Placing Equities in Taxable Accounts vs. Retirement Accounts

Retirement accounts such as IRAs and section 401(k) plans are generally tax efficient. The effective tax rate is zero for Roth IRAs and traditional deductible IRAs, as well as for employer-sponsored plans like section 401(k) and section 403(b) plans (assuming tax rates are constant over time and there are no matching contributions by the employer). An effective tax rate of zero for these retirement plans is illustrated by the following examples.¹

Example 1: At age 45 John makes an after-tax Roth IRA contribution of $4,000. At age 60 he withdraws all the accumulated earnings, avoiding the 10 percent penalty tax under section 72(t). Assuming an 8 percent pretax rate of return, the $4,000 contribution grows to $12,688 ($4,000 * (1 + 0.08)¹⁵ = $12,688). John may withdraw the entire amount tax free because it’s a Roth IRA, and the effective tax rate on the earnings is zero because the withdrawal is tax free.

Example 2: Assume that John, age 45, has a constant tax rate of 24 percent and contributes the pretax equivalent of $4,000 to a traditional deductible IRA. (The maximum IRA contribution allowed for taxpayers under age 50 for 2020 under section 219(b)(5)(A) and Notice 2019-59, 2019-46 IRB 1091, is $6,000.) The pretax equivalent is $5,263 ($4,000/(1 - 0.24) = $5,263). At the end of 15 years at a rate of return of 8 percent, the $5,263 compounds to $16,695 ($5,263 * (1 + 0.08)¹⁵ = $16,695). If John withdraws the entire balance at the end of 15 years and is still in the 24 percent tax bracket, the after-tax accumulation is $12,688 ($16,695 * (1 - 0.24) = $12,688), the same accumulation as the Roth IRA contribution.

Consequently, the tax rate is zero on earnings from a traditional deductible IRA (assuming constant tax rates) and from a Roth IRA. The tax rate on earnings within an employer-sponsored section 401(k) or section 403(b) plan would also be zero (assuming no employer contribution and constant tax rates). If there is an employer match, the tax rate will normally be less than zero. Yet despite the general tax efficiency of retirement plans, it is sometimes more tax efficient to hold equities in a taxable account. This report examines scenarios in which that might be the case.

I. Effective Tax Rates in Taxable Accounts

Table 1 illustrates the after-tax rate of return and effective tax rate for equities held in taxable accounts, based on the long-term holding period and the tax rate for capital gain and dividends (assuming an 8 percent pretax rate of return).² When purchasing individual stocks, a long-term holding period is easily achieved by adopting a buy-and-hold strategy for stocks that have appreciated in value. If instead of directly purchasing stocks, an investor acquires equities through mutual funds or exchange-traded funds (ETFs), capital gain distributions can generally be avoided by purchasing either index funds or ETFs that track a broad-based index. For example, none of Vanguard’s many equity ETFs and index funds (not actively managed funds) had a capital gain distribution for 2019.³

Table 1. After-Tax Returns and Effective Tax Rates for Equities in a Taxable Account

	Holding Period
	1 Year and 1 Day	10 Years	20 Years	30 Years
0 percent tax rate for dividends and capital gain
After-tax return	8%	8%	8%	8%
Effective tax rate	0%	0%	0%	0%
15 percent tax rate for dividends and capital gain
After-tax return	6.8%	7%	7.2%	7.3%
Effective tax rate	15%	12.2%	10.1%	8.7%
23.8 percent tax rate for dividends and capital gain
After-tax return	6.1%	6.4%	6.7%	6.9%
Effective tax rate	23.8%	19.7%	16.5%	14.2%
This table assumes that the pretax return is 8 percent (6 percent for capital gain and 2 percent for dividends) and that dividend income is qualified and thus taxed at the same rate as long-term capital gain.

