Individual retirement accounts (IRAs) and 401(k) plans have long been celebrated for their ability to offer significant tax benefits, which help individuals grow their retirement savings more efficiently. Contributions to these accounts, particularly traditional IRAs and 401(k)s, are made on a pre-tax basis. This effectively reduces taxable income during the contribution years, allowing investors to defer taxes on their earnings until withdrawals begin in retirement.
Beyond the tax deferral on contributions, any capital gains, dividends, or interest earned within these accounts accumulate tax-free year after year. Taxes are only due when money is withdrawn, which typically occurs post-retirement. This makes IRAs and 401(k)s advantageous vehicles to build a nest egg over the long term.
Despite these advantages, there are important considerations and limitations associated with these retirement accounts that investors need to understand. A significant constraint is the lack of flexibility due to regulatory requirements imposed by the IRS. For example, individuals are usually obligated to start taking required minimum distributions (RMDs) at a certain age, forcing withdrawals regardless of whether they need the funds.
Moreover, early access to savings in IRAs and 401(k)s—specifically withdrawals taken before the age of 59 1/2—generally incurs a 10% penalty on top of any regular income tax liabilities, except under certain exceptions. However, life’s unpredictability means there could be scenarios requiring access to these funds sooner than expected, which can result in costly penalties.
Consider the possibility of an individual who plans to remain employed until age 62, the earliest age to claim Social Security benefits. If that person faces a layoff at age 57, finding new employment might prove challenging. In such cases, tapping into retirement savings could become a necessity.
There are some exceptions to early withdrawal penalties. For instance, if you leave your employer during or after the year you turn 55, penalty-free access to that employer’s 401(k) might be allowed. However, if you have recently changed jobs and possess only a modest balance in your current 401(k), your main retirement funds—likely held in an IRA—may not be accessible without penalties.
This example highlights the importance of maintaining some portion of retirement savings in a taxable brokerage account. Unlike IRAs and 401(k)s, taxable accounts do not have age restrictions or penalties for withdrawals, granting investors full access to their money whenever needed. This liquidity provides a vital safety net for unexpected circumstances where early access to funds is necessary.
Nevertheless, the tax advantages offered by IRAs and 401(k)s mean they should generally remain a priority in retirement planning. Where possible, individuals should aim to maximize contributions to these accounts before allocating funds toward taxable investments. However, practical limits exist, especially with 401(k) plans, which have high contribution maximums that may not always be fully achievable.
Given this, a sensible approach would involve first contributing enough to a 401(k) plan to secure the full employer match, which is essentially free money increasing overall returns. Any remaining savings available for retirement should then be flexibly allocated between further tax-advantaged contributions and taxable brokerage accounts.
For illustration, if one can allocate $12,000 annually toward retirement savings and receives a $5,000 employer match in their 401(k), they should contribute at least the $5,000 match. The remaining $7,000 could be split, such as investing half in the 401(k) and the other half in a taxable account.
The exact proportion between these accounts depends on individual circumstances and preferences. The key takeaway is ensuring a portion of savings remains accessible outside of restricted accounts to accommodate unexpected life changes, thereby avoiding unnecessary penalties and maintaining financial stability.
In summary, IRAs and 401(k)s are powerful savings tools due to their tax benefits but come with constraints that can hinder access to funds prior to retirement age. Incorporating taxable brokerage accounts into retirement planning enhances flexibility and provides a buffer against unforeseen events requiring early withdrawal. Thoughtful allocation between these accounts tailored to personal financial goals and contingencies can lead to a more resilient retirement strategy.