Many Americans save for retirement through 401(k)s. These accounts offer tax-deferred benefits, which means your money can grow tax-free until you withdraw it. But for those who don’t have access to an employer-provided retirement account or just want to save more money beyond the IRS limit for a 401(k), Morningstar says taxable accounts are used to Buying and selling investment securities can help you save more for retirement. Here’s what you need to know.
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Compare 401(k)s with Taxable Accounts
provided by the employer retirement accounts like 401(k)s gives employees the ability to make automatic investments while getting tax relief — the money you put into the plan can grow tax-free through retirement.
While it’s a popular retirement savings option, the Chicago-based financial services company Morningstar pointed out that not all 401(k) are created equal. Some charge high administrative costs, others offer expensive investment streams, and employers don’t have to make matching contributions.
Also, not all workers have access to 401(k)s. And the IRS also limits how much you can put into the account. For the year 2023, the contribution limit is $22,500 (workers 50 and older can contribute up to $30,000).
Similarly, if you want to invest more in retirement and you have contributed the maximum amount to 401(k) and other funds. retirement account options like an IRAMorningstar says you might consider moving your money into a taxable account.
Taxable accounts, often referred to as taxable brokerage accounts, allow investors to buy and sell stocks, bonds, exchange-traded funds (ETFs), mutual funds and other investment securities.
However, unlike 401(k)s, the IRS does not set a contribution limit on taxable accounts, nor does it penalize investors for early withdrawals—it charges a 10% penalty fee on 401(k) withdrawal taken before age 59.5 unless you qualify for an exception.
Taxable accounts also allow retirement investors to hold investments for longer without having to withdraw funds, while the IRS imposes required minimum distribution (RMD) for 401(k)s (in 2023 will be delayed until age 73).
Retirement investors should be aware that the money they make by selling investment securities through a taxable account will be taxed as income. But if you hold those securities as long-term investments for more than a year, you can pay capital gains or dividend taxwhich for some investors may be lower than federal income tax rate.
4 factors to determine when a taxable account is better
Morningstar broke down four common factors to help retirement investors determine when a taxable account might beat a 401(k):
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Assess whether your 401(k) plan has high administrative fees. As an account holder, you may be charged for investments, plan management, and personal services. These fees are often disclosed on the plan manager’s website or the fund’s prospectus, among other marketing sources, and can eat into your retirement savings over time. Therefore, you should compare your 401(k) with other plans for evaluation.
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Make sure your taxable account investments are tax-efficient. Morningstar says that “a taxable account will rarely be a better choice unless you can invest in securities that generate some income distribution, capital gains, or both.” And the financial services company recommends that investors choose a brokerage platform that can offer “a good range of low-cost, tax-efficient options” such as “index-tracking ETFs and municipal bond fund”.
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Consider your tax bracket when contributing. before tax contributions to a 401(k) fund will reduce your prepaid taxable income. However, this is more valuable to higher-income investors who are looking to reduce their taxable income during the year of their contribution. As an example, if you marginal tax rate is 32% (earnings $182,100 to $364,200 for tax year 2023) and you contribute $20,000 to a 401(k), you’ll save $6,400 in taxes that year.
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Consider your tax bracket when making withdrawals. Taking money from a taxable account can benefit you more than a 401(k). Investors withdrawing money from a taxable account will owe capital gains tax on the sale of securities. But those who withdraw from a 401(k) fund will be taxed at a higher rate than ordinary income. You should also keep in mind that since you pay no taxes on your 401(k) contributions, you will owe ordinary income tax on the entire withdrawal, while taxable account investors will only tax on capital gains. And for this reason, high-income investors may prefer taxable accounts to 401(k) on withdrawals.
bottom line
For retirement investors comparing taxable accounts to 401(k)s, Morningstar says it’s difficult to give them all a shot. So, if you are planning a retirement investment strategy, you should consider that both the tax bracket and the tax rate will change over time. This will affect your contributions and withdrawals. You should also compare administrative fees and make sure your investments are tax-efficient. Furthermore, you should be aware that these accounts are not mutually exclusive — financial advisors will recommend having both when possible to develop a comprehensive retirement strategy.
Tips for retirement investing
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If you are looking at different investments for your retirement, here are 13 types of financial investment for 2023.
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