In Table 1, when the capital gain tax rate and dividend tax rate are both zero, the effective tax rate is zero and the after-tax return is 8 percent, as expected — the same as the pretax rate of return. This effective tax rate is the same as the zero rate achievable in retirement plans (assuming constant tax rates).⁴

When the capital gain and dividend rates are 15 percent, the effective tax rate is 15 percent and the after-tax rate of return is 6.8 percent if the holding period is one year and one day. As the holding period increases, the effective tax rate decreases and the after-tax return increases. This is because deferring capital gain realization allows the taxpayer to invest during the deferral period funds that would otherwise have to be paid in taxes. As Table 1 shows, for a 30-year holding period, the after-tax rate of return increases to 7.3 percent and the effective tax rate decreases to 8.7 percent.

Thus, for all but high-income taxpayers, there is little to no advantage to holding equities in a retirement account if the taxpayer adopts a long-term holding strategy.⁵ Even at the highest rate of 23.8 percent, with a holding period of 30 years, the effective tax rate is 14.2 percent, which arguably is not a big difference from the 0 percent achievable in a retirement account.

The remainder of this report discusses seldom-considered advantages to holding equities in a taxable account instead of a retirement account.

II. Opportunity for Capital Loss Harvesting

Harvesting capital losses regularly in a taxable account gives the taxpayer the opportunity to lower the effective tax rate and increase the after-tax return on equities. This tax strategy works best with individual stocks, as opposed to mutual funds or EFTs, because of the greater likelihood of generating a loss. The strategy has gotten easier to carry out for two reasons: Commissions to buy and sell stock have declined significantly (in some cases to zero), and the bid-ask spread after decimalization has narrowed significantly.⁶

In a taxable account, capital losses are first offset against capital gains, and any excess capital losses are offset against up to $3,000 of other income.⁷ Capital losses exceeding the $3,000 limit retain their character as short-term or long-term and are carried forward to first offset capital gains in subsequent years, and to then offset up to $3,000 in other income.⁸ In netting capital losses against capital gains, short-term capital losses are first offset against short-term capital gains.⁹ Because short-term capital gains are taxed at ordinary income tax rates, it makes sense to recognize stock loss sales before they are held for more than one year and one day.

A. Enhanced Rate of Return

At least two comprehensive studies have tried to quantify the enhanced after-tax rate of return achievable by tax loss harvesting. In a study published in 2003, Andrew Berkin and Jia Ye estimated the extra rate of return assuming 20 percent, 35 percent, and 50 percent tax rates.¹⁰ They performed a Monte Carlo simulation over a 25-year period at an 8 percent pretax rate of return. It was assumed that when a security sold at a loss, an identical security was immediately reacquired. At a 20 percent tax rate — the realistic rate if a buy-and-hold strategy is adopted — the extra return was estimated to be 0.31 percent per year after liquidation of the reacquired security. At higher assumed tax rates, the extra return was higher, as expected.

Shomesh Chaudhuri, Terence C. Burnham, and Andrew W. Lo found similar results in a more recent study.¹¹ They used historical data from the Center for Research in Security Prices for 1926 to 2018 (the period for which reasonably reliable stock price data are available) and assumed tax rates of 20 percent, 35 percent, and 50 percent. At the 20 percent rate, they obtained the same 0.31 percent increase in after-tax return on average over the 1926-2018 period. And as in the previous study, higher after-tax returns were achieved at the higher tax rates, as expected.

Both studies support the strategy of engaging in methodical tax loss harvesting in a taxable account to achieve a higher annual after-tax rate of return.

B. Avoiding the Wash Sale Rules

In implementing the tax loss strategy, taxpayers need to avoid the wash sale rules, which disallow the recognition of a capital loss from the sale of stock if the investor acquires substantially identical stock within 30 days before or after the date of sale.¹² If the investor is subject to the wash sale rules, the disallowed loss is added to the basis of the newly acquired shares.¹³

The wash sale rules can be avoided by simply waiting at least 31 days before reacquiring the shares. This strategy makes the most sense when the price of the stock has historically been stable. If the stock has historically been volatile, however, the investor might be reluctant to wait more than 30 days for fear of a significant increase in the stock price during the waiting period. If that is the case, the investor might consider purchasing another stock in the same industry, because stocks within the same industry are often highly correlated.

