If you're going to save money for retirement, it's a good idea to use tax-advantaged accounts like IRAs and 401(k)s to build up your nest egg. That's because these plans offer several benefits.
With a traditional IRA or 401(k) plan, your contributions are made on a pre-tax basis. This helps to shield some of your income from taxes. Investment gains in an IRA or 401(k) are also tax-deferred, so you're not taxed year after year, but rather, only once you start to take withdrawals.
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Meanwhile, with a Roth IRA or 401(k), you won't get a tax break on the money you contribute to your savings. However, you will get the benefit of tax-free gains in your account, as well as tax-free withdrawals. That's a huge perk in retirement, because many seniors don't want to have to worry about paying taxes on a large portion of their income.
Also, as a point of clarity, starting in 2024, Roth 401(k)s will no longer impose required minimum distributions. IRAs have worked that way for years. But in either account type, you get the option to leave your money alone as long as you want so it can enjoy tax-free growth.
You may be in the habit of funding either a traditional or Roth IRA or 401(k) on a regular basis. And that's a very good thing. But if you only contribute to one of these accounts, your retirement plans might go awry.
Leave yourself more options
While it definitely makes sense to save for retirement in an IRA or 401(k), you should know that these accounts require you to wait until age 59 1/2 to take withdrawals. Removing funds at an earlier age could mean facing a 10% early withdrawal penalty.
There are some exceptions to that penalty. With an IRA, you can take a limited withdrawal without penalty for a first-time home purchase, for example.
Similarly, there are rules that allow you to access your 401(k) penalty-free if you're 55 or older and leave the employer sponsoring your retirement plan at that age or later. And with a Roth account, you can generally take an early withdrawal penalty-free as long as you're certain you're not touching the gains portion of your account.
But otherwise, tapping a tax-advantaged retirement plan early means risking a penalty. That's not a risk you want to take.
That's why it pays to contribute at least a small amount of money to a non-tax-advantaged account while you're funding your IRA or 401(k). That way, if you decide you'd like to retire early, or if you're forced to retire early due to circumstances outside your control, you'll have access to some unrestricted funds.
Many people don't realize they'd like to retire early until they get to their mid- or late 50s and start to feel burned out. If you get to that age without any money in a non-tax-advantaged savings plan, you might have limited options. But if you have enough of a balance in a taxable brokerage account to cover your expenses for a bit until you turn 59 1/2, then you'll have that flexibility.
Don't only chase those tax breaks
It's natural to want to eke out as much tax savings as you can in the course of building your retirement nest egg. But do yourself a favor and leave the door to early retirement open by funding a regular brokerage account as well. You might end up really happy you did if you decide you'd like to end your career early and take life in a different direction.
