When to start taxable investments?

[jules4]

Hi everyone,

Both my husband (28) and I (25) have 401k plans through our employers, and we are both currently contributing 10%. We are not maxing out our annual contributions yet.

My question is--I have read that we should completely max out our 401ks before we invest in taxable accounts. Is this true in every instance? Should we be maxing out BOTH of our 401ks if we are able? Should we open another IRA account in addition to our 401k (assuming we are able) and max that out before we buy any taxable stock or other investments?

What if we want more options for building wealth over the short term? Retirement is so far away it's not as fun knowing all of that money is off limits for the next 40 years.

Thanks for your help,

Julia

[jIM_Ohio]

Your options-

401k max out
Roth or traditional IRAs
taxable accounts

I would do the following for simplicity:

401k to match

then
401k to 15% tax bracket
then
Roth IRA

**then**
if 15% tax bracket, taxable account
if 25% tax bracket or higher, 401k and Roth/traditional IRA once you max the 401k

Reference Room

examples:
If you can use 401k to get taxable income under 68k (see table linked above) then use Roth for any available monies, that means the 401k saved you 25% (in taxes) and the Roth was contributed to when you were in 15% tax bracket. Roth works best if your tax rate is higher in retirement than when you worked.

If you can do above AND max the Roths, then any additional money should be in a taxable account (pay taxes at 15%) and keep the investment tax efficient (avoid capital gains and dividends).

If you cannot get taxable income below 68k (meaning all income is taxed in 25% bracket), then max 401ks and save 25% (or more- depending on fed and state tax brackets). If you are eligible for Roth after maxing the 25% deduction, then use the Roths. If you are not eligible for Roths, use traditional IRAs. Basically because tax bracket is so high (25% or higher) use every shelter you can find- 401k for a deduction, then an IRA to shelter gains and dividends from taxes. Then use taxable accounts (and possibly muni bonds) for additional investments.

[jules4]

Thanks for your reply. Maxing out our 401ks wouldn't get us under $67k.

So our situation would be the second scenario you listed. What do you mean by saving 25%?

So you're saying we should max out both 401ks, an additional Roth (if we qualify) or traditional IRA, and then, lastly, taxable investments. Can we have two IRAs, one for each of us?

[jIM_Ohio]

Thanks for your reply. Maxing out our 401ks wouldn't get us under $67k.

So our situation would be the second scenario you listed. What do you mean by saving 25%?

So you're saying we should max out both 401ks, an additional Roth (if we qualify) or traditional IRA, and then, lastly, taxable investments. Can we have two IRAs, one for each of us?

max both 401ks
then max Roth IRAs or traditional IRAs (yes you have one for each of you- IRAs are in one person's name only)
then after maxing IRAs consider tax efficient methods of saving- like paying down mortgage, muni bonds, or mutual funds which do not pay lots of dividends or capital gains.

[jules4]

Sweet, thanks for your help. We actually don't own a home yet, but do have enough in savings for a down payment. I imagine your advice wouldn't change much based on the fact that we rent.


Thanks again for your help!

[jIM_Ohio]

Sweet, thanks for your help. We actually don't own a home yet, but do have enough in savings for a down payment. I imagine your advice wouldn't change much based on the fact that we rent.


Thanks again for your help!

Most of my advice is based on keeping you tax efficient. If your AGI and or taxable income on tax return is above 69k married filing jointly, you are earning higher than 75% of Americans.

My advice is based on keep as much wealth as possible (in your account) and not pay taxes when you don't have to.

It's possible as you learn more you may want to max the Roth's before the 401k (and lots of advice on the net will suggest this). IMO it's a tax decision, and if you think you can SPEND less than 69k per year today (if you retired) my advice will save you more in taxes. My advice is once you get into the 15% tax bracket, put every dime you can save into the Roth, but stay in the 15% bracket (do not lower 401k contribution if it raises your tax bracket).


If you have $43,000 to invest ($16,500 in each 401k plus $5000 in each Roth) that is a great savings plan (regardless of tax bracket).

If you have less than this- say $23,000, and you put $10,000 in a Roth and $13,000 in the 401ks, that works, or if you put all $23,000 in 401ks that works too (the fact you are saving trumps which type of account you use regardless of all other advice given).

