I'm a firm believer in taking advantage of any tax break the IRS will give you. And for this reason, I'm a fan of saving for retirement in an IRA or 401(k).
With a traditional IRA or 401(k) plan, your contributions are made on a pre-tax basis, allowing you to shield some of your income from the IRS. Plus, your money gets to grow on a tax-deferred basis, so you don't pay taxes on investment gains every year. Instead, you pay those taxes when you're ready to actually take withdrawals from your retirement savings.
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But traditional IRAs and 401(k)s also have some major drawbacks. And for this reason, it's important to diversify your retirement savings.
The problem with IRAs and 401(k)s
There are two problems with relying on IRAs and 401(k)s alone for your retirement savings. First, these accounts impose a 10% early withdrawal penalty for taking distributions before turning 59 and 1/2. Secondly, these accounts force you to start taking withdrawals known as required minimum distributions, or RMDs, once you turn 73 or 75, depending on your year of birth.
For this reason, it's a good idea to have some of your retirement savings in a taxable brokerage account. With a taxable brokerage account, there's no such thing as pre-tax contributions. And you pay taxes on investment gains every year. On the other hand, you get a lot more flexibility with your money.
Let's say you end up with $3 million in retirement savings by age 58. You may feel that you've saved enough and are ready to retire. But if you can't access your savings without a penalty, that's a problem.
Or, you might end up getting laid off at age 58 and have difficulty getting hired at a new job. If you have a few million in retirement savings to tap, you might tell yourself you'll forgo full-time work and cobble together an income between side hustle earnings and retirement plan withdrawals. But again, if tapping your IRA or 401(k) results in a penalty, that's a problem.
The same could hold true if you're able to get by in retirement without having to tap your IRA or 401(k). In that case, RMDs could become a huge hassle for you and create a yearly tax bill you don't need.
With a taxable brokerage account, you don't have to worry about these things. You can take withdrawals penalty-free at any age, and you won't be forced to take your money out at any point in time.
Give yourself more options
It's a good idea to contribute to an IRA or 401(k) for the tax savings involved. And if you have a 401(k) with a workplace match, it especially makes sense to contribute enough money each year to claim your free money in full.
The point, rather, is that you shouldn't keep all of your retirement savings in an IRA or 401(k) because of the restrictions. Having a decent chunk of money in a taxable brokerage account could buy you more options if your retirement timing doesn't go as planned, or if you end up wanting to leave your money alone for longer.
