You can use both employer-sponsored 401(k) accounts and taxable investments to grow your money. Despite the similarities between these investment options, different rules apply to the taxation of your contributions, earnings and capital gains. Additionally, taxable accounts provide you with a greater degree of liquidity and more investment options than 401(k) accounts.
Contributions to your 401(k) are made on a pre-tax basis, and the account grows tax deferred, which means your earnings compound before taxes are assessed. Additionally, many employers make matching contributions to 401(k) accounts, which increases your bottom line significantly over time. On the downside, 401(k) accounts are subject to annual contribution limits. Taxable accounts contain money that has already been taxed. You do not get the benefit of matching contributions, and you have to pay income tax on dividends and interest earnings for the year they are earned. However, no annual contribution limits apply to taxable investment accounts.
The shares you hold in a 401(k) generally grow in value over the course of your investment term. When you withdraw from your account, you pay income tax on your contributions, your earnings and any realized capital gains. With a taxable account, you pay capital gains annually rather than ordinary income tax on gains that you realized as a result of shares growing in value. For shares held less than a year you pay the short-term capital gains rate, which is the same as your ordinary income tax rate. For shares held more than a year, you pay the long-term capital gains rate. For many investors, the long-term gains rate amounts to much less than their ordinary income tax rate.
Typically, a 401(k) plan contains several mutual funds. The funds are selected by the 401(k) plan custodian, and you may choose which funds to buy with your contributions. Investments in taxable accounts are not restricted; you can invest your cash in any type of security that you choose without having to decide between a narrow list of mutual fund options. Additionally, 401(k) plans cannot include tax-exempt investment options such as municipal bond funds. You can buy tax-exempt funds and securities as part of your taxable investment.
You can sell or liquidate taxable investments at any time without having to pay tax penalties, although you may have to pay any applicable capital gains tax. Additionally, you may have to pay sales commissions or interest penalties when you cash in some mutual funds or certificates of deposit. Withdrawals from 401(k) accounts are also subject to income tax and possible sales commissions paid on the underlying mutual funds. However, you also pay a 10 percent tax penalty for making withdrawals from a 401(k) before reaching the age of 59 1/2. You can avoid this penalty fee in certain severe economic circumstances, but no such penalty applies to taxable accounts.
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