This is a ratio that I struggle with. Obviously the greater amount that one has in a tax-advantaged investment account, the less tax drag you’re going to pay for. With the current options of investment vehicles, one can potentially squirrel away a relatively hefty amount in a tax-advantaged account. Small business owners know what I’m talking about. So do managing partners in their practices. If you have several high-income ventures, you can shove away a solid six-figures in tax-deferred accounts.
When your earning velocity slows down, the tax-deferred amounts can be slowly withdrawn to fill up our lower tax brackets. For some physicians, this can mean shifting from a 50+% marginal tax (sometimes even effective tax) bracket down to something like a 10-15% effective bracket.
If you are able to do that, then you’re in an envious position. Some of us are just stuck in an employed position where we can only fill up the employee portion of our 401k space. Unfortunately we all know that saving only this amount will never be enough to a safe retirement, especially if you decide to hang up your hat early. I am in this very situation, and I end up putting most of my stock/fund investments in a taxable account.
Over the years, I try to shove away as much as I can to catch up for the lost years of no income during schooling. I’d anticipate that eventually my tax-advantaged accounts will only amount to about 10% or less of my total investments. This is perhaps a much smaller percentage of what most people will have, but this also creates an interesting arrangement that I will have to consider later in life. There are considerations for putting your investments in a taxable account.
- Tax drag during investing years. Investment vehicles will need to be tax efficient, as dividends and interest that gets kicked out is taxed. Funds with high loads or high levels of activity will kick out taxable events.
- Liability. Unlike investments in your 401k, tax-sheltered accounts, or (shudder) cash-value investments, your debtors can access your investments in a taxable account. You need to protect it appropriately. Umbrella insurance is the key word.
- You will likely have less of this to invest. You are investing your post-tax income in this vehicle. In some ways, this isn’t really a huge disadvantage, but it does seem that way because Uncle Sam has already taken away what you can put into this vehicle. He will also continue to take away from it through further taxes on growth.
- During withdrawal years, income is treated only as capital gains taxes, which is lower than traditional income. You can really combine this with your tax-deferred account withdrawals to minimize your tax burden during retirement.
- No maximum amount that you can invest. The sky is the limit.
- No minimum that you have to withdraw either.
- Tax loss harvesting. If you end up with a loss in a particular category, you can sell it, and purchase similar funds at the lower rate.
Whenever I do go through the pros and cons of taxable accounts, I do feel a little bit more at ease. It’s not bad that we have many options to grow our wealth. After all, the true secret to building wealth is saving more than you spend.
How much of your investments belong in taxable accounts?