Why diversifying the tax structure of your retirement investments makes sense

The standard—and very good—advice about retirement savings is to maximize your contributions in tax-deferred plans such as 401(k)s and IRAs. That way your money compounds without being reduced by taxes and if you wind up in a lower bracket in retirement, you’ll owe less in taxes on the money than if you paid them while working full time.

But that advice has its limits.

In some cases, you’d be better off saving for retirement in an account that isn’t tax deferred and paying any taxes on the earnings each year in exchange for more freedom. That’s because tax-deferred accounts come with strings attached.

Savings earmarked for retirement but placed in regular (not tax-deferred) brokerage accounts offer you flexibility that may be better for you than a current tax exclusion.

Here are a few good reasons:

  • You may need the money before you turn 59½
  • You may not need to withdraw the money once you turn 70½
  • There is no guarantee that your tax bracket in retirement will be lower than it is now

The penalty for early withdrawals

In the last recession, a lot of people younger than 59½ found themselves needing to take money out of their retirement plans just to pay the bills and they paid a hefty price to the Internal Revenue Service to do so. If you withdraw from a traditional IRA or 401(k) before that age, you generally owe income taxