Since their invention in the 1970s, retirement accounts like the 401(k) and the traditional IRA have been touted as ideal ways to tuck money away for retirement. And in many ways, they live up to the hype. Tax-free growth of tax-deductible contributions to these vehicles really lets you rack up gains without being held back by tax concerns along the way.
As with most choices in life, however, this one comes with trade-offs. Although postponing taxes — and simply managing the taxation of this money — has its obvious benefits, retirement accounts have their downsides too.
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To this end, here’s a closer look at five reasons why you might not want to keep all of your retirement savings in an IRA or 401(k).
1. Your money is tied up — at a cost
OK, contributions to a retirement account aren’t exactly inaccessible once they’re in there. Getting to this money could come at a cost, though. If you’re not yet 59-1/2 years old when you take it out, it’s taxed as income when it’s withdrawn, in addition to a 10% penalty on the amount withdrawn.
There are some reasonable exceptions that can negate this penalty, such as medical expenses, using the money for a first-time home purchase, or unforeseen catastrophic emergencies. Outside of these expenses, though, plan to pay a modest amount above and beyond any taxes due.
Withdrawals from taxable brokerage accounts and savings accounts, of course, don’t incur these costs.
2. Less flexibility, fewer options
This probably won’t apply to all investors. In a handful of cases, though, you won’t be able to do as much with a retirement account as you can with an ordinary brokerage account. For example, brokerage accounts can be marginable. Retirement accounts can’t.
Margin accounts are simply brokerage accounts that allow you to borrow money to own more stocks, potentially achieving more returns than you otherwise might. Margin accounts also allow you to earn interest by lending out shares of stocks you own to short sellers of those same tickers. Certain kinds of option trading strategies also require margin, along with approval from your broker.
It’s also possible — albeit relatively rare — that you won’t be able to hold an unusual asset in a retirement account that you might be able to hold in a brokerage account. Real estate that’s personally owned or controlled by you, real precious metals (including gemstones), life insurance, and S corporations are typically not allowed in an IRA.
3. You’ll eventually be forced to make withdrawals anyway
Contributions to retirement accounts may be tax-deductible, and the growth of your investments may be tax-free. That won’t be the case forever, though. Sooner or later, you will be required to start taking money out of these accounts — the year in which you turn 73, in fact. They’re called required minimum distributions, or RMDs.
This, in and of itself, isn’t disastrous. The cash or investments in your 401(k) or IRA are still fully yours when you withdraw them. Besides, while retirement accounts defer or postpone taxation, they were never meant to simply sidestep taxes indefinitely.
There is one potentially significant downside of RMDs, though. That is, in most cases, the entirety of this withdrawal is taxable as income. If the minimum distribution (as dictated by the IRS’s RMD rules) is big enough, it could bump you into a higher tax bracket.
4. No interim tax benefits
Paying taxes upon withdrawal isn’t the only potential tax-related drawback with IRAs and 401(k) accounts, though. In the same way that the growth, profits, and income the investments held in a retirement account don’t result in annual taxable gains, you also don’t get to reduce your yearly tax bill by offsetting any income with investment losses suffered in these accounts.
Obviously, you’d still rather not take any losses for any reason at any time. It happens, though. Not getting any break for suffering such setbacks in an IRA, however, could ultimately cause you to compound this drawback by inspiring you to stick with a losing position you’d happily otherwise get out of were it in a taxable brokerage account.
5. You’re betting on uncertain future tax brackets
Last but not least, the overarching premise of IRAs and 401(k) accounts is using tax-deductible contributions now and deferring the taxation of this money’s growth to a time when you’ll be in a lower tax bracket. And for most people most of the time, the strategy works. You’ll likely earn less taxable income in retirement, when you’ll also likely need less income.
This isn’t a guarantee etched in stone, however. Lower-income workers who are also disciplined savers and investors could end up making more money in retirement. And while it’s not been a problem yet, it’s not inconceivable that tax brackets and tax rates could change in the future in a way that puts people with a great deal of their retirement savings in retirement accounts at a disadvantage.
You may not like your top marginal tax rate right now, but there’s much to be said for at least knowing exactly where you stand and what you’ll owe.
Think strategically, recognizing and responding to the pros and cons
Is this a warning meant to discourage you from putting any money into retirement accounts? No. It’s just some food for thought. IRAs and 401(k) accounts still have their obvious upsides. For many investors, though, a more thoughtful, strategic mix of both account types could be in order.
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You’re Making a Huge Mistake if You Keep All Retirement Savings in an IRA or 401(k) was originally published by The Motley Fool
Disclaimer : This story is auto aggregated by a computer programme and has not been created or edited by DOWNTHENEWS. Publisher: finance.yahoo.com
