your 401(k) or IRA and want to save more. Currently, 401(k) plan contribution limits are $19,000 ($25,000 if age 50 and older). Some households, especially dual-income households, may be able to save aggressively for retirement. Consider someone under age 50 earning $160,000 a year. Using the 15% retirement savings target, he should aim to save $24,000 or more each year, well above the $19,000 contribution limit. The next option, an IRA, could be problematic as Roth IRAs have income limitations and a Traditional IRA may be nondeductible. Additional savings can be invested in a taxable account.
4. Your only IRA option is nondeductible. Continuing from the previous scenario, a non-deductible IRA means that you do not qualify for a tax deduction when contributing to a Traditional IRA, losing that tax benefit. This happens when you or your spouse have access to a workplace plan, which makes deductibility subject to income limitations. While earnings will still grow tax-deferred in a nondeductible IRA, they will be taxed as ordinary income when the money is used. With a taxable account, you may benefit from a lower long-term capital gains tax rate.
For example, the same, single person under age 50 making $160,000 cannot contribute to a Roth IRA and, assuming he is participating in his company plan, he cannot deduct his contributions to a Traditional IRA. He would benefit from a 0% and 15% long-term capital gains rate versus a marginal income tax bracket of 24%:
|Long-term Capital Gains Tax Rates||Ordinary Income Tax Rates|
|Rate||Taxable Income||Rate||Taxable Income|
Source: Tax Foundation
Some investors might open a nondeductible IRA and then convert it to a Roth IRA (known as a backdoor Roth). Be careful with this strategy if you have multiple IRAs. All of your IRA accounts are factored in when calculating the “pro-rata rule,” which determines what income will be taxable upon conversion. (Even though you may not get a deduction for the current IRA contribution, you may owe taxes if any of your other IRAs were funded with pre-tax money.)
Opening a taxable account
Taxable accounts (also known as brokerage accounts) are available at just about any financial services firm. You can typically invest in a variety of stocks, bonds, mutual, and exchange-traded funds. When saving in taxable accounts, be mindful of the fees and how interest, dividends, and capital gains are taxed.
The benefit of tax diversification
Using a combination of pre-tax, Roth, and taxable accounts to save for retirement can provide you added flexibility when you need to spend that money. Just as you diversify your investments to help tackle the uncertainty of the markets, diversifying the tax treatment of your accounts can help you weather the uncertainty of the tax landscape and manage your income in retirement.