I included this article by Christine Benz, Director of Personal Finance at Morningstar, in a weekly digest email to subscribers: 6 Key Reasons Why Investing in a Taxable Account Is Underrated. I said I disagreed with every reason given in the article. Several subscribers asked me to elaborate why.
Before we start, let me say I’m not against investing in a taxable account. My wife and I have more investments in taxable accounts than in tax-advantaged accounts. I’m only against investing in a taxable account while leaving tax-advantaged accounts not maxed out.
Roth >= Taxable
It’s easy to see why a Roth account is preferable to a taxable account. Both are funded with post-tax dollars. The Roth account is tax free, both during accumulation and during withdrawals. In a taxable account, you pay tax on dividends during accumulation and you pay tax on capital gains during withdrawal. That’s why it’s called a taxable account.
You can make a taxable account more tax-efficient if you manage to stay in the 15% bracket, when you pay 0% on qualified dividends and long-term capital gains. But the room is limited. The room is also better used for something else, such as a Roth conversion. The 0% is also only the federal income tax. Most states still tax the dividends and capital gains as regular income.
The dividends and capital gains even at 0% tax rate also count in AGI, which affects all kinds of phaseouts. For instance they will reduce your ACA tax credit, acting effectively as an additional 10-15% tax.
A Roth account doesn’t have these problems. If you have a choice between contributing to a Roth account and leaving the money in a taxable account, it would be foolish to leave the Roth account not maxed out while simultaneously putting money in your taxable account. That’s why people do backdoor Roth and mega backdoor Roth. If you are not getting a tax deduction anyway, you want the money in Roth.
So far so good.
Traditional Deductible >= Roth
This may come as a surprise to you when you hear debates on Traditional vs. Roth. Doesn’t it depend on your tax brackets? Yes, but after you consider your tax brackets and if you still decide to put money into a Traditional account, that means you already determined that, to the best of your ability to estimate today, a Traditional account is better than a Roth account for you for the amount of money you are putting into Traditional. If that’s not the case you would just put the money in Roth.
If you realize Traditional isn’t better, you can always convert it into a Roth, right now. If you are contemplating leaving a traditional account not maxed out, you can contribute to it to hit the max and then immediately convert the same amount from a traditional account to Roth. The contribution in and the conversion out cancel each other. The tax deduction from the contribution and the tax on the conversion also cancel out. You then effectively added money to Roth. We already know adding to Roth is better than putting money in a taxable account.
Therefore a traditional deductible account can be thought of as a super Roth. It’s either better than a Roth or effectively the same as a Roth.
Expenses and Fees
Some employer-sponsored plans have higher expenses and fees than the taxable accounts you control. The rule of thumb there is a “rule of 30” — the extra expenses times the number of years your money stays in the plan must equal to 30 or above to negate the tax advantage.
If the plan’s expenses and fees are higher by 2 percentage points, unless the money stays in the plan for more than 15 years, you are still better off investing in the plan.
Reasons for Taxable
Christine Benz wrote in her article:
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.
For the reasons I gave above, I see saving in a taxable account exactly as a last resort, and exactly just if I’ve run out of tax-sheltered receptacles for my money.
All six key reasons in Christine Benz’s article are reasons that make a taxable account not as bad if you line up everything well. They still don’t make it better than a Roth account or a super Roth Traditional deductible account. Let’s look at each one:
- Extreme flexibility: A Roth account is flexible enough. You don’t need extreme flexibility.
- Near-tax-free compounding if you plan carefully: Straight tax free without caveats is better.
- You can use tax losses to reduce your tax bill: Capped at $3,000/year as a deduction, not enough to make it better than a Roth.
- You may be able to enjoy no- or low-tax withdrawals: Still count as AGI. Still taxed by states. Tax free no strings attached is better.
- You’ll have more control over your tax bill in retirement: Actually you have less control than if you have a Roth account.
- Your heirs will receive a step-up in basis: Inherited Roth accounts are also tax free. After RMD, what’s left grows tax free too.
Taxable accounts are at the bottom of the list as they should be.
Do you agree or disagree? Are you leaving tax advantaged accounts not maxed out while you invest in taxable? Why? Chime in!