III. Opportunity for Stepped-Up Basis

The basis of property acquired from a decedent is equal to the fair market value of the property on the date of the decedent’s death¹⁴ (or on the alternative valuation date under section 2032, if elected). Consequently, there is a permanent avoidance of capital gain tax on any unrealized appreciation of equities at the time of the decedent’s death. In contrast, appreciated property held in retirement accounts is not entitled to a step-up in basis because distributions from a retirement plan are considered income “in respect of a decedent.”¹⁵

If the taxpayer dies during the holding period, the tax rate will be zero on the appreciated portion of the equities held in a taxable account. The tax value of the basis step-up as measured by the reduction in effective tax rates can be roughly approximated by looking at the probability of dying during the holding period.

The reduction in the effective tax rate may be roughly approximated by multiplying (1 - the cumulative probability of dying over a specified holding period given the taxpayer’s gender and starting age) by the effective tax rate before considering the likelihood of a stepped-up basis. The cumulative probability of dying during a specified period is derived from the latest Social Security actuarial life table.

Table 2 illustrates the effective tax rates if stepped-up basis isn’t considered and if it is considered for holding periods beginning at age 35 and at age 50. The taxpayer is more likely to die during a holding period that begins at age 50 than during a holding period of the same length that begins at age 35, so there is a greater reduction in the effective tax rate. For example, at a 15 percent tax rate for dividends and capital gain, the effective tax rate for a 20-year holding period decreases from 10.1 percent if stepped-up basis isn’t considered to 9.3 percent if it is considered and the holding period begins at age 35. The effective tax rate decreases from 10.1 percent to 7.5 percent if the 20-year holding period begins at age 50.

Also, as expected, the greater the appreciation in equities relative to basis, the greater the reduction in the effective tax rate. For example, at the 23.8 percent tax rate for dividends and capital gain, the effective tax rate is 17.9 percent for a 10-year holding period that begins at age 50, and only 5 percent for a 30-year holding period.

Table 2. Decreases in Effective Tax Rates, Factoring in Life Expectancy^a and Stepped-Up Basis

	Holding Period
	10 Years	20 Years	30 Years
15 percent tax rate for dividends and capital gain
Effective tax rate if stepped-up basis not considered	12.2%	10.1%	8.7%
Effective tax rate if stepped-up basis considered and holding period begins at age 35	11.9%	9.3%	6.9%
Effective tax rate if stepped-up basis considered and holding period begins at age 50	11.1%	7.5%	3%
23.8 percent tax rate for dividends and capital gain
Effective tax rate if stepped-up basis not considered	19.7%	16.5%	14.2%
Effective tax rate if stepped-up basis considered and holding period begins at age 35	19.2%	15.1%	11.3%
Effective tax rate if stepped-up basis considered and holding period begins at age 50	17.9%	12.2%	5%
aBased on male life expectancy. Same pretax rate of return assumptions as in Table 1.

IV. International Stocks in Taxable Accounts

A. Tax Advantages

Including international equities in a portfolio has the advantage of providing additional diversification. Retirement plans such as an IRA or a section 401(k) are considered tax-exempt trusts under section 401. Consequently, dividends from foreign equities that are paid in a retirement account are net of withholding taxes and the taxes withheld are not refundable. In contrast, if foreign equities are held in a taxable account, the taxpayer may claim a tax credit for the foreign dividend withholding taxes.

