Taxable Account vs. 401(k)

by Jack Ori

When putting money aside for retirement, you have several options. Many businesses allow you to put money into a 401k account -- a retirement savings account that you don't have to pay taxes on it until the account matures. You can also put your money into a regular investment account, but you must pay tax on the income you invest into this account as well as the gains.

Tax on Profits

Taxable accounts not only require taxes paid on your initial deposit, but also require you to pay taxes on your profits from the account every year. Conversely, when you deposit money into your 401k account, you don't pay taxes on that money -- it's pretax dollars. You also don't pay taxes on your investment income; you only pay taxes when you make withdrawals from the account.

Tax Brackets

How much tax you pay on either your taxable account or your 401k account depends on the tax bracket your investment pushes you into. If you make a large profit on a taxable account, it can make your income high enough to trigger additional taxes. The same thing can happen when you get distributions from your 401k. However, if you are already retired when you start taking 401k distributions, you may be in a significantly lower tax bracket to begin with than you are in while working.

Limitations

If you put money into a 401k, you can't take it out until you reach the age of 59 1/2. If you take it out earlier, it is subject to a 10 percent penalty for early withdrawal. If you are having a financial crisis, you may be able to waive the penalty, but you still will have to pay taxes on the distribution. Taxable accounts may also require you to keep your investment in the account for a certain period of time, but it may be a shorter period of time than your 401k.

Automatic Deductions

Most 401k plans allow you to elect automatic deductions from your paycheck. Thus, your employer withholds your 401k contribution and deposits it for you before paying you, so your contribution automatically goes into your account. If you open a taxable investment account, you usually have to manually deposit money into the account. Thus, you may not fund the account on a regular basis.