The Case for Taxable Retirement Investing: Part 1

For decades, retirement savers have been encouraged to max out their tax-deferred retirement savings using 401(k)s and IRAs. The idea of using taxable accounts for retirement savings has been, if anything, an afterthought – a way to invest only after tax-deferred plans were fully funded.

But for high net worth investors, taxable accounts offer several potential advantages and can be a valuable complement to tax-deferred investments. By saving in both types of accounts, investors may be able to gain additional tax benefits before retirement while setting the stage for greater tax-related flexibility during retirement and in legacy planning.

3 Pre-Retirement Advantages of Taxable Accounts

1. A Wider Variety of Investment Choices: In many cases, investments in company-sponsored tax-deferred retirement plans are limited by type of investment, asset class, and provider. Using a taxable account gives you and your advisor greater freedom to choose whatever investments you see fit. In addition, you can move your money to a different provider and set up as many taxable accounts as you like.
2. Use Losses to Offset Taxable Gains and Income: Losses in retirement accounts are just that – losses, because they can’t be used to offset gains or ordinary income. In contrast, losses in taxable accounts may be able to be used to offset capital gains and up to $3,000 in ordinary income annually, which can result in a lower tax bill.
3. Potential for Tax-Free Compounding: Through careful portfolio construction, you and your advisor can create a taxable portfolio that may be unlikely to generate significant capital gains, dividends or income. For example, investments in some broad-market stock index funds, exchange-traded funds or tax-efficient mutual funds or separate accounts may make it possible to hold stocks for many years without significant tax consequences. On the fixed income side, investments in municipal bonds are exempt from federal income tax and, in some cases, state income tax.

Potential Tax Benefits for Retirees
This approach isn’t limited to retirement savers, as investors who use taxable accounts along with tax-deferred accounts during retirement may also benefit. Over the years, investments in a taxable account have the potential to grow unfettered by distribution requirements and their accompanying tax liabilities.

Moreover, taxable accounts can also offer estate planning benefits. When you pass on assets in taxable accounts to your heirs, they receive what the IRS terms a “step-up” in their basis, which can essentially erase capital gains liabilities incurred over your lifetime. This could mean that when your heirs eventually sell their inherited assets, they would only pay tax on the difference between the value of the assets when they received them and their value at the time of sale. That could result in a much lower ultimate tax bill than if they had to pay taxes based on the original purchase date.

All investing involves risk, and investors should talk with their financial and tax professionals to determine what may work best for them. Adding a taxable account to your retirement income planning arsenal has the potential to provide financial benefits, both while planning for – and living in – retirement.