Saving for retirement is one of the most important financial goals, and many people are advised to maximize their 401(k) or IRA contributions. These tax-advantaged accounts offer a great way to grow your savings.
However, some financial advisors warn against putting all your retirement funds into just these accounts.
The reason? Focusing exclusively on 401(k)s and IRAs can limit your flexibility, increase your tax burden, and even affect your ability to manage finances in retirement. Here’s why diversifying your retirement savings strategy could benefit you in the long run.
The Downside of Relying Solely on 401(k)s and IRAs
Tax Uncertainty
One of the biggest concerns with relying heavily on tax-deferred accounts like 401(k)s and IRAs is tax uncertainty. These accounts allow you to defer paying taxes until you withdraw funds in retirement, but no one knows what tax rates will look like decades from now.
Many financial advisors, such as Daniel Razvi from Higher Ground Financial Group, highlight that tax rates could be significantly higher when you retire. This could eat into the money you’ve saved.
An analogy to consider: Imagine entering a business deal where one party can change the terms after 20 years. This is essentially the risk with 401(k)s and IRAs—by the time you need to withdraw funds, the “terms” (tax rates) could have worsened, leaving you with less money than expected.
Higher Tax Rates in Retirement
When you start withdrawing from your 401(k) or IRA, the money is taxed as ordinary income. Income tax rates tend to be higher than long-term capital gains tax, which is what you’d pay on investments from a traditional brokerage account.
For instance, if most of your retirement savings are in IRAs or 401(k)s, you could be trapped paying higher taxes, especially if tax rates rise or your income in retirement pushes you into a higher tax bracket.
Retirement account withdrawals could also trigger Required Minimum Distributions (RMDs) once you reach age 73.
These RMDs are mandatory withdrawals, and whether you need the money or not, you’ll have to pay taxes on them, which can increase your taxable income and raise your Medicare premiums or trigger taxes on Social Security benefits.
Inherited IRAs: Passing on a Tax Burden
With the IRS’s recent changes to inherited IRAs, non-spouse beneficiaries now have to withdraw all funds within 10 years of inheriting the account.
If the withdrawals come during their peak earning years, it could result in a hefty tax bill. This means you may be unintentionally passing on a tax burden to your heirs.
How Other Accounts Can Help You Save on Taxes
Roth IRAs
A Roth IRA offers tax-free withdrawals in retirement, as you contribute to the account with after-tax dollars. Unlike traditional IRAs or 401(k)s, Roth IRAs aren’t subject to RMDs, so you can let your money grow tax-free for as long as you want.
This makes them a great tool for tax diversification, allowing you more control over your taxable income in retirement.
Non-spouse beneficiaries of Roth IRAs must still liquidate the account within 10 years, but they don’t owe taxes on the withdrawals, giving them more flexibility and less tax liability compared to traditional IRAs.
Brokerage Accounts
A brokerage account can also offer tax advantages. Unlike IRAs and 401(k)s, brokerage accounts aren’t subject to RMDs.
Plus, if you hold investments for over a year, withdrawals are taxed as long-term capital gains, which usually have lower tax rates than ordinary income.
Moreover, inherited brokerage accounts benefit from a step-up in basis, meaning the value of the account is adjusted to the current market price at the owner’s death.
If the heirs sell the assets immediately, they don’t have to pay capital gains tax on the increase in value during the original owner’s lifetime.
Health Savings Accounts (HSAs)
If you have a high-deductible health plan, you can contribute to a Health Savings Account (HSA), which offers triple tax advantages: contributions are tax-deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free.
In retirement, you can also use HSA funds to pay for healthcare costs, which are a significant expense for many retirees.
If you save your healthcare receipts, you can also withdraw funds later in retirement against those expenses tax-free, giving you another tool for managing taxes in retirement.
Building a Diversified Retirement Strategy
So, how should you allocate your retirement savings? Financial advisors recommend diversifying across different account types to give you more control over your taxes and withdrawals. Here are some tips:
- Max out employer matches: If your employer offers a match on your 401(k), take full advantage of it. This is free money and a guaranteed return on your investment.
- Split your savings: Consider allocating your retirement savings across multiple account types. For example, some advisors suggest putting 50% in tax-deferred accounts (like 401(k)s or IRAs), 25% in Roth accounts, and 25% in brokerage accounts.
- Leverage HSAs: If you have access to an HSA, use it as a long-term savings tool. While it’s designed for healthcare expenses, HSAs can serve as a tax-efficient way to cover retirement costs.
- Plan for flexibility: The goal of a diversified strategy is to give yourself flexibility in retirement. By having money in taxable, tax-deferred, and tax-free accounts, you can control your income and potentially lower your tax bill.
Focusing solely on your 401(k) or IRA may seem like a straightforward approach, but it could limit your options in retirement. Taxes are unpredictable, and relying too much on tax-deferred accounts could lead to higher taxes down the line.
By diversifying across different savings vehicles like Roth IRAs, brokerage accounts, and HSAs, you’ll have more control over your income and taxes, ensuring a more comfortable retirement.
FAQs
Why shouldn’t I rely only on my 401(k) or IRA?
Relying solely on tax-deferred accounts can expose you to higher future taxes and limit your flexibility.
What’s the benefit of a Roth IRA?
Roth IRAs allow tax-free withdrawals and aren’t subject to Required Minimum Distributions.
How does a brokerage account help in retirement?
Brokerage accounts offer flexibility and lower capital gains taxes compared to income taxes on IRA withdrawals.
What is a Health Savings Account (HSA)?
HSAs offer tax-free contributions, growth, and withdrawals for qualified medical expenses.
What is tax diversification?
Tax diversification involves saving in different account types to manage tax liabilities in retirement.