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I've had this question for a little while and I asked a professional about it today, but I don't think I worded it well. As such, I didn't get a good answer.

Theoretically, given an equivalent amount of money, why would I put my money into a 401k or IRA instead of another investment vehicle?

From what I understand, capital gains are not taxed unless they are realized. (I understand that dividends may be different, even if reinvested, although I'm not quite sure.) The major benefit of a traditional 401k or IRA is the way the taxes are handled; you are not taxed on contributions you make until you begin pulling from the account.

I'm not sure how this is different than a non-retirement account. Couldn't you invest for long-term capital gains (as many retirement plans do) and achieve a similar result by realizing the gains later on and being taxed on those? Or is it the contributions that are the key here?

Additionally, since retirement accounts have a contribution limit (year 2015 in the US, where I live, it's $18,000 and $5,500 for the 401k and the IRA, respectively), wouldn't investing without the retirement account let you contribute more if you were capable of doing so?

I want to note that I'm asking this for knowledge purposes. (Knowledge is power, and this stuff is cool!) I do currently enjoy a 401k and Roth IRA and I don't intend to give them up soon. I suppose the real area of knowledge I'm looking for is how different kinds of investments are taxed.

Thanks!

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First of all, there are some differences between the retirement accounts that you mentioned regarding taxes. Traditional IRA and 401(k) accounts allow you to make pre-tax contributions, giving you an immediate tax deduction when you contribute. Roth IRA, Roth 401(k) are funded with after tax money, and a non-retirement account is, of course, also funded with after tax money. So if you are looking for the immediate tax deduction, this is a point in favor of the retirement accounts.

Roth IRA & Roth 401(k) accounts allow the investment to grow tax-free, which means that the growth is not taxed, even when taking the investment out at retirement. With Traditional IRA and 401(k) accounts, you need to pay tax on the gains realized in the account when you withdraw the money, just as you do with a non-retirement account. This is a point in favor of the Roth retirement accounts.

To answer your question about capital gains, yes, it is true that you do not have a capital gain until an investment is sold. So, discounting the contribution tax deductions of the retirement accounts, if you only bought individual stocks that never paid a dividend, and never sold them until retirement, you are correct that it really wouldn't matter if you had it in a regular brokerage account or in a traditional IRA. However, even people dedicated to buy-and-hold rarely actually buy only individual stocks and hold them for 30 years.

There are several different circumstances that will generally happen in the time between now and when you want to withdraw the money in retirement that would be taxable events if you are not in a retirement account:

  1. If you sell an investment and buy a different one, the gains would be taxable.

  2. If you want to rebalance your holdings, this also involves selling a portion of your investments. For example, if you want to maintain an 80% stock/20% bond ratio, and your stock values have gone up to 90%, you might want to sell some stock and buy bonds. Or if you are getting closer to retirement, you might decide to go with a higher percentage of bonds. This would trigger capital gains.

  3. Inside a mutual fund, anytime the management sells investments inside the fund and realizes capital gains, these gains are passed on to the investors, and are taxable. (This happens more often with managed funds than index funds, but still happens occasionally with index funds.)

  4. Dividends earned by the investments are taxable.

Any of these events in a non-retirement account would trigger taxes that need to be paid immediately, even if you don't withdraw a cent from your account.

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Ben Miller's answer is very thorough, and I up voted it. I believe that the ability to rebalance without tax implications is very import, but there are two aspects of the question that were not covered:

  • The 401K in many cases comes with a company match. Putting enough money into the fund each year to maximize the match, give you free money that is not available in the non-retirement accounts. The presence of that match is to encourage employees to contribute: even if they are tying up their funds until retirement age; and they are into a plan with only a handful of investment options; and they may have higher expenses in the 401K.

  • The question also had a concern about the annual limits for the 401K (18,000) and the IRA (5,500). The use of a retirement account doesn't in any way limit your ability to invest in non-retirement accounts. You can choose to invest from 0 to 23,500 in the retirement accounts and from 0 to unlimited into the non-retirement accounts. Double those amounts if you are married.

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