The 401k saving you 25% means this- every dollar put in 401k saves 25% taxes on that money- saving $100 to 401k drops tax bill by $25. The 25% is based on your HIGHEST TAX BRACKET. If your highest tax bracket is 15%, then it makes less sense to use 401k and makes more sense to use the Roth. Look here for help on tax brackets Reference Room Its a long explanation below, but I want to prove a few points to you to help with Roth discussion too. If math overwhelms you, I apologize. I tried to quote the summary of 3 different example to show you how 401k keeps more money.

If you earn $100,000 (gross income before all deductions) the taxes look like this:

Std deduction ($11,400)
personal exemptions (times 2) ($3650*2=$7300)

those are subtracted from the 100k

You are now taxed on the $81,300

that tax looks like this:
first $16750 is taxed at 10% ($1675)
up to $68,000 is taxed at 15% (68,000-15760=51250*15%=$7687.50) ...so tax is $1675+$7687.50=$9362.50 so far)
the last portion is taxed at 25%
meaning $81,300-68000=$13,300 is taxed at 25% ($13,300*25%=$3325)

So your total tax on $100k is
$1675+$7687.50+$3325=$12687
that is just federal tax- if you have state taxes, those are also taken out.
SS is 6.2% so that is $6200 (all 100k is taxed)
Medicare is 1.45% so that is $1450 (all 100k is taxed)

So of your 100k in income
12687 went to federal taxes
6200 went to SS
1450 went to medicare
the rest goes to you (or state taxes)

100,000-(12687+6200+1450)=79663

total take home
$79663
total federal income taxes paid
$12687
total investments
$0

you lost about 21% ($20,337 to be exact) to various taxes (medicare, SS, federal income tax).


Using a 401k helps you KEEP more of your money, and every dollar in the 401k saves you $.25 in taxes (25% savings).

Take same example (100k gross income from employers) and put $23,000 of that in a 401k.

The new math is this

100k income
$6200 SS tax paid
$1450 medicare tax paid
$23,000 to 401k
the $11400 std deduction still exists
the $7300 exemptions still exist

100k- (23,000+11,400+7300)= 100k-49350=58300 (taxable income)

then calculate federal taxes on that $58300 using same math as before
first $16750 is taxed at 10% (tax=$1675)
up to 68,000 is taxed at 15%
so that math is ($58300-16750)*15%=$41550*15%=$6232
so total federal tax is $1675+$6232=$7907.50

Your total take home this this example is

100k
minus these taxes
$6200
$1450
$7907.50
minus this deposit to 401k
$23000

total take home
$61442.50 (this is about 18k less than above)
total taxes paid
$7907 (this is almost half what it was without 401k)
total investments
$23,000 (so keeping 23k cut your tax bill in half)

If you go for the "sweet spot", its to get taxable income below 68k (so you pay taxes in 15% bracket, then open Roth and put some money there).

That math looks like this

100k gross income
we know std deduction and exemptions take you to 81k in income, so put 14k in 401k (drops that to 67k in income before taxes) and put the balance in Roth (only up to the 23k I used to invest in second example)

So math is
100k gross income
$11,400 std deduction
$7300 (2 exemptions)
$14,000 (smaller 401k deposit)

taxable income is
100k-(11400+7300+14000)

$67300 is taxable income

tax paid is
$1675 on first $16750 (10% bracket)
next income taxed at 15%
$7582.50 on next income (67300-16750)*15%=50550*15%

so total tax paid is $9257

take home is 100k-$9257-$6200-$1450-$14,000

total take home
$69093 (this is between both of above because less was put in 401k)
total taxes paid
$9257 (this is lower than original because some was put in 401k)
total investments
$14,000 (putting 14k in 401k dropped tax bracket to 15%)
If you put $9000 of the number in red into a Roth IRA, this will look very similar to second example (23,000 invested with take home pay being only 2k less)

[dczech09]

Jim has it right looking at it from a tax stand point. I do want to chime in with my 2 cents though:

You probably have one of two motivations for asking about using your tax-shelters and taxable brokerage accounts- 1) for retirement and 2) for other miscellaneous savings (not just retirement).

If you're looking strictly at retirement, then follow the following hierarchy-
-Max 401k
-Max IRA
-Variable annuity
-Taxable account

Now on the other hand, if you are looking to have this taxable brokerage account not for retirement, but for miscellaneous savings such as vacations, future car, house downpayment,or any other mid or long term goals, then perhaps a taxable account could benefit you. However, it is the mantra of finance that you utilize these types of investments for long-term investment goals only.

Personally, I like the idea of having money set aside in a taxable account for growth over the mid-term; this way when I need the money for a purpose such as those I stated above, then I can pull the money out and not worry about a penalty. At the same time, I also know that if I hold the money in there for a longer period of time, it is in an investment that can appreciate in value.