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Bah. Accounting for traditional IRA is a nightmare if you want to convert incrementally. It’s also incredibly expensive to do it all at once, a big hit to your MAGI that year, which can hit you with underwitholding penalties in some corner cases. I don’t think it affects your tax bracket but to avoid the incremental accounting you could need to come up with a substantial amount of money at once. I settled on Roth IRA, traditional 401k. Tax diversification without the accounting headaches.
Harry Sit says
You have some accounting only if you make non-deductible contributions. If the traditional IRA is all pre-tax, it’s just whatever you convert you pay tax on.
Bill Marshall says
Taxable accounts are at the bottom, agreed. But they still make it on the list. I think there is a lot of unconscious “nanny state” thinking as people are accumulating savings. IRA/401k/403b/457 accounts are subsidized by the govt, so contribute to them. Once that is done, they’ve satisfied their required savings and all will be OK. Anyone who has run the numbers knows better, and you need to contribute to taxable accounts also. Not instead of, but also. Having to pay taxes on the dividends or capital gains just provides excuses for people who would rather spend than save. So the proper next section of this article is “Taxable >>> nothing”
Harry Sit says
I agree. That’s why more than half of our investments are in taxable accounts.
I actually disagree a little bit as this is not a universal truth. My wife and I are on track to retire by 40 (not that we will) with money invested solely in Roth IRA and/or 401(k). I certainly wouldn’t discourage anyone from investing extra cash into a taxable account though.
The average household income in the US is $52k. I don’t know if the average number of workers in the house is two, but let’s assume for the sake of argument that this household has two worked. Each has a 401(k) or 403(b) at work, which caps with the federal max of $18k (as opposed to the percent of salary cap that used to be more common). They are well below the Roth IRA income limit. 18 + 18 + 5.5 + 5.5 = $47k total contribution to just those four accounts. They could contribute up to 90% of their income. So for the average household, no, they are never going to get past the taxable accounts.
Even for a well above average household making $104k, twice the average, those four accounts would let them shelter 45% of their gross income.
Harry, I agree, and you didn’t even mention advantages with respect to asset protection.
Hi. I’m new to investing and could use help with what is probably a dumb question. Right now I am contributing the max to an HSA and contributing up to the employer match on my 403b. I’m maxing out my Roth and have a small amount in taxable and contribute to a 529. Because I have read that contributing to the HSA hurts me overall due to a lower Social Security (because I am below the second bend point), I think I will stop adding to the HSA. (Or is that a bad idea?) With my employer, any retirement contributions of mine that are above the employer match are “supplemental retirement contributions” that will reduce my Social Security benefits. Wouldn’t this mean that I should not make any supplemental contributions to retirement, for the same reason that I should stop contributing to my HSA? I appreciate any and all guidance on the math here. I do understand that a lot of things could happen Social Security before I retire.
(Also, if anyone has ideas about whether using a 529 is the right thing to do, I’d love to hear it!)
Harry Sit says
Anna – If you want to pay Social Security tax on your HSA contribution and have it count as earnings for Social Security benefits, you can contribute on your own to an HSA of your choice, not through your employer’s payroll. See Best HSA Provider for Investing HSA Money.
Additional 403b contributions will not affect your Social Security, if your program is similar to this 403(b) Supplemental Retirement Program at Michigan State University.
529 plan is Roth-like but for college expenses. I would do it only after you have adequate retirement savings.
The second bend point means that earnings beyond that point are much less valuable (less than half). But that doesn’t necessarily mean that SS taxes up to that second bend point are a good deal. An HSA is definitely a good deal because it’s tax free going in and out, so personally, that’s what I would choose (and am choosing).
Thanks for addressing this question in your usual very clear manner! Now, how about ranking Non-Deductible Traditional IRA?
My guess is that it’d be
Traditional >= Roth >= Non-Deductible Traditional >= Taxable
though perhaps only for certain types of assets in the non-deductible, like those throwing off significant interest or non-favored dividends (e.g., REITs).
I’m curious to know your take.
Harry Sit says
John – You only do non-deductible traditional IRA shortly before you convert it to Roth. In that sense your ranking is correct.
