Jargon within the investing (and finance) world is what makes finances so intimidating. The verbiage of “taxable” and “non-taxable”, while intended to be extremely descriptive, doesn’t always help you understand meaning. These two terms are actually the most common types of investment accounts. At a surface level, this can seem quite simple but there are a few layers to unpack so let’s jump in.
What does taxable and non-taxable mean?
The status of taxable and non-taxable refers to how the earnings within each type of account is treated. A taxable account is one that will be taxed on any earnings within the account. For example, within a taxable account any dividends received or gains realized when you sell an investment will be taxed. Those taxes may vary depending on the investment but there will be a tax bill associated with it. In contrast, a non-taxable account would have no taxes due for any growth or earnings even if investments are sold. Instead, non-taxable accounts are either funded with money that is only taxed before a contribution, taxed as income when a distribution is taken, or never taxed.
The long term value of having accounts that can grow tax free can actually be seen when you account just for the annual taxes you pay on a standard investment brokerage account. Let’s look at an example:
Starting portfolio value: $150,000
Time frame: 30 years
Annual growth: 7%, 1% from ordinary dividends and .5% from realized gains.
Over a 30 year time frame the non-taxable account grows ~$70,000 more than the taxable account. On top of this added growth is the benefit of deferring or removing the income tax associated with assets entering or exiting these accounts.
What types of accounts fall into these categories?
Typically, if you are going to be opening an investment account and funding it with direct dollars from your paycheck or an inheritance, this would be a standard brokerage account which is taxable. This can be a joint or individual account. Bank accounts that pay interest are also considered taxable as you are required to pay taxes on any interest earned.
Non-taxable accounts have a much larger reach. Most commonly, you will have your individual retirement accounts (IRA) which can be Traditional or Roth. Other retirement accounts are your company retirement plans such as 403(b), 401(k) or 457. Within those plans you can typically contribute to both “pre-tax” and Roth accounts. Learn more about the differences here. Other less commonly used accounts that also can grow tax free are 529 college savings accounts. Money contributed to a 529 would be taxed in advance, however, it will grow tax free and can be withdrawn tax free if used on qualified education expenses. Some of these even have state level tax breaks!
In some unique cases you may never pay taxes. While not for everyone, Health Savings Accounts (HSAs) can create what the finance industry calls “a triple whammy”. Money contributed to these accounts is pre-tax, can be invested and grows tax free and if the money is used for qualified medical expenses, it can be withdrawn tax free too.
If you need to take money out of your investments or savings where should you go first?
This is one of the bigger questions we get asked when it comes to investments. You’ve spent a few years accumulating your wealth and now you have a big purchase that requires you to liquidate (sell) your investments and use the cash (think wedding or home down payment). As a general rule, we will always want to withdraw from taxable money before we touch retirement if you are not in retirement. The reason for this is that non-taxable money typically has penalties if not used within their expected capacity. Take a look at the chart below to see where those penalties fall.
*Roth account contributions can be withdrawn penalty free before 59.5 years old. Remember, you’ve already paid taxes on Roth contributions. Also, in many cases, in addition to the 10% penalty, the withdrawals will also be taxed at your current income bracket.
With this in mind, we usually will take money from areas that don’t have penalties. But what if you would need to withdraw 95% of your taxable money to pay for your purchase? Or for some, what if you only have 60% of what you need in your taxable account?
We would never want you to use 100% of your taxable money to pay for a large purchase because we want to make sure you have additional money for (a) emergencies or (b) future goals. The first thing to consider is, should you really move forward with a purchase that requires you to dip into your non-taxable assets? If so, your Roth assets would be the place to start. All contributions to Roth accounts can be withdrawn tax free.
As planners we will always recommend you save for your spending goal and not use your retirement or college saving assets. It’s important to buy within your means and not prevent you from reaching your longer term goals by focusing only on more immediate ones.
So how do I think about saving between these two types of accounts?
For the scenarios we just discussed, it’s important to contribute to taxable accounts and retirement accounts when you are younger because within the first 5-15 years of your professional life you may have some large purchases (car, wedding, home, children). In order to pay for these you will want to build a pool of investments/money that you can withdraw from without penalty. Even if you don’t know when you might hit these goals, you should contribute a small portion of your wealth here when you can. This money doesn’t have to be invested, it can be held in a high yield savings account (i.e cash) but you should have some money available for larger purchases.
Retirement, however, is of utmost importance and you have a nice long runway of potential growth to take advantage of. We suggest everyone start their career contributing at least 1% of their salary to a retirement account and strive to hit the maximum contribution limits (IRA or 401k) as soon as possible. The sooner you make retirement contributions a part of your standard saving the sooner you can retire.
The strategy we are employing here suggests that all finance goals within the next 3-5 years should be in cash or cash-like investments. Above 3-5 years, or if there is uncertainty around whether this is a true goal, (i.e. you’re not sure if you actually want to buy a house in the future) savings can be invested with a moderate to aggressive investment strategy in a taxable account. Simultaneously you should be contributing to non-taxable retirement accounts and attempting to maximize where possible.
We know it’s not always easy to understand how to split up your savings, however, if you are saving, that’s the first step! Next, let’s make sure you diversify your savings by contributing to taxable accounts and retirement or non-taxable accounts.
If you have any questions about what is right for you, talk to your Origin planner.