Ultimately I would say it comes down to WHAT you would use this account for. Again, Jim's analysis is great and shows a good tax strategy that could work to your benefit greatly.

Also keep in mind that everything I said here is assuming that you have your emergency fund set, you are debt free (mortgage is only acceptable debt), and you are saving for your childrens' college (if applicable).

[cptacek]

If you're looking strictly at retirement, then follow the following hierarchy-
-Max 401k
-Max IRA
-Variable annuity
-Taxable account

Variable annuity? Really?

[kork13]

Now on the other hand, if you are looking to have this taxable brokerage account not for retirement, but for miscellaneous savings such as vacations, future car, house downpayment,or any other mid or long term goals, then perhaps a taxable account could benefit you.

Personally, I like the idea of having money set aside in a taxable account for growth over the mid-term; this way when I need the money for a purpose such as those I stated above, then I can pull the money out and not worry about a penalty.

I'll simply second this. I use my taxable investment accounts for mid-term savings, which right now are primarily geared toward a home downpayment, though really it could serve any purpose. Use the 401k/IRA's for retirement savings, and taxable investments for mid-term (~5-15 yrs)savings. Just my opion though, FWIW.

[MonkeyMama]

I agree with kork. There are things you need to save for, outside of retirement accounts.

Of course, mostly agreed with everyone. I just wanted to point out that from a tax standpoint, it is also MUCH easier to invest in tax-deferred accounts. As your taxable accounts grow in more varied investments, you do have to worry much more about the tax consequences of dividends and sales (much of which can be unpredictable). IT can become a lot to manage. You can no longer do a simple rebalance without considering the tax ramificarions. So, my stance is pretty much to only invest in tax-deferred accounts, to simplify my whole tax situation, even if I am only in the 15% tax bracket to begin with. This is why I would probably pay down my mortgage before investing heavily in non-tax-deferred accounts. (IT merely keeps things simple).

For now, most our savings would go to IRAs (we don't have 401ks), Kids UGMA accounts for college (they don't have enough $ in there to be taxed), cash for emergency funds/mid-term savings. As our cash balance grows we may expand to more aggressive strategies than cash. When the kids hit a taxable threshhold, we may put more in 529s or ESAs. But, for now, all I know is my taxes are very simple. No dividends or mutual fund sales to report. I Can prepare my taxes January 1 since I am not the whim of all the mutual fund reporting.

[jIM_Ohio]

I agree with kork. There are things you need to save for, outside of retirement accounts.

Of course, mostly agreed with everyone. I just wanted to point out that from a tax standpoint, it is also MUCH easier to invest in tax-deferred accounts. As your taxable accounts grow in more varied investments, you do have to worry much more about the tax consequences of dividends and sales (much of which can be unpredictable). IT can become a lot to manage. You can no longer do a simple rebalance without considering the tax ramificarions. So, my stance is pretty much to only invest in tax-deferred accounts, to simplify my whole tax situation, even if I am only in the 15% tax bracket to begin with. This is why I would probably pay down my mortgage before investing heavily in non-tax-deferred accounts. (IT merely keeps things simple).

For now, most our savings would go to IRAs (we don't have 401ks), Kids UGMA accounts for college (they don't have enough $ in there to be taxed), cash for emergency funds/mid-term savings. As our cash balance grows we may expand to more aggressive strategies than cash. When the kids hit a taxable threshhold, we may put more in 529s or ESAs. But, for now, all I know is my taxes are very simple. No dividends or mutual fund sales to report. I Can prepare my taxes January 1 since I am not the whim of all the mutual fund reporting.

Simplicity works for some, and I agree that paying down mortgage before using taxable accounts has many benefits to it to keep it simple.

The flip side to above is put small cap stocks in taxable accounts, and as long as you have about 25k to play with, spread that 25k around to 10-20 different small cap stocks, and if you make a bad decision, sell it at a loss and make sure you claim the $5000 loss each year on tax return if you have losses you can realize.

I recently read some articles on people with "high" incomes which pay no income tax and this was a popular technique to shield another 5k from income tax. These people invested enough money that something they held (somewhere) lost money, so YMMV and do this only if you understand taxes enough to know where the information is entered on tax return.

[jules4]

Thanks for all of the advice. My husband and I have a combined gross annual income of about 125k. We don't have any debt. If there was a way we could make it into that 15% tax bracket it would be great, but we can't. For now I think we'll just push it to the limit with our 401ks and get our taxable income down as much as possible.

