What are your goals, and how are you saving for them?
One of the most basic questions asked in financial planning, yet one of the hardest to answer for a client. A lot of times, clients don’t even know what they are saving for! The default is to save as much as they can into retirement accounts so that they can be prepared for retirement.
The clients I work with are typically younger so it is hard to believe that the only thing they have to look forward to is retirement. But, if you do not have a specific idea on what to save for, it seems like the easiest and most straightforward option.
When you are saving into a retirement account, you generally cannot access this money without taxes or penalties until you are 59.5 years old. There are some exceptions to the rules, but generally if you are saving in retirement accounts you should be following all the rules to ensure you are getting the tax benefits you originally signed up for by contributing to those accounts.
With limited accessibility, you should contribute to a retirement account only if this money is reserved for retirement. But what if you want to enjoy some of your savings before you’re 60? Enter: investing outside of a retirement account and in a taxable investment account.
A taxable account may also be called a “brokerage account”. This is an account opened with a custodian that allows investments. Some of the big banks that have these accounts include Robinhood, Schwab, Fidelity, Vanguard, etc.
Once opened, it is just like any other investment or retirement account. You can transfer money in and then invest in any available security or fund. The difference here is that your company sponsored retirement plan will have a set number of investment options; investing outside of the company sponsored retirement account opens up the whole investment universe, which can be overwhelming but also brings more flexibility. The bank will track all your transactions and report any taxable income at the end of the year in a 1099 statement.
Speaking of taxes….
The general reason individuals choose to save in a retirement account is for the tax benefits. The two main types of contributions are;
Pretax contributions, which allow deferral of taxes on contributions and investment growth until you withdraw (in retirement), or
Roth contributions, which are after tax contributions that allow you to never pay taxes on that money again (assuming you follow all the rules).
There is no way I can argue these benefits, and they can really help to compound the growth by avoiding any tax drag within your investments.
But you can also invest outside of retirement accounts in a tax efficient manner. Long-term capital gains taxes are reported when an investment is held for longer than one year. If you are investing in equities, it should be with the expectation you are holding on for at least one year anyways. Certain funds or investments may pay interest, dividends or capital gains distributions that should be considered.
Capital gains tax rates are somewhere between 0% - 20% vs. ordinary income tax rates that range from 10% - 37% (as of 2020). Although most states tax all income the same, some will also give a tax break for long-term capital gains (booyah, AZ). These capital gains taxes are not assessed until you sell an investment - if you do not sell, then there will be no taxes aside from any distributions mentioned above (interest, dividends and capital gains distributions). If you keep a buy and hold strategy with your investments, you may be able to defer taxes over a long period of time.
Any time you put pre-tax money into a retirement account and you take a taxable withdrawal, it will be taxed at ordinary income tax rates. There is no such thing as capital gains taxes in a retirement account (unless you hold company stock in a 401(k) called Net Unrealized Appreciation which is out of scope for this blog).
Even if there is an exception to allow a Roth IRA withdrawal prior to 59.5 years old (like education expenses, certain medical expenses, etc.), you may avoid a 10% penalty, but any investment income will be taxed at ordinary income tax rates. In this scenario, you would have changed the nature of the investment gains to ordinary income tax rates when you could have invested in a taxable account and kept more advantageous capital gains tax rates.
My point is that just because the IRS gives you rules that allow you to take withdrawals, this does not mean that it is the best way to save money. There still may be an added cost if you save into an account that is not conducive to your spending or goals. Saving into retirement accounts lowers your flexibility and can result in more costs.
Finally, if you have ever heard of tax-loss harvesting, this can only be done in a taxable account. This strategy helps you to realize paper losses while staying invested - and carrying forward investment losses indefinitely on your taxes to offset future investment gains. You cannot tax-loss harvest in a retirement account.
Whenever you save money into a retirement account, there are pros and cons. The main pro is tax advantages. The main con is that you must adhere to the IRS rules, or else you may undo those tax advantages AND get penalized.
The reverse is true with a taxable account; the pro is that there are no account rules, it’s your money and you can do what you want with it. The con is that you lose tax advantages, but as I mentioned above, depending on your situation it may even become more tax friendly. And just because it is “less tax advantageous” does not mean that it is tax disadvantageous.
For many of my young professional clients, there is a lot of life to live and still a lot of milestones to hit prior to retirement. Milestones are expensive! Here are some I can think of:
Wedding (followed by a honeymoon)
Starting a business?
Retire early - before age 59.5 ;)
Trip around the world?
Who knows what may be coming up for you, and the best way to prepare for what happens is to have the flexibility to fund these events as they come.
On top of this, having the peace of mind that you have this extra money that can be tapped at any time for any purpose, and available in your bank account in a day or two is priceless. This may be a great back up option in the event of an emergency fund being inadequate, and allows you to invest aggressively in your retirement accounts knowing that you have a few lines of defense before having to tap into these retirement accounts.
Final point: if you end up never spending this money, it can STILL be used for retirement and can help you have a “tax diversified” portfolio.
People talk about being “house rich, cash poor”, well what about “retirement rich, cash poor”? Has anybody ever said “dang I wish I didn’t save so much for retirement”? Maybe not, but it may have been said in a different way to the tune of “man I wish I had had a few more experiences while I was still young and had more energy”.
This is definitely not to say do not invest in retirement accounts, but to say do not wait until you are 65 and retired to enjoy your life. Plan responsibly for the future, but find that balance that allows you to enjoy your money today.