OB Lation says
As I understand it, if you have a Non-Deductible IRA and do not convert to Roth, you end up with mandatory withdrawals “RMD” (unlike a Roth) that are then taxed as Ordinary Income instead of the presumably lower long term capital gains rate that you get with a Taxable account. So a non-deductible IRA seems to be the least desirable of the different accounts. That is, if your do not convert to Roth.
Jeremy @ Go Curry Cracker! says
Traditional before Roth before Taxable is the right order for most people
But we retired in our 30’s, have our legal residence in a no-tax State, and most of our time is spent traveling abroad so no ACA subsides. In this situation, taxable is better, so we never contributed to a Roth while working
Roth’s are great for mainstream retirement plans, but when retiring 20 or 30 years before Age 59.5, access to earnings is important. We fund most of our lifestyle with qualified dividends and long term capital gains, all at a 0% tax rate
Each year we do a Roth IRA Conversion equal to the Standard Deduction and Personal Exemptions, so pay zero tax on those funds. It is looking like we will be able to get all of our 401k/Traditional IRA money converted to a Roth at 0% tax rate over the next 30 years or so before the RMD would cause a higher tax rate
Each year I use the Foreign Tax Credit from our international holdings to further increase the size of the tax free conversion, and do capital loss and capital gain harvesting to increase cost basis in the taxable account
I’ve published our tax returns on the blog for the past two years, which show total income of nearly $100k with $0 in income taxes. Here is the return from 2014: http://www.gocurrycracker.com/go-curry-cracker-2014-taxes/
(Feel free to edit out the link, I don’t want to spam your site, just to share an example of why we didn’t contribute to Roth accounts)
Thanks Harry, I’ve been enjoying your site for some time
Harry Sit says
Thank you for stopping by Jeremy. I’ve been following your and Winnie’s journey for some time too. I like your food posts and your bike tour.
You set up a great system that works well for your specific situation. For everyone else who stay in the U.S., chances are they will access ACA. As you said, half of your $100k total income isn’t really income. It’s just resetting your basis higher, which happens automatically if inside a Roth IRA. The 0% rate on qualified dividends and long-term capital gains is also a relatively recent phenomenon. I would say the risk of it not staying that way for the next 40 years is much higher than the risk of Roth IRA distributions not staying tax free. I would prioritize Roth conversion over harvesting capital gains when I’m in a low tax bracket.
Jeremy @ Go Curry Cracker! says
Thanks Harry, yeah I’m looking forward to doing more bike trips
I’m in complete agreement on prioritizing Roth conversions over harvesting gains in the low tax years
What are your thoughts on the value of access to earnings (vs contributions) for somebody retiring with 20-30+ years before Age 59.5?
Harry Sit says
Given that there are many years after 59-1/2, I think if they must tap Roth earnings before then, they don’t have enough saved or other income sources or their expenses are too high.
On a related topic, since you wrote the book Explore TIPS, I’m curious about your take on this statement: “since TIPS are exempt from state tax, they are usually best held in taxable accounts.” (From http://blogs.wsj.com/totalreturn/2015/01/15/low-inflation-bad-for-tips-nope/). One thing I noted is that the article doesn’t talk about the issue of “phantom” income from the TIPS inflation adjustment to their principal value. I’m also wondering if you otherwise agree with the overall argument of the article.
I think another account worth mentioning is the HSA. You can invest your HSA in a low-cost mutual fund. With HSA you get a tax deduction up front and tax-free distributions for qualified expenses. If you have leftover HSA money after retirement age, the HSA can then work like a traditional IRA (assuming you want to take some distributions for unqualified expenses).
A taxable account is good for a few reasons.
1. Tax loss harvesting allows me to mitigate downside risk when the stock market crashes. This is better than a Roth IRA where you cannot mitigate risk by deducting $3000 per year in losses.
2. The amount of taxes saved in huge stock market drops is much greater than the qualified dividend taxes that I pay on tax efficient ETFs that I hold in my taxable account. I have a pretty high income, and a relatively low taxable account balance so my situation may be different than most people.