Jim, Thanks for the explanation on the 25% savings in taxes. Makes perfect sense!

Also, thanks to those who chimed in about having a mid-term savings taxable investments. That's what I was initially wondering about. I would love to have some investments going that are not strictly retirement. Retirement isa ways off and we have a lot of stuff we'd like to do with our money between now and then.

What kinds of taxable investments do you guys prefer?

Thanks again You have all been really helpful!

[jIM_Ohio]

Thanks for all of the advice. My husband and I have a combined gross annual income of about 125k. We don't have any debt. If there was a way we could make it into that 15% tax bracket it would be great, but we can't. For now I think we'll just push it to the limit with our 401ks and get our taxable income down as much as possible.

Jim, Thanks for the explanation on the 25% savings in taxes. Makes perfect sense!

Also, thanks to those who chimed in about having a mid-term savings taxable investments. That's what I was initially wondering about. I would love to have some investments going that are not strictly retirement. Retirement isa ways off and we have a lot of stuff we'd like to do with our money between now and then.

What kinds of taxable investments do you guys prefer?

Thanks again You have all been really helpful!

The best taxable investment I own is PRPFX- Permanent Portfolio. It is a great approach for money which you want to keep. Other assets may perform better, but Permanent portfolio is consistent without much volatility. Google it to read about its history. PRPFX is the only mutual fund which used the historical permanent portfolio approach. Many at bogleheads have modified the approach to something more modern.

The best way to preserve capital is to invest in 5-8 different types of investments which are completely uncorrellated.

Like stocks
foreign currencies
commodities
bonds
cash
real estate

If you put REITs in a taxable account, you lose the tax efficiency of Permanent Portfolio. However it might help performance (some).


As for above- my family has a gross income of about 120k and we are in 15% tax bracket. Granted we get 2 extra exemption (from kids).

Here is math for you to get into 15% bracket:


130k gross income (added in a fudge factor for you if you get raises)

goal is 67k taxable income (68k is bracket cap, $1000 of wiggle room)

130k-67k=$63,000 of deductions and adjustments

Std deduction ($11,400)
personal exemptions (times 2) ($3650*2=$7300)

44300 of deductions needed after basic tax code adjustments

$16,500 for max 401k spouse 1
$16,500 for max 401k spouse 2
$33k total adjustment

$11300 of deductions and adjustments still needed

If you have access to an HSA, use that for another $5000 (check IRS for exact max, it is probably about $5350).

$6300 of adjustments needed
Depending on fudge factor above, you are now "just under" 68k taxable income

If you do not have access to an HSA, use an FSA, but only put enough in it which you will spend. HSA's will carry over year over year (meaning if you do not spend, you do not lose money). FSA are use it or lose it, so only put in what you spend on health care per year. If you have glasses (for example) at end of year in Dec go get prescriptions renewed and get prescription sunglasses too with FSA money before its lost.
If you have any other pre-tax deductions (child care account or other) take advantage of that. I hqave listed the big ones, but there are other above the line deductions. If either spouse is self employed, you have a way of putting more than $16,500 into a 401k by using a SEP IRA or similar (higher contribution limits).



And taxable income is now under $68k

If you get a house and have mortgage interest which is about $17,000 per year, you will be in 15% tax bracket until mortgage is paying less than 16k in interest per year.

17k is the $11,400 std deduction plus the $6300 I could not find a deduction for.


If you have two kids anytime soon, you should also be in 15% tax bracket as well (even without mortgage). If you have a mortgage and kids, you will not need the HSA or max 401k and you should still make it into 15% bracket.

[kork13]

What kinds of taxable investments do you guys prefer?

As MM mentioned, I prefer simplicity. Thus, I'm mostly using index mutual funds, which track various stock indexes -- S&P 500, Wilshire 1500, and so on. They're easy, give you decent diversification right off the bat, and also tend to be more tax-efficient than an actively managed fund. Additionally, I prefer mutual funds over individual stocks, because you don't have to worry so much about the number of shares or when you bought/sold each one. Rather, you can buy fractional MF shares (such as 23.6145 shares for $200), instead simply having to worry about the amount of money you want to work with. Again, that's just a simplification matter for me.

[jules4]

We don't have kids or a mortgage, and have an FSA rather than an HSA. We are using $1000 this year on our FSA and will use all of it by the end of the year--barely. I don't think we could go any higher. Have you given up on us getting into that 15% bracket yet?

Maybe if we buy a house soon?