When planning for retirement, one of the most common pieces of advice is to maximize your 401(k) or Individual Retirement Account (IRA). While these accounts offer significant tax advantages, relying solely on them may not be the best strategy.
Financial advisers are increasingly urging individuals to diversify their retirement savings across different types of accounts to manage taxes better and maintain flexibility. Here’s why focusing exclusively on 401(k)s and IRAs could be a mistake.
1. Potential Tax Disadvantages
While 401(k)s and IRAs provide tax-deferred growth, meaning you don’t pay taxes on contributions or earnings until you withdraw the money, this tax deferral can become a double-edged sword.
The future tax landscape is unpredictable, and there’s a significant chance that tax rates will be higher when you retire, especially if you’re drawing large sums from these accounts.
Higher Tax Rates at Withdrawal
Withdrawals from 401(k)s and traditional IRAs are taxed as ordinary income, which could push you into a higher tax bracket.
For example, if you’ve accumulated a significant amount in these accounts, substantial withdrawals could result in higher taxes, reducing the amount of money you actually get to keep.
In contrast, income from investments held in a brokerage account is often taxed at lower long-term capital gains rates.
Required Minimum Distributions (RMDs)
Starting at age 73, you must begin taking Required Minimum Distributions (RMDs) from your 401(k) or IRA, whether you need the money or not.
These forced withdrawals can increase your taxable income, potentially triggering higher taxes on Social Security benefits and increasing Medicare costs.
Moreover, RMDs limit your control over when and how much money you withdraw, which can be particularly burdensome if tax rates are unfavorable.
2. Lack of Tax Diversification
Tax diversification—spreading your investments across different types of accounts—can provide more flexibility and potentially lower your overall tax bill in retirement. By having a mix of tax-deferred, tax-free, and taxable accounts, you can strategically manage your withdrawals to minimize taxes.
Roth Accounts
Roth IRAs and Roth 401(k)s are funded with after-tax dollars, meaning you won’t owe taxes on withdrawals as long as you meet the age and holding period requirements.
Unlike traditional 401(k)s and IRAs, Roth accounts are not subject to RMDs, allowing your money to grow tax-free for as long as you like. Additionally, Roth accounts can be especially beneficial if you expect to be in a higher tax bracket in retirement.
Brokerage Accounts
Brokerage accounts offer another layer of tax diversification. Unlike retirement accounts, they are not subject to RMDs, and long-term capital gains taxes on investments held for more than a year are typically lower than income tax rates.
Moreover, inherited brokerage accounts benefit from a “step-up” in basis, which can significantly reduce the tax burden on your heirs.
Health Savings Accounts (HSAs)
HSAs are a triple tax-advantaged savings vehicle for those with high-deductible health plans. Contributions are tax-deductible, the account grows tax-free, and withdrawals for qualified medical expenses are also tax-free.
In retirement, you can use HSA funds for healthcare costs or keep receipts for past expenses and withdraw the money tax-free later.
3. Flexibility and Control Over Withdrawals
Relying solely on 401(k)s and IRAs can limit your control over your retirement income strategy. Diversifying your retirement savings across various accounts gives you more options to manage your income and taxes effectively.
Strategic Withdrawals
With a mix of tax-deferred, tax-free, and taxable accounts, you can choose which account to withdraw from based on your tax situation each year. For instance, if your income is lower in a particular year, you might withdraw from a traditional IRA.
In years when your income is higher, you could tap into your Roth IRA or brokerage account to minimize the tax impact.
Avoiding Tax Traps
By spreading your investments, you can avoid tax traps that might arise from RMDs or large withdrawals from a single type of account.
This approach also helps in managing your tax brackets more efficiently, ensuring that you don’t unintentionally bump yourself into a higher tax bracket by withdrawing too much from a 401(k) or IRA.
While 401(k)s and IRAs are valuable tools for retirement savings, they shouldn’t be your only focus.
Diversifying your retirement accounts—by including Roth IRAs, brokerage accounts, and HSAs—can help you manage taxes more effectively, increase your withdrawal flexibility, and protect your financial future against unpredictable tax rates.
By adopting a more diversified approach, you’re not just diversifying your assets but also safeguarding your retirement from potential tax pitfalls.
FAQs
Why might relying solely on 401(k)s and IRAs be a bad idea?
Relying only on these accounts can lead to high taxes in retirement and limit your withdrawal flexibility.
What are the tax implications of 401(k) and IRA withdrawals?
Withdrawals are taxed as income, which can push you into higher tax brackets.
How can Roth accounts help in retirement planning?
Roth accounts offer tax-free withdrawals and are not subject to RMDs, providing more flexibility.
What is the benefit of having a brokerage account in retirement?
Brokerage accounts are taxed at lower long-term capital gains rates and are not subject to RMDs.
Why is tax diversification important in retirement?
Tax diversification helps manage your tax burden more effectively and provides flexibility in choosing the best withdrawal strategy.
