Investing Outside Retirement Accounts: A Practical Guide to Growing Your Money

Most of the literature and discussion surrounding investing is focused overwhelmingly on investments inside tax-advantaged retirement accounts, and for good reason, since their special tax treatment is extremely valuable. Nevertheless, many investors have significant amounts of money outside these accounts, either saved for imminent use, stashed unproductively in cash, or saved for some purpose other than funding their retirement. This money should be treated differently and separately, due to the different tax dynamics, time horizons, and investment restrictions. It’s a frequent mistake for people to treat a taxable account as a piggy bank with a different label, when in fact a proper taxable investment strategy can produce far better results.

There are two primary categories of investment that most people should handle before considering more aggressive (and frequently riskier) allocations of their taxable investment dollars: paying down consumer debt and maximizing contributions to tax-advantaged accounts (typically employer-sponsored plans, IRAs, and/or self-employed accounts). Paying off installment loans like credit cards or bank loans typically provides an absolutely guaranteed return in the form of the interest rate on the loan, which frequently significantly exceeds the returns available on a comparative investment in taxes. Mortgages, by contrast, typically provide much lower rates of interest, and they’re also often tax-deductible, so the advantage is frequently much less clear. Tax-deferred investing, meanwhile, has enormous advantages which should be exploited to the maximum extent possible before allocating additional money to taxable accounts. Tax-advantaged or tax-deferred investing offers opportunities that taxable accounts simply don’t possess, so the latter should generally be pursued only after the former have been exhausted.

After establishing a basic allocation to both taxable and tax-deferred accounts, there is another, separate consideration known as asset location that affects how investors should deploy their money within a taxable account, with implications for the broader portfolio as well. Unlike asset allocation, which considers the mix of investments across a single account in general, asset location is concerned specifically with the relative position of investments inside a taxable account. The simplest way to summarize this consideration is that investments that have the potential to generate large amounts of taxable income should be placed inside a tax-deferred account whenever possible, and those that are inherently tax-efficient should be located in a taxable account.

A thoughtful approach to asset location can yield consistently superior results with no additional risk. Vanguard’s research has found that an optimally applied asset-location strategy typically produces between 5 and 30 basis points of additional annualized return on a portfolio, depending on its composition, due to the tax advantages. These benefits are substantial on their own, but they become even more valuable when one considers that the extra return is generated on the entire portfolio with no additional risk.

Stock funds are frequently much more tax-friendly than they initially appear, due to the way they’re structured and operated. Conventional mutual funds are required by law to pay realized capital gains – those arising from the sale or redemption of fund shares – to shareholders in the form of dividends at the end of the year, even if those shareholders did not redeem any shares themselves. ETFs, alternatively, avoid this particular tax liability (as well as the associated drag on returns) in most cases due to a structural feature known as in-kind redresses. When large institutional investors – who account for a considerable amount of the overall trade volume – wish to redeem shares in an ETF, they can do so in-kind, meaning that they receive actual securities comprising the underlying portfolio, instead of cash. As a result, the fund is not actually obligated to sell any of its securities directly – and therefore incur a taxable gain – when processing the redemption request. The result, for small investors, is dramatically lower tax liability with few disadvantages.

The tax benefits of ETFs and index mutual funds typically outweigh the costs several times over due to this unique tax efficiency, which causes them to generate significantly lower realized capital gains than actively managed funds. One study found that, while ETFs, index mutual funds, and actively managed funds – the last of which constitute the majority of all mutual funds – all had roughly similar levels of internal capital gains (between 4% and 6%), the amount of gains paid to shareholders in the form of dividends was significantly lower for ETFs – approximately 0.1% compared to nearly 4% for actively managed mutual funds.

The interest on municipal bonds is typically exempt from both federal and state income taxes, which makes their yields comparatively attractive (particularly for higher-income taxpayers). Nevertheless, the precise benefits should be evaluated on a case-by-case basis, in comparison to standard taxable bonds or a combination of the two, by calculating each bond’s tax-equivalent yield and comparing it to the yields of comparable taxable bonds. The tax-equivalent yield for a tax-exempt bond is a hypothetical yield that a taxable bond would need to match the yield of the tax-exempt one, taking the investor’s marginal tax rate into account. It’s relatively simple to calculate: you simply divide the tax-exempt yield of the municipal bond by (1 – tax rate).

When compared to a taxable bond, a 3.5% municipal bond is actually equivalent to a 4.49% taxable bond at the 22% tax bracket, a 5.15% taxable bond at the 32% tax bracket, and a 5.56% taxable bond at the 37% tax bracket. The higher one’s tax bracket is, the more attractive a comparable municipal bond is compared to a taxable one; thus, these bonds are most appealing to high-income earners and frequently unattractive to those with low incomes, who are much better off purchasing regular taxable bonds with higher yields.

The expected period of time before a given sum of money is needed should be the primary factor in deciding what (if any) account it should be kept in and how it should be invested. It is always preferable to locate funds that are likely to be needed in the near future (typically, within a year or less) in cash or cash substitutes rather than in interest-bearing or dividend-paying accounts. With regard to cash, it really depends on the precise situation, but a checking or savings account is usually sufficient for most purposes, as long as it avoids monthly maintenance fees or other unwise expenses. Money-market mutual funds typically provide a better yield than savings accounts while still being easily available, and a tax-free money-market fund is an especially attractive alternative for people with high incomes.

For funds that are available for a somewhat longer time but still need to preserve principal and provide income with predictable purchasing power, inflation-linked options are frequently the most sensible choice. Specifically, Series I savings bonds, which have a variable annual rate that consists of a fixed component and an inflation component that increases twice a year, currently offer a total rate of return of over 4%, with an annual purchase limit of $10,000 for most investors. As the time horizon lengthens, so does the ability to withstand short-term fluctuations in pursuit of long-term gains, which opens the door to a wider variety of riskier but more rewarding options: individual stocks, real-estate investments, and diversifying one’s portfolio with funds or exchange-traded funds that focus on these areas specifically.

None of this requires a single perfect investment. It requires matching money to its actual job: paying off expensive debt and filling retirement accounts first, placing tax-inefficient and tax-efficient holdings in the accounts where each does the least damage, understanding the specific mechanics that make certain funds and bonds more tax-efficient than others, and sizing every choice to when you'll actually need the money. Handled with that much intention, a taxable account stops being an afterthought next to retirement savings and becomes a real, flexible piece of the overall plan.

This article is for general educational purposes and isn't personalized investment or tax advice. Tax treatment depends on your individual circumstances and can change; consider talking with a licensed financial advisor or tax professional before making investment decisions.