Because foreign dividend withholdings in a retirement account are lost to the taxpayer, the after-tax rate of return from international equities is reduced when held in a retirement account. The amount of the reduction will vary depending on the country composition of the portfolio — the withholding rate varies from 0 percent for Great Britain to as high as 25 to 30 percent for Norway and Germany. The most common withholding rate is 15 percent.¹⁶

The dividend yields are, on average, higher for foreign companies. The overall yield for international stocks is estimated to be around 3 percent. The 3 percent yield is derived from information on the website for the Vanguard Total International Stock Fund, a large, internationally diversified low-cost index fund. The dividend yield was estimated by dividing the dividend distributions of the fund over the previous 12 months by its current price.¹⁷ At a 3 percent yield and an average withholding rate of 15 percent, the after-tax return in a retirement account is reduced by 0.45 percent (0.03 * 0.15).

B. Ensuring Dividends Are Qualified

To achieve the greatest tax efficiency for foreign equities held in a taxable account, the dividends should be classified as qualified, because qualified dividends are taxed at long-term capital gain rates.¹⁸ However, ensuring that dividends from a foreign corporation are qualified is not as straightforward as it is for dividends from a domestic corporation. The dividend must meet at least one of three criteria:

• the foreign corporation is incorporated in a possession of the United States;

• the foreign corporation is eligible for the benefits of a comprehensive tax treaty with the United States that includes an exchange of information program; or

• the stock on which the dividend is paid is tradable on an organized stock exchange (normally either the New York Stock Exchange (NYSE) or NASDAQ).¹⁹

The common ways to invest in foreign equities are through international mutual funds, international ETFs, and American depositary receipts (ADRs). ADRs, which allow direct investments in foreign stock, offer investors the best opportunity to receive qualified dividends. Generally, a non-trivial portion of dividends from international mutual funds and ETFs will not be classified as qualified. For example, for the Vanguard Total International Stock Index Fund, only 66.87 percent of dividends for 2019 were qualified. For the Vanguard Emerging Markets Stock Index Fund, only 39.75 percent of dividends were qualified.²⁰

Using ADRs in a taxable account allows the investor to choose the specific ADRs whose dividends are qualified. ADRs are stocks that trade in the United States but represent a specific percentage of stock ownership in a foreign corporation. An ADR might be the equivalent of a single share, multiple shares, or a fraction of a share. ADRs trade on either an organized U.S. stock exchange (normally the NYSE or the NASDAQ) or the over-the-counter market (OTC) market. The OTC market is not considered an organized exchange. If an ADR trades on either the NYSE or NASDAQ, dividends from the foreign corporation represented by the ADR are qualified because the stock meets the criterion of being traded on an organized exchange. If an ADR trades solely on the OTC market, dividends are qualified only if the United State has a tax treaty with the country in which the foreign corporation is domiciled.²¹

Thus, to ensure that they receive qualified dividends from ADRs in a taxable account, investors should purchase an ADR traded on the NYSE or NASDAQ; if they purchase an ADR on the OTC market, they should confirm that the United States has a tax treaty with the country in which the foreign company is located.

V. Excessive Fees

Taxpayers incur ongoing fees on funds held in section 401(k) plans or section 403(b) plans. These fees are commonly expressed as an annual expense ratio, which is the total annual percentage of a fund’s assets used to cover expenses. The total expense ratio is generally grouped into two broad categories: administrative fees and investment management fees.

Administrative fees cover the cost of maintaining the plan itself, primarily the cost of recordkeeping. They may be borne entirely by the plan sponsor or the plan participants, or the cost may be divided between the two. Investment management fees, which are typically the largest component of the section 401(k) plan fees, are paid to fund advisers to manage a particular fund within the plan. These fees will vary by fund and are usually borne entirely by the participants. If, for example, a plan offers both actively managed and index funds, the actively managed funds will almost always incur a higher expense ratio than index funds.

