The Better Investor Savings Bucket

There are many nice tax savings features of tax-favored retirement accounts—Individual Retirement Accounts, Roth IRA’s, 401(k) Plans, etc. And I’ve written a large number of posts about them. One of the subtler benefits of tax-favored retirement accounts compared to taxable investment accounts is how they make you a better investor.

Think about it. When you have your savings in a taxable investment account, the income tax consequences taints every investment move you make (or neglect to make).
• You tend to prefer tax-exempt municipal bonds over treasury or corporate bonds—so you don’t have to pay federal income tax on the interest.
• You tend to prefer your own state’s municipal bonds over your neighboring state’s, so you don’t have to pay state income tax on the interest.
• You tend to prefer stocks over bonds so you can benefit from temporarily tax-free appreciation and lower-taxed capital gain instead of taxable interest.
• You tend to prefer growth stocks over dividend-paying stocks for the same reasons.
• You tend to hold onto stocks that have substantially appreciated to avoid triggering a whopping capital gain.
• For the same reason, you tend to avoid rebalancing your mix of stocks and bonds to get back to your desired asset allocation.
• You tend to hold onto recently purchased stocks for longer than you might otherwise wish so you can turn high-taxed short-term gain into low-taxed long-term gain.
• As you age, you tend to hold onto highly appreciated stocks so your family can benefit from the increase in tax basis that occurs at death. Which some days feels like it’s just around the corner, doesn't it?
• When your stocks lose value, you tend to sell them prematurely for no other reason than to benefit from the tax losses.

All of these distortions in your thinking and acting just melt away when your investments are in a tax-favored retirement account. The shelter of its tax-exemption allows you to make the right investment decisions untainted by extraneous tax consequences. Goodness knows it’s hard enough to do that without the Tax Code breathing down your neck.