3. If you’re planning to retire very early, having a large taxable account is critical as I plan to withdraw the taxable account first in early retirement before age 59.5. Of course with a Roth IRA, original contributions can be withdrawn at any time, but the total amount of original contributions may not be enough to fund the early retirement period through age 59.5.
Harry Sit says
The benefits of tax loss harvesting diminish over time while the taxes on dividends increase over time. If you deliberately give up traditional or Roth contributions in favor of putting money in a taxable account you are setting yourself up for higher cost in the long run for limited benefits in the short run. Especially when you have a high income now and you retire early, the benefits of converting money from a traditional tax deferred account to Roth at near-zero tax cost are huge.
Taxable accounts are great, but they are not so great that they should be prioritized over traditional or Roth contributions. They still come last.
For retiring early you can use a Roth conversion ladder.
1) Convert one year’s living expenses from deferred to Roth and pay taxes on it.
2) Wait 5 years
3) Converted money now counts as contributions and you can withdraw it without (additional) taxes nor penalties.
You do need a source of money to pay living expenses for the first four years, such as a taxable account or a previously funded Roth account. But after that, your conversion ladder is rolling and you just repeat the above steps every year.
I am fully aware that tax advantaged accounts like a traditional 401(k), HSA, and Roth IRA are much better over the long-term compared to taxable accounts. I am already maxing out all 3 accounts. I am only pointing out where taxable accounts are better than a Roth IRA. I plan on retiring early before the taxable account grows past the point where taxes on dividends exceed tax savings on losses. I plan on using the entire taxable account for early retirement in the same way as Jeremy has pointed out in an earlier post. I plan on doing partial Roth conversions after retirement when my income is low. I plan on filling in the standard deduction and exemption with the partial Roth conversion every year and filling in the taxable income limit for 0 taxes on dividends and long-term capital gains. I am fully aware that a partial Roth conversion up to the standard deduction and personal exemption is much better than tax loss harvesting in early retirement.
My priorities are as follows:
1. Max out Traditional 401(k)
2. Max out Roth IRA
3. Max out HSA
4. Max out Mega Backdoor Roth IRA
5. Any remainder goes to my Taxable Account
I fully understand the power of the Roth IRA in combination with the 401(k) for early retirees. I was one of the first people to create a plan to do rolling partial Roth conversions in early retirement when the Roth IRA was in its infancy. The 5-year Roth conversion rule was put in place to close a loophole where traditional IRA owners, under age 59 ½, would have been able to convert to a Roth IRA and then take a Roth IRA distribution to avoid the 10% early distribution penalty that would have applied if they took the distribution directly from their traditional IRA. I discovered this prior to the rule change, and after the rule change I found that the IRS orders of distribution work perfectly during the 5-year waiting period. Since original Roth IRA contributions can always be withdrawn and they are the first dollars that are withdrawn according to IRS rules, all you need is 5-years of living expenses from the original Roth IRA contributions. Then, it’s just a matter of converting what you need for year 6 in year 1, for year 7 in year 2, and so on. Since the converted Roth basis is distributed in a FIFO method, it’s perfect. It’s an elegant strategy that I stumbled upon many years ago.
I was told that if you have a Roth IRA and it earns interest that interest would be tax if you have a Roth IRA and you withdraw a large amount of money that money would not be taxed because it is taxed during the tax season and you would only pay on the interest for that tax season for that Roth if you was to take money directly out of the Roth you would not have to pay tax on the money you were true because you already paid it during the time it was earning interest is that true
Rollover questions. First I have heard you can do a Roth IRA 60 day rollover back to the same account. I’ve also heard you can’t. Which is it. Secondly there is a limit to doing IRA 60 day rollovers to once every 12 months. Does this apply to the individual or to the account. In other words if you have more than one IRA such as one traditional and one Roth can you do the 60 day rollover in a twelve month period out of each of them or just out of one?
Harry Sit says
What’s the purpose of the contemplated 60-day rollover? Usually the objective can be accomplished in other ways without resorting to a 60-day rollover. Then you don’t have to worry about the intricacies of a 60-day rollover. Now, to answer your specific questions:
– You can do a 60-day rollover from a Roth IRA.
– The once per 12 months limit applies to the individual. It doesn’t matter which type (traditional, Roth, SEP, SIMPLE).