Although overall section 401(k) plan fees vary widely by plan sponsor, the larger the plan asset size, the lower the average cost per participant. According to BrightScope, a leading provider of information about section 401(k) plan sponsors, the average expense ratio per participant was 0.91 percent in 2012. For plans with less than $1 million in assets, the average expense ratio per participant was 1.6 percent; for plans with more than $1 billion in assets, it was 0.38 percent.²²

For taxable accounts and IRAs, the taxpayer has the opportunity to control the expense ratio. For example, if all the equity fund options in a section 401(k) plan have expense ratios exceeding 1 percent, the taxpayer can lower his expense ratio by placing the money in a low-cost index fund or directly into stocks in a taxable account. Of course, the taxpayer could also invest in a low-cost equity index fund within an IRA, but IRAs have income and contribution limits. If, for example, the annual cost to invest in a section 401(k) plan is 1 percent higher for the taxpayer than investing in a taxable account, the annual after-tax return for the section 401(k) plan is reduced by 1 percent compared with the taxable account.

Beginning after November 1, 2011, ERISA requires that all plan participants timely receive information about their plan expenses.²³ Consequently, section 401(k) plan participants should be able to determine their annual expense ratios.

VI. RMDs May Result in a Higher Tax Rate

Section 401(a)(9) requires that after 2019, taxpayers begin required minimum distributions (RMDs) from employer-sponsored plans (such as the section 401(k) plan and traditional IRAs) no later than April 1 following the year in which the taxpayer reaches age 72 (up from age 70½ under prior law).²⁴ Employees are allowed to delay RMDs from employer-sponsored plans until the year they retire (except if the employee is a 5 percent owner).²⁵

Because of the RMD rules, contributions to a retirement account can push the taxpayer into a higher tax bracket when the RMDs begin. To assess whether that will be the case, it’s necessary to have a basic understanding of the RMD rules.

The RMD for a given year is calculated by adding all the balances in all the taxpayer’s retirement accounts as of December 31 (excluding Roth IRAs) and dividing that amount by a life expectancy factor. The taxpayer uses either the uniform lifetime table or the joint and last survivor table, both of which are located in reg. section 1.401(a)(9)-9. Taxpayers will use the joint and last survivor table only if they are married with a spouse who is at least 10 years younger.²⁶

Table 3 displays the life expectancy factor for ages 72 to 80 from the uniform lifetime table and, based on the life expectancy factor, the percentage of balance that must be withdrawn. As the taxpayer gets older, the life expectancy factor increases while the remaining life expectancy decreases.

The following example illustrates how to calculate the RMD.

Example 3: Taxpayer has a balance of $1 million in her retirement account as of December 31 before the year the RMDs begin. She expects to earn a 5 percent annual return on the remaining balance. After 2019, for the first-year RMD, she is required to receive a distribution of $39,100 ($1 million * 0.0391) according to Table 3. For the next year, the distribution will be the balance as of December 31 of the prior year multiplied by 0.0405. The balance as of December 31 would be calculated as follows:

• $1 million - $39,100 distribution in the first year = $960,900;

• $960,900 * 5 percent annual return on the balance = $48,045; and

• $960,900 + $48,045 = $1,008,945.

Therefore, the RMD for the next year would be $40,862 ($1,008,945 * 0.0405).

As this example shows, if the rate of return on the remaining balance is more than the percentage of the balance required to be withdrawn, the remaining balance will increase compared with the balance of the previous year.

Table 3. RMD Payments Based on the Uniform Lifetime Table

Age	Distribution Period	Percentage of Account Balance That Must Be Withdrawn Annually
72	25.6 years	3.91%
73	24.7 years	4.05%
74	23.8 years	4.2%
75	22.9 years	4.37%
76	22 years	4.55%
77	21.2 years	4.72%
78	20.3 years	4.93%
79	19.5 years	5.13%
80	18.7 years	5.35%

In lieu of decreasing contributions to tax-deductible retirement accounts to reduce the RMD, taxpayers might consider contributions to a Roth IRA, a Roth section 401(k) plan, or a Roth section 403(b) plan, if any of those options are available. Although the contributions are made with after-tax dollars, qualified distributions from Roth retirement plans aren’t taxable,²⁷ and the Roth IRA isn’t subject to the RMD rules.²⁸ Although Roth section 401(k) plans and Roth section 403(b) plans require RMD distributions, the distributions are not taxable. Moreover, a Roth section 401(k) plan or a Roth section 403(b) plan can be rolled over to a Roth IRA.²⁹

Although Roth retirement plans will often make economic sense in lieu of increasing contributions to a taxable account, they may be unavailable or significantly restricted. The Roth IRA may not be an option for a taxpayer because of the annual income limit, or it may be restricted in amount because of the annual contribution limit. And not all employers that offer a traditional section 401(k) or section 403(b) plan also offer a Roth section 401(k) or a Roth section 403(b) plan.

VII. Retirement Accounts Can Generate UBTI

Retirement accounts generate unrelated business taxable income when they produce income from (1) direct investment in a partnership or S corporation³⁰ or (2) a debt-financed activity.³¹ For example, income from master limited partnerships, which are publicly traded limited partnerships primarily investing in oil and gas pipelines, would be included as UBTI. Stocks purchased on margin or real estate purchased with a nonrecourse loan would be classified as a debt-financed activity, and income derived from those activities would thus count as UBTI.

If more than $1,000 of a retirement account’s net income is from UBTI, the fiduciary of the account is responsible for paying the tax and filing a Form 990-T. Because retirement accounts are treated as tax-exempt trusts, the income tax rates for trusts and estates would apply.³² Under amendments made by the Tax Cuts and Jobs Act, taxes on trusts reach the maximum 37 percent rate on taxable incomes of only $12,950 for 2020.³³ Although the same activities are subject to taxation in a taxable account, they are taxed at the lower individual income tax rates, which don’t reach 37 percent until taxable income is $518,400 or $622,050 for 2020, depending on the filing status.³⁴

VIII. Less Liquidity in Retirement Accounts

Unlike with taxable accounts, withdrawals from retirement accounts can be subject to a 10 percent penalty tax on any amount included in gross income.³⁵ The 10 percent penalty tax will increase the tax rate by 10 percent and significantly reduce the rate of return. The major exception to the penalty is for withdrawals made after age 59½.³⁶

There are, however, several other exceptions. For employer-sponsored retirement plans and IRAs, the 10 percent penalty is waived for death or disability of the taxpayer³⁷ and for distributions consisting of substantially equal periodic payments over the taxpayer’s life.³⁸ For employer-sponsored plans only, the penalty is waived for distributions to an employee for separation of service after reaching age 55³⁹ and for payments under a qualified domestic relations order.⁴⁰ For IRAs only, the 10 percent penalty is waived for first-time homebuyers (up to $10,000)⁴¹ and for qualified higher education expenses.⁴² If the taxpayer for an unforeseen reason needs access to funds and his only source of liquidity is a retirement account, the 10 percent penalty will need to be paid unless an exception applies.

IX. Health Savings Accounts

Although health savings accounts aren’t taxable accounts, they are worth addressing because they are arguably more tax efficient than retirement accounts. Contributions to HSAs up to specified limits are tax deductible,⁴³ earnings within the HSA are not taxable,⁴⁴ and distributions for qualified medical expenses are not included in taxable income.⁴⁵ Therefore, the effective tax rate is less than 0 percent, as opposed to 0 percent for retirement accounts (assuming constant tax rates).

To be eligible for an HSA, the individual must have a high-deductible health plan and maximum annual out-of-pocket expenses. For 2020, a single individual must have an annual deductible of at least $1,400, and a plan covering a family must have an annual deductible of a least $2,800.⁴⁶ A health plan, however, is allowed to have little or no deductible for preventative care.⁴⁷ The maximum out-of-pocket expenses (deductibles, copayments, and other amounts other than premiums) may not exceed $6,900 for single coverage or $13,800 for family coverage.⁴⁸

Similar to IRAs, there is an annual contribution limit to an HSA. For 2020 the annual contribution limit is $3,550 for an individual with self-only coverage and $7,100 for an individual with family coverage.⁴⁹ If the participant is at least age 55, an additional catch-up contribution of $1,000 is allowed.⁵⁰

Medical expenses are considered qualified if they meet the definition of medical care in section 213(d). Payments can be made only to the participant, spouse, or dependents. With exceptions, payments made for health insurance premiums are not considered qualified.⁵¹

If a distribution from an HSA is not for qualified medical expenses, it is included in gross income.⁵² Also, there is a 20 percent penalty tax imposed on the distribution.⁵³ Although the distribution is still taxable, the penalty is waived for nonqualified medical expenses once the taxpayer reaches age 65,⁵⁴ becomes disabled, or dies.⁵⁵

If a participant starts funding an HSA at an early age, the account can accumulate a considerable sum. For example, assume a participant begins to contribute $3,550 per year to an HSA at age 35 and continues making the same contribution annually until age 65.⁵⁶ If no distributions are made by the end of that 30-year period, at a 6 percent rate of return, $297,495 will be accumulated.⁵⁷ Of course, it’s highly likely that the participant will have withdrawn funds from the HSA to pay for out-of-pocket medical expenses over that period.

Fidelity Investments annually estimates what a retiring couple will spend on out-of-pocket medical expenses over their remaining lifetimes (starting at age 65). The most recent figure is $285,000.⁵⁸ Even if an HSA balance is not spent exclusively on medical expenses, disbursements for expenditures made after the participant reaches age 65 are included in gross income but not subject to the 20 percent penalty. Effectively, this is the same treatment given to a traditional deductible IRA, assuming the 10 percent tax penalty is avoided.

Most individuals will lack sufficient funds to contribute the maximum amount allowable to both an HSA and their retirement accounts. If an individual has contributed enough to an employer-sponsored retirement plan to take full advantage of any employer match and is eligible for an HSA, it will usually be tax advantageous for her to allocate at least a portion of her discretionary funds to an HSA.

X. Conclusion

Retirement plans are generally tax efficient. If tax rates are the same when contributions and distributions are made, the effective tax rate is zero. However, as discussed in this report, there are circumstances in which it might make more economic sense to allocate equity funds to a taxable account instead of a retirement account. This will normally be the case only if the individual with a taxable account otherwise maintains a tax-efficient equity portfolio by investing in an index or ETF equity fund or maintaining an individually managed stock portfolio in which capital gains are rarely realized. Almost without exception, an employee should make the requisite contribution to an employer-sponsored plan to take full advantage of any employer matching funds before considering an allocation to a taxable account.

If the individual has taken full advantage of any employer match and infrequently realizes capital gains, other factors might justify allocating funds to a taxable account, particularly if the taxpayer doesn’t have a high tax rate. Factors to consider are the opportunity to harvest capital losses in a taxable account, the opportunity for heirs to receive a stepped-up basis on appreciated capital assets upon the taxpayer’s death, not missing out on dividend withholdings from international stocks, and the possibility of lowering the equity portfolio’s expense ratio. Allocating fewer funds to a retirement account reduces the possibility that the RMD will result in a higher tax rate when those distributions begin. Retirement accounts can generate UBTI, whereas taxable accounts cannot. Retirement accounts are potentially less liquid because of the 10 percent premature withdrawal penalty; HSAs are generally more tax advantaged than retirement accounts, so they merit consideration in allocating an individual’s discretionary funds.

Although the decision of how to allocate funds between retirement accounts and taxable accounts (as well as HSAs) will depend on each taxpayer’s circumstances, a taxpayer shouldn’t automatically assume that a retirement account is the better choice.