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.
By the way if you are not subscribing to the blog by email, you are missing half the content. Every Friday or Saturday I send out an email with links to 5-10 articles that I find interesting but I don’t have time to write a full post about. Instead I just put some short comments under each article. If you prefer to read regular blog articles by RSS feed or in other ways you can also subscribe to only the digest emails.
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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