Advantages of long term taxable account

[edro]

I often hear you should contribute the maximum to your traditional IRA, Roth IRA and 401k before contributing to a taxable account.

IRAs and 401ks accounts are all taxed at normal income rates, correct?
Pay normal income rates on Roth IRAs now.
Pay normal income rates on Trad IRAs and 401ks in retirement.
Regardless, you pay normal income rates, whatever that may be at the time you withdraw.

Taxable investment accounts only have a 0% to 20% tax rate (long term capital gains) depending on what tax bracket you are in. (most likely to be 15%)

A sure 15% rate seems like a good deal, especially when you consider there are no minimum required distributions, no age limit to withdraw and heirs can have it tax free.

What am I missing?
Why would you prioritize taxable accounts LAST when it has a locked in lower tax rate in retirement?

 

[Exterous]

I often hear you should contribute the maximum to your traditional IRA, Roth IRA and 401k before contributing to a taxable account.

IRAs and 401ks accounts are all taxed at normal income rates, correct?
Pay normal income rates on Roth IRAs now.
Pay normal income rates on Trad IRAs and 401ks in retirement.
Regardless, you pay normal income rates, whatever that may be at the time you withdraw.

Taxable investment accounts only have a 0% to 20% tax rate (long term capital gains) depending on what tax bracket you are in. (most likely to be 15%)

A sure 15% rate seems like a good deal, especially when you consider there are no minimum required distributions, no age limit to withdraw and heirs can have it tax free.

What am I missing?
Why would you prioritize taxable accounts LAST when it has a locked in lower tax rate in retirement?

For a taxable account you pay taxes on the income before you invest it and then pay the additional LTCG tax on your withdrawals

For Roths you pay taxes on the income before you invest it BUT the gains are tax free. No LTCG tax in Roths

401ks (or 403b, 457, 401a) reduce your current taxable income so putting say $15k into your 401k doesn't actually mean your take home is $15k less. As a base example lets say you are single, make $80k and take the standard deduction and nothing else. You would owe ~$19,000 in federal taxes. Now put $15k into a 401k and your tax bill drops to ~$14,500. Thats a $4,500 difference over a taxable account

There is the reduction in flexibility though.

 

[dullard]

Lets do a very simple example. To make it even more simple, I'll ignore state income tax which varies by state and consider just federal income tax.

Suppose you are in the federal 25% tax bracket now and will be when you retire. Suppose you can get a 15% long term capital gains tax rate. Suppose you are going to be paid $1333.33 that you want to invest. Suppose you can invest at a reasonably typical 8% annual gains and will sell it in 20 years. Suppose you want to decide between (A) taxable accounts, (B) IRA/401K, or (C) Roth IRA. Which should you use?

(A) Taxable account:
You are paid $1333.33 but have to pay 25% federal tax on it ($1333.33 * 0.25 = $333.33). You are left with $1000.00 after tax to invest. In 20 years that becomes $1000*1.08^20 = $4660.96. Now you sell it and have to pay taxes on the gains. Your $1000 investment gained $3660.96 to become $4660.96. Thus you pay 15% tax on $3660.96, which is $549.14. You are left with $4111.81.

(B) Tax-deferred IRA/401k account:
You are paid $1333.33 but you don't pay federal tax now, it is deferred. You are left with $1333.33 to invest. In 20 years that becomes $1333.33*1.08^20 = $6214.59. Now you sell it and have to pay taxes on everything. Thus you pay 25% tax on $6214.59, which is $1553.65. You are left with $4660.95.

(C) Roth IRA account:
You are paid $1333.33 but have to pay 25% federal tax on it ($1333.33 * 0.25 = $333.33). You are left with $1000.00 after tax to invest. In 20 years that becomes $1000*1.08^20 = $4660.96. Now you sell it, but since it is a Roth IRA, you don't pay any more taxes ever. You are left with $4660.96.

So, which would you choose when it is all said and done? Option (A) $4111.81, (B) $4660.95, or (C) $4660.96?

The taxable account, even with the guaranteed lower tax rate is the worst choice in this simple example.

Note: as you said, taxable accounts have some great advantages (such as try donating the taxable stocks rather than selling them and you get secret option (D) of $5826.20 since you never pay taxes the gains and get a tax break on the principal and gains). But taxable accounts also have disadvantages such as taxes on dividends, lack of ability to redistribute to meet your investment goals (since that would trigger short-term higher taxes), etc.

 

[edro]

Oh dammit... I forgot about income tax now... I'm an idiot.
So taxable accounts are taxed at normal income rates now AND 15% in retirement.

Thank you both!