The number of options available to Americans looking to save for retirement has probably never been higher. From stocks to bonds to mutual funds, precious metals to agricultural commodities to ETFs, there are thousands upon thousands of investment options available to investors. In fact, there are so many choices that it can be overwhelming to the investor just looking to make a safe, comfortable return in order to build up savings for retirement.
Most investors stick to tried and true investment vehicles, whether it’s brokerage accounts or employer-sponsored 401(k) plans. But while 401(k) and IRA account assets have grown tremendously in size over the past several decades, the trend recently has swung the other way, with more and more investors now favoring traditional taxed brokerage accounts rather than tax-advantaged accounts such as IRAs and 401(k)s.
While there are certainly benefits to having a traditional brokerage account alongside a tax-advantaged account, ignoring the many benefits of tax-advantaged accounts can hurt you in retirement. So let’s look at some of the benefits of tax-advantaged accounts and see how they can help you achieve your dreams of retiring comfortably.
Disadvantages of Tax-Advantaged Retirement Accounts
Let’s start with the disadvantages of tax-advantaged retirement accounts first. The major (and some would say only) disadvantage of tax-advantaged retirement accounts is that your money could be tied up for a long time. Any money that you have tied up in a traditional 401(k) or IRA account won’t be available for distribution until you turn 59 ½. Taking any money from those accounts before then will incur income taxes as well as an additional 10% penalty.
There are some exceptions to the penalty when withdrawing money for certain hardships, or in the case of IRAs when withdrawing money to pay for educational expenses or the purchase of a home. And you can take a loan from a 401(k) for certain qualified expenses too, although you have to pay yourself back that loan with interest. But you don’t want to get into the habit of thinking of your 401(k) or IRA account as a piggy bank that’s always available to you in an emergency. Taking money out for any reason will harm your ability to continue building up wealth for the future.
Traditional brokerage accounts, on the other hand, don’t have the same taxes and penalties associated with them. You’ll have to pay capital gains taxes on any earnings you’ve made, but the money in those accounts is available to you whenever you need it. That makes these accounts attractive to investors who want to build up savings for retirement but want to have the flexibility to be able to draw on some of that money in case of an emergency.
Advantages of Tax-Advantaged Retirement Accounts
The major advantage of tax-advantaged retirement accounts such as IRAs and 401(k)s is that they are sheltered from taxes. Traditional IRA and 401(k) accounts allow you to use pre-tax dollars to make investments. Those investments grow tax-free until the time comes to take a distribution.
Because contributions to IRAs and 401(k)s come before taxes, they reduce your taxable income in the present. Contributions to an IRA can even be tax-deductible in some cases. And by not having to pay capital gains taxes every year on earnings and dividends, tax-advantaged retirement accounts allow you to grow your wealth for decades unimpeded by taxes, which would otherwise take a huge bite out of your earnings.
Roth retirement accounts are tax-advantaged in a different way, being funded through after-tax dollars but then growing tax-free and not being taxed at all at distribution time. And as long as you’ve held a Roth IRA account for 5 years you won’t be penalized for withdrawing your contributions before you turn 59 ½. The only penalties and taxes come if you try to withdraw earnings before you turn 59 ½.
Another major advantage of tax-advantaged accounts is the ability to perform rollovers of your assets. If you have an old employer-sponsored 401(k) account that isn’t doing well, or if you have an IRA account that you want to put to better use, you can roll over those assets into another tax-advantaged retirement account.
Many investors take advantage of that to diversify their portfolios, investing in assets that they otherwise might not be able to invest in, like gold and silver. Rolling over assets from a 401(k) to a gold IRA account allows investors to take advantage of gold’s ability to safeguard retirement assets against inflation and financial crisis while still maintaining the same tax treatment.
Trying to do the same thing with assets in a traditional brokerage account would result in a taxable event, requiring payment of capital gains taxes, thus reducing the amount of money that could then be invested in gold. That ability to roll over assets tax-free is the other major advantage of tax-advantaged retirement accounts. Being taxed every time you try to diversify your portfolio or make a change in investment strategy can eat into your investment earnings, and tax-advantaged retirement accounts can prevent that from happening.
Diversification Is Key
As with anything else investment-related, diversification is key. If you’re worried about the lack of flexibility with tax-advantaged accounts then split your savings between tax-advantaged and non-tax-advantaged accounts. But at the minimum be sure to take maximum advantage of any employer-offered matching contributions to a 401(k) plan, as failing to do so means leaving free money on the table.
Ultimately the decisions about how much to invest in tax-advantaged versus non-tax-advantaged accounts is a personal one that investors need to figure out for themselves. But given the advantages that tax-advantaged accounts offer, they’re too important an investment tool for investors to overlook completely.