Why you should keep money in taxable accounts
Why you should keep money in taxable accounts
And not just because public schools, parks, and roads are good things
The beauty of traditional IRAs, 401(k)s, and other retirement accounts is that they are tax deferred. You don’t pay income tax until you withdraw money, so the investments held in the account grow free of any capital gains or income taxes. This makes them powerful as savings vehicles and tax shelters.
These accounts are so good at what they do that some people have no money outside of them, and that’s a mistake. Just about everyone needs some money in taxable accounts.
The most obvious use is for an emergency fund. In a perfect world, you would have three to six months of living expenses in a low-risk account to cover the cost of the unexpected. If you can’t save that much, at least aim for enough to cover a car or appliance repair.
As you near the official retirement age of 59 ½ for tax-deferred accounts and 62 to draw Social Security, the benefit of taxable accounts becomes obvious: you can afford to retire early, or go semi-retired, without paying a penalty tax or reducing your Social Security benefit. The closer you are to retirement, the more important taxable savings become.
The traditional advice for younger employees is to contribute enough to their retirement plan to get their employer match. After all, a lot of people in their 20s and 30s have student loans, want to save money for a down payment, and may have some consumer debt. Saving for retirement is important at a young age, but it’s not urgent. Once you turn 55 or so, I would argue that many people should contribute enough to their employer retirement plan to receive any match offered, and no more. As retirement becomes urgent, the value of tax deferral is not only less important, but it may also be detrimental.
The penalty tax on early retirement withdrawals is huge. It’s 10% if you don’t qualify for an exemption, on top of the income tax that may be due. Sure, you’ll have to pay taxes on your taxable accounts, but the overall rate will almost certainly be lower.
And, if you take an early withdrawal, you lose the benefit of the tax-deferred investment compounding.
Instead, put the money into accounts that you can touch when your employer decides that its earnings per share a penny too light and that highly compensated (read: old) employees need to go. Or maybe you want to work less but can’t afford to live on less money without touching your retirement funds.
Social Security is calculated as a total dollar value based on the amount of money that you contributed and your life expectancy when you retire. If you start collecting at age 62, the payments are smaller because they are divided over 120 more months than if you wait until you are 72. If you have health issues or are in a financial bind, there’s no need to wait, but if you can wait, you will receive larger payments. If you have reason to believe that you will live to be longer than your Social Security life expectancy (if, for example, your parents and grandparents all lived past 90), those larger payments will come in handy.
Any financial company will be happy to open a taxable account for you, and then you’ll be in better shape to retire on your terms.