Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared Feb. 27, 2013.
Even newbie investors are probably somewhat knowledgeable about the importance of investing heavily in tax-sheltered vehicles--IRAs and company-retirement plans. Taking advantage of tax-deferred compounding--or even tax-free compounding, in the case of Roth vehicles--is one of the easiest ways for investors to improve their bottom lines.
Yet as meaningful as those tax savings can be, there are also situations when saving in your taxable account is the right way to go because practical considerations outweigh the tax hit you'll take to do so. Here are some of the key occasions when saving within the confines of a taxable account makes sense, even though it could cost you a bit more in taxes from year to year.
You May Need the Money Soon
If there's a realistic chance you'll need part of your savings in the near future--for example, you're saving for a goal that's close at hand or you're building an emergency fund--you're usually better off saving in a taxable account than you are within the confines of a tax-sheltered vehicle such as an IRA, a 401(k), or a college-savings vehicle such as a 529. The key reason is that if it turns out you need to tap the tax-sheltered assets prior to college or retirement, you'll have to pay penalties and/or taxes to get your mitts on those assets. (Roth IRA contributions are the notable exception--see below for details.)
Taxable accounts carry no such strictures, though you'll have to pay taxes on an annual basis on any investment income from those assets as well as on any capital gains when you sell. It's also worth noting that the tax costs, in absolute terms, of holding short-term assets in your taxable accounts are apt to be quite low right now--one small silver lining of the current, low-yield environment. (Sadly, the tax costs in relative terms--as a percentage of your return--are still very high.)
Sure, in an ideal world you'd save for each of your specific financial goals in exactly the right bucket--retirement savings in your company retirement plan and IRA, college savings in a 529, and near-term goals in your taxable accounts.
Here in the real world, though, it can hard to know which of those goals should take precedence. Maybe your child will get a scholarship, thereby obviating the need for her college fund. (Wouldn't that be nice? My colleague Adam Zoll discussed what happens in that situation in this article (http://news.morningstar.com/articlenet/article.aspx?id=535906).) Or perhaps you'll need to buy a new roof with some of the money you had earmarked for retirement. If you have competing financial priorities--or even competing financial "maybes"--you might be better off saving within a taxable account rather than tying the money up in a retirement- or college-specific investment.
If you're multitasking with your investments, however, first check to see whether you're eligible to contribute to a Roth IRA before assuming that a taxable account is the best, most flexible receptacle for your savings. (In 2013, single income tax filers earning less than $127,000 and married couples filing jointly who earn less than $188,000 can make at least a partial contribution to a Roth.) The Roth is geared toward retirement, but you can withdraw your contributions at any time for any reason without taxes or penalties. If you don't end up needing the money prior to retirement, you'll be able to enjoy tax-free withdrawals after age 59 1/2. That makes it a good first stop--even before cash--for multitaskers.
You've Maxed Out Your Tax-Sheltered Options
One of the key reasons for saving in a taxable account is purely logistical. If you're a higher-income earner who's in a position to sock a lot away for retirement, you're apt to find that your tax-sheltered options will only take you so far. Investors in 401(k) plans are limited to $17,500 in annual contributions if they're under 50 and $23,000 if they're over 50. IRA investors can contribute $5,500 a year if they're under 50 and $6,500 if they're over 50. (College savers aren't likely to hit this roadblock, as 529 contribution limits, while varying by state, are extremely generous.) If you find yourself in the position of having maxed out all of the tax-sheltered retirement vehicles available to you, saving additional assets in a taxable account will be a necessity. The good news is that if your retirement is many years away, your retirement savings are likely to be skewed toward stocks, which carry lower tax costs than bonds. Moreover, taxable assets can be a godsend in retirement, as withdrawals of long-term holdings from taxable accounts are taxed at the lower long-term capital-gains rate, whereas IRA and 401(k) withdrawals are generally taxed as ordinary income.
While taxable investors will forgo some of the tax breaks associated with tax-sheltered investments, it's still possible to minimize the tax hit. For higher-income investors saving for short- and intermediate-term goals, municipal bonds and bond funds can make a compelling alternative to taxable bonds; use the tax-equivalent yield function of Morningstar's Bond Calculator to compare yields on taxable and muni bonds. Longer-term taxable investors have even more options, as stocks tend to be much more tax-friendly than bonds. Individual stocks, tax-managed mutual funds, and broad stock market index funds and ETFs tend to do a good job limiting the tax collector's cut of your returns.