The standard — and very good — advice about retirement savings is to maximize your contributions in tax-deferred plans such as 401(k)s and IRAs. That way, the thinking goes, your money compounds without being reduced by taxes and if you wind up in a lower bracket in retirement, you’ll owe less in taxes on the money than if you paid them while working full-time.
But that advice has its limits.
In some cases, you’d be better off saving for retirement in an account that isn’t tax deferred and paying any taxes on the earnings each year in exchange for more freedom. That’s because tax-deferred accounts come with strings attached.
In the recession, some people younger than 59½ needed to take money out of their plans to pay the bills and paid a hefty price to do so.
Savings earmarked for retirement but placed in regular (not tax-deferred) brokerage or mutual fund accounts offer you flexibility that may be better for you than a current tax exclusion.
Here are four good reasons:
- You may need the money before you turn 59 ½
- You may not need to withdraw the money once you turn 70 ½
- There is no guarantee that your tax bracket in retirement will be lower than it is now
- If you’re a top earner at a small company, you may find yourself restricted on the amount you can contribute to the employer’s plan
The Penalty for Early Withdrawals
In the last recession, a lot of people younger than 59½ found themselves needing to take money out of their retirement plans just to pay the bills and they paid a hefty price to the Internal Revenue Service to do so. If you withdraw from a traditional IRA or 401(k) before that age, you generally owe income taxes and a tax penalty equal to 10 percent of the amount you withdraw. The 10 percent penalty may be waived on a 401(k) withdrawal if you leave your employer at age 55 or older.
Some people figure they can get around the early withdrawal penalties by structuring the withdrawal as a loan, but that’s problematic because the IRS rules are complicated.
“Figure out another way to get the money,” says Melody Juge, an investment adviser with Life Income Management in Flat Rock, N.C.
Sure, you can take out actual loans against a 401(k) in many circumstances. But that money generally must be repaid within five years.
Mandatory Withdrawals on Retirement Accounts
The IRS requires you to start withdrawing money from a traditional IRA or 401(k) at age 70 ½; Roth IRAs have no such rule, but Roth 401(k)s do. The requirement to take money by age 70 ½ could be a problem for someone who may not retire as early as the tax laws assume.
“Tax-deferred accounts do not mean tax avoidance,” says Larry Ludwig, who runs a financial blog called Investor Junkie.
Ludwig notes that if you have money in a tax-deferred plan and are in a very high tax bracket in a year after you turn 70 ½, you’ll have to withdraw money from the plan and pay taxes on it whether you want to or not.
“People haven’t really thought about this,” Ludwig says. He recommends diversifying the tax structure of your retirement investments, keeping some money in tax-deferred accounts and some in ones that aren’t tax-deferred.
The Uncertain Future of Tax Rates
The benefits of tax deferral assume that future tax rates will be significantly lower than today’s. Given the deficits faced by the federal government and by most states, however, it’s difficult to say that that will be the case.
If the marginal tax rate you’ll pay in retirement is higher than the one you face today, you’re better off paying the taxes now, according to recent research published in the Financial Analysts Journal.
Keeping your retirement savings in investments with different tax treatments is one way to hedge the risk of costly tax-law changes.
Eric McClain, a Certified Financial Planner with the McClain Lovejoy financial planning firm in Vestavia, Ala., says investors should think about tax planning over decades rather than simply dividing time into before retirement and after retirement.
“We sometimes see early retirees with effective tax rates of 10 percent, but with looming IRA-required withdrawals and Social Security pushing them into the 25 percent plus bracket,” he says.
Depending on the client, McClain may recommend: converting the traditional IRA to a Roth IRA; large IRA withdrawals in years with a low marginal tax rate to reduce future required distribution or changes in asset allocation to include more non-taxable investments.
Limits for Some Small Business Employees
Senior employees at small companies may have another reason to keep some retirement money in an account that’s not tax-deferred. The IRS sets limits on how much money can be contributed in an employer plan based on the worker’s income and age, as well as levels of participation in the retirement plan. So low employee participation in a small business 401(k) plan can limit the amount senior employees can contribute.
If you find yourself in that position and can afford to put extra money away for retirement, invest it in an account that’s not tax-deferred so you can help yourself have a comfortable retirement.
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