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Taxable accounts in retirement: Why they’re more important than you think

April 5, 2019

The backbone of most people’s retirement funding are the tax sheltered accounts such as IRAs and 401(k)s. These accounts are fantastic, and rightly should make up the bulk of your retirement saving. Maximizing contributions to these accounts is a must and should be at the top of your personal finance priority list each year.

But depending on your situation, contributing over and above these accounts into taxable savings and brokerages accounts can be an extremely beneficial strategy and an impactful part of your future retirement.

Saving additional money in taxable accounts can be impactful later during your retirement years. For instance, pulling money out of taxable accounts can have tax benefits during retirement as this money is not considered “income” and is not taxed as such. While selling investments before pulling money out can result in taxable events, this doesn’t apply to savings in savings accounts, CDs, etc. Money you pull out of these accounts to pay bills doesn’t get taxed whereas if you’re pulling money out of a 401(k), it’s going to be taxed as income before you use it to pay bills.

Here’s a brief example. If your goal is to have $100,000 in retirement funding per year and you have $250,000 in a savings account, you can pull $25,000 a year out of this savings account tax-free for 10 years (at least) and only need to pull $75,000 each year out of retirement accounts.

Additionally, if you aim for some degree of an early retirement, you can withdraw money out of taxable accounts at any time whereas your tax-sheltered accounts can often have penalties if you attempt to withdrawal money out before the specified retirement age.

What are the other benefits of taxable accounts in retirement? Let’s look at a few more:

  • Taxable brokerage accounts have no limits of what you can invest in. You can buy just about any normal financial instrument. Many 401(k) accounts with employers typically have a select few funds or investments that you can choose from.
  • There are no contribution limits to a taxable account. 401(k) accounts and IRA accounts are all regulated by the IRS and have specific amounts you can contribute on an annual basis. Similarly there are no income thresholds that come into play. You can put as much as you want into a taxable account no matter how much money you make.

Tax efficiency is an important topic when planning your overall strategy and how your taxable accounts fit into this strategy. This is discussed at length in our tax cost ratio article. Equity index funds are good instruments for your taxable accounts as they are typically more tax efficient than bonds and more traditional mutual funds.

So what’s the best strategy? Use these rules as guidelines for your retirement savings strategy:

  • Max out all 401(k) accounts at all times. This is crucial.
  • Max out the IRA contribution each year as well. If you’re married, both spouses should be doing this.
  • If your income is below the threshold, utilize the Roth IRA for your IRA contributions. If not, consider the backdoor Roth IRA strategy each year. Note that this will require you not having a traditional IRA with funds in it (it’ll have to be rolled over to a Roth).
  • If your 401(k) allows, or if you run a solo 401(k), consider the mega backdoor Roth IRA strategy in which you can stash even more funds into a Roth IRA.
  • Layer in contributions to a traditional, taxable investment account so that you’re building up your taxable account funds as well. As discussed above, taxable accounts in retirement give you flexibility later during your retirement years.
  • Lastly, if you have extra money left over, throw it at your mortgage. Your return on your mortgage is tax free, and not having a mortgage in retirement means you need less money during retirement. This can also help you sell fewer investments and withdrawal less money early in retirement, and thus, keep your money building longer.

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