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How to Choose Between Taxable and Tax-Advantaged Investment Accounts

Sarah Bromley
August 10th, 2022

Failing to optimize your investments for taxes can eat into your returns considerably. But if there was a single, universally applicable rule on whether to choose a taxable and tax-advantaged investment account, there wouldn’t be any need for two account types to exist in the first place. Instead, they both have their perks and drawbacks, and you’ll need to make a choice based on your circumstances.

Fortunately, we’re here to help you break everything down. We’ll run through the key differences between each account, the types of investments each one is suited to, and other key considerations.

Taxable vs. tax-advantaged investment accounts: The basics

First of all, let’s quickly define exactly what we’re talking about here. How do taxable and tax-advantaged accounts work, and which accounts fall into these categories?

Taxable accounts

A taxable account is simply an account that doesn’t protect your money from the taxman. Account types in this category include checking accounts, saving accounts, and brokerage accounts.

At first glance, it might seem like an account that taxes your money isn’t worth your while, but they offer a lot of flexibility. Unlike tax-efficient alternatives, there are no penalties or restrictions regarding your withdrawals.

Plus, if you plan to invest over the long term, even taxable accounts offer some tax benefits. Namely, investing for a year or more means you’ll have to pay the long-term capital gains rate on your investments (between 0% and 20%) rather than short-term capital gains tax, which faces the same tax rate as the rest of your income. You’ll also have the option to defer your taxes to a different fiscal year when you sell.

This means that your tax burden may not turn out to be as high as you expected, as long as you’re smart with how you proceed.

Tax-advantaged accounts

Tax-advantaged accounts help you optimize your investments for taxes. There are two main types: Tax-deferred accounts and tax-exempt accounts.

When you have a tax-deferred account, you’ll be able to use your investments as a tax deduction immediately, meaning you’ll have a larger sum of money that can grow over time. Most people expect to receive a pension income lower than their current salary, so it makes sense to do things this way. Examples include traditional IRAs, 401(k)s, and 403(b)s.

Meanwhile, tax-exempt accounts don’t give you any tax break upfront — so you’ll have to contribute to them using your after-tax dollars — but you won’t have to pay any taxes when you make withdrawals. Considering that you may face more tax later on when your investments are worth more, this can make sense. It can also help business owners who've sold their company and want to create a transition plan for their finances. Roth IRAs, Roth 401(k)s, and 403(b)s are all examples, as are 529 plans.

Some also may turn to alternative investment strategies like private placement life insurance (PPLI) and private placement variable annuities (PPVA), which allow you to reduce taxes using insurance premiums. However, they’re a very specific investment type best suited to particular scenarios and those with multi-million-dollar net worths.

Then there are charitable remainder Unitrusts (CRUT) and charitable remainder annuity trusts (CAT). These are tax-exempt trusts that pay you an income and then give the funds to a beneficiary after you pass away. They can be a useful way to reduce taxes while giving back to the world, but since you’ll lose control of the assets as soon as the trust is created, they’re a niche choice that not everyone would opt for.

Should you choose taxable or tax-advantaged accounts?

We’ve explained the differences between taxable and tax-advantaged accounts, and given you examples of the most popular choices. But there’s still one important question left: Which should you choose?

That’s going to come down to a few crucial factors.

The tax efficiency of your investment

You’re probably all too aware of capital gains tax, but some investments trigger it more than others. On one end of the spectrum, we have actively managed funds, which involve asset managers frequently buying and selling securities — triggering more capital gains and the corresponding taxes. Using the same logic, it makes sense that ETFs trigger less capital gains tax because nobody is actively managing them.

Bonds also tend to be tax-efficient since most types aren’t taxable at either the federal, state or local level (or all three). However, the exception is corporate bonds, which don’t have any tax benefits.

If you’re interested in investing in tax-efficient assets like these, it’s less important to put your money in a tax-advantaged investment account.

The liquidity you need

Taxable accounts are much more liquid. Unlike tax-advantaged accounts, they don’t involve any withdrawal penalties for taking out money, which is perfect if you think you may need to use the money to cover emergencies (like medical bills) or future purchases (like buying a new car).

Overall, tax-advantaged investment accounts are a great option for long-term savings such as retirement or your childrens’ education. However, if there’s a chance you may need to withdraw money sooner, taxable accounts can be a smarter choice — especially if you can opt for something tax-efficient, such as bonds.

How much you’re saving

You can save a lot more money in a taxable account since they don’t have any contribution limits, unlike tax-advantaged investment accounts. As of 2022, you can invest up to $6,000 per year into a traditional or Roth IRA and $20,500 into a traditional or Roth 401(k) or 403(b) — and a little more if you’re 50 or older.

For many individuals, it makes sense to max out tax-advantaged accounts, then move onto taxable accounts for any cash they have left over. However, some people may choose to prioritize taxable accounts for other reasons.

How much flexibility do you need

Taxable accounts offer greater flexibility when it comes to withdrawals. Not only can you withdraw money without a penalty, but you can choose to leave the money in if you prefer. In contrast, if you have a tax-advantaged account, you’ll have to withdraw required minimum distributions (RMDs) once you reach a certain age. Note that this rule doesn’t apply to Roth IRAs.

What do you want to invest in

With a Roth IRA, you are generally limited to investing in conventional assets like stocks, bonds, and mutual funds. However, some specialist providers have emerged to enable crypto investments (such as BitIRA), and a self-directed IRA gives you access to more investment types, including real estate syndications.

Still, a brokerage account comes with greater flexibility and allows you to invest in almost anything without having to go through the steps involved in setting up an SDIRA. Not only will you be able to invest in assets like real estate investment trusts (REITs), commodities, and hedge funds, but you can also trade with margins, which isn’t legally allowed in an IRA.

This is great for achieving diversification.

What will it be?

Few would dispute the advantages of tax-efficient accounts, and they’ll ultimately play a role in the strategies of most investors. But don’t underestimate the advantages of taxable accounts, such as greater liquidity, the ability to save more money, more investment options, and improved flexibility. Depending on the timeframe you plan on investing over and how you plan on accessing the money in later life, they’re an option worth considering.

In conclusion, both types have their drawbacks and benefits, many investors end up with multiple accounts across different brokers and providers. If you find that this makes it harder for you to keep track of everything, consider a portfolio tracker like Vyzer. Vyzer can sync to all your accounts, including more unusual investments and accounts such as private equity or real estate syndications, making it a natural choice for experienced investors with more complex portfolios.