The Benefits of Not Saving in a Retirement Account
Qualified retirement plans are often marketed as an effective way to save money for the future because of their tax advantages. In the right situation, this can be true, but many investors get so caught up in saving through their retirement plans that they overlook other available options. You should consider saving at least some money outside your retirement plans, as they have only a few disadvantages while offering several unique benefits.
What is a Retirement Account?
When financial advisors refer to a retirement account, they are typically referring to a qualified plan that meets certain requirements set by the IRS and offers several tax advantages. The 401(k) and the Individual Retirement Account (IRA) are two examples of qualified retirement plans.
The most common tax advantage of qualified retirement plans is that they offer tax-deferred growth. As long as you keep your savings in these accounts, you won’t owe taxes on your investment earnings. If you own stock that pays a dividend or you sell shares for a gain, you won’t have any taxable income provided you keep the money in your plan. Doing this can lead to a higher long-term rate of return because you aren’t losing money every year to taxes.
Some qualified retirement plans, such as the 401(k) and the traditional IRA, also offer a tax deduction for your contributions. With this benefit, you can save money for retirement while also reducing your current tax bill.
Problems with Retirement Accounts
While the tax benefits of retirement accounts can be very useful, they come with a number of restrictions that can be problematic. First, there are limits regarding the amount you can invest per year in a retirement plan. For example, as of 2013, the most you can contribute in a 401(k) per year is $17,500 if you are younger than 50 and $23,000 if you are 50 or older. There’s no guarantee you can invest even this much, as your annual contribution limit is based on certain factors, such as your salary and the way your company set up the 401(k).
Retirement accounts also limit when you can take out your money. Since they are retirement plans, you are supposed to keep this money in the account until you turn at least 59 1/2 or 55 for work plans if you leave your job. If you withdraw money before then, the IRS will charge income tax plus a 10 percent penalty. In a few special situations, you can take out money early without the penalty, but retirement accounts generally restrict your ability to withdraw money before you reach retirement age, which can be a problem if you want to retire early.
Once you retire, all your withdrawals from retirement plans will be taxed as income, which is usually at a higher rate than what you would pay for taking money out of non-retirement plans. Finally, the IRS mandates that you start taking money out of retirement accounts by a certain age. These withdrawals are known as required minimum distributions (RMD) and start when you turn 70 1/2. If you don’t do this, the IRS will charge a tax penalty worth 50 percent of what should have been taken out, which can be a problem if you don’t need the money and wanted to leave it as an inheritance. You’ll be forced to make withdrawals and pay taxes anyway.
Some non-retirement investments are worth considering. One option is to invest in a regular brokerage account, which is just like investing through your retirement plan, where you can buy and sell stocks, bonds, and mutual funds. The main difference is that a regular brokerage account doesn’t have the tax advantages and restrictions of a qualified retirement plan.
You can also use a brokerage account to make more sophisticated investments that aren’t allowed in a retirement plan. These investments include such trades as short selling stocks, investing in futures contracts, or buying and selling option contacts. Handled properly, these trades can help increase the return of your portfolio, but you won’t have these investment options in a retirement plan.
Investing in real estate is another popular alternative to saving through a retirement plan. Buying some real estate can help diversify your investment portfolio, and the IRS also offers several tax advantages that can be quite helpful.
Non-Retirement Accounts—Fewer Restrictions
One advantage of non-retirement accounts is that these investments offer considerable flexibility. Having these accounts can be helpful in different ways. First, you can take money out of these investments whenever you want. These accounts don’t have the same restrictions as qualified plans, and the IRS doesn’t charge a penalty on early withdrawals. You can take your savings out of these investments at your convenience.
At the same time, you can also keep money in your non-retirement accounts as long as you want. The IRS doesn’t have any required minimum distribution rules for these investments. If you reach retirement age and realize you don’t need the money, you can hold onto the investments for the future or just never sell them and leave them as an inheritance for your heirs. You will never be forced to take a distribution.
Non-Retirement Accounts—Possible Tax Advantages
When you withdraw money from your non-retirement investments, taxes are usually less than when you take money out of a retirement account. One reason is because you will have basis in these assets. Basis is the money you paid into an investment. The IRS lets you get this money back tax free so that when you sell a stock in a brokerage account not all the proceeds will be taxable. Your savings in a retirement plan don’t have basis because you put in before-tax money. As a result, when you take money out, the entire withdrawal is taxable.
You can also minimize the taxes on your non-retirement investments. If you lose money on an investment, you can use that loss to offset the gains on your other investments. By timing your sales properly, you can minimize the taxes on your gains. If you have significant losses, you can also take up to a $3,000 deduction against your regular income. In addition, if you hold onto an investment for more than a year, when you sell it for a gain, the gains will be long term. The long-term gain tax rate is 20 percent. The IRS taxes withdrawals from retirement plans at your income tax rate, which likely will be higher.
Non-Retirement Accounts—Charitable Contributions
Finally, non-retirement investments are usually better for philanthropic activities. If you want to give away stock from a brokerage account, you can just directly transfer the shares without selling them, which can be beneficial. You don’t ever have to pay taxes on your capital gains. At the same time, you get a deduction for the full market value of your stocks. If you wanted to make a donation from a retirement account, you’d have to withdraw the money, pay taxes on the withdrawal, and then make the donation.
Retirement plans should have a place in your financial plan. Just make sure they aren’t the only part of your financial plan because you’d be missing out on the many benefits of non-retirement accounts. To build a balanced investment plan, you should consider working with a professional. Call one of our financial advisors at R.W. Rogé & Company for more information on both your retirement and non-retirement investment options.