Key Reasons Why a Taxable Account May Be Underrated, Part 1

Tax-sheltered savings vehicles offer tax-deferred compounding, meaning investors won't pay any taxes on a year-to-year basis as long as they don't withdraw any assets. And depending on the vehicle, they may also receive a tax break on contributions and/or withdrawals, too. Those tax breaks can help enhance take-home return.

With all the attention paid to accumulating money in those tax-sheltered accounts, many investors see saving in a taxable account as a last resort—something to be considered only after they've fully funded their tax-sheltered accounts.

But investing via a taxable account can be a sensible maneuver, and not just if you're running out of tax-sheltered receptacles for your money. In fact, investors may want to consider simultaneously funding their taxable and tax-sheltered accounts, and the current tax and interest-rate environment make saving in a taxable account particularly sensible. Here are six key reasons why.

Reason 1: Flexibility.

Investing via a taxable account carries two key advantages, both of which make the taxable account more flexible.

First, liquidity: If you have near-term income needs or are simply building an emergency fund, a taxable account will allow you access to your money without any strings attached (though you may owe taxes if your investments have appreciated). True, a Roth IRA allows you to tap your contributions (not your investment earnings) at any time and for any reason, which is one reason it's a suitable vehicle for younger investors who are conflicted between saving for near-term financial goals and retirement. But for higher-income folks who need to use their tax-advantaged options for retirement savings, putting money for liquidity needs into a taxable account may be the way to go.

The other reason investing in a taxable account is so flexible is that you can invest in literally anything. You'll have to choose from a preset menu if you're investing in a company retirement plan, for example. And while you may have more leeway when investing in an IRA, there are still a few investment types that are off limits. A taxable account is the one account type that gives you carte blanche. (Of course, it also gives you more opportunity to make mistakes!)

Reason 2: Compounding and potentially minimizing taxes if you plan carefully.

When investing inside of a taxable account, it may not be all that difficult to simulate the tax-deferred compounding you get with many tax-sheltered vehicles. The key is to choose investments that kick off limited taxable income and capital gains distributions. For example, income from municipal bonds is exempt from federal and in some cases state income taxes. Choosing tax-efficient securities can make it possible to buy and hold a basket of securities for years inside a taxable account while owing very little in taxes on that portfolio during your holding period.

It's also worth noting that income is low on an absolute basis right now, so the tax hit associated with owning securities that produce income that is taxed at your ordinary income tax rate is also going to be pretty low, at least in dollar terms. (That will change if yields go up, though.)

Reason 3: You can use tax losses to reduce your tax bill.

In addition to the ability to have your assets grow without owing a lot in taxes, investing in a taxable account also gives you the ability to harvest losses, something that is not easy to do with investments held inside tax-sheltered accounts. You can sell securities that are trading below your purchase price and use your loss (the difference between your purchase price and your sale price) to offset capital gains or, if you still have excess losses, up to $3,000 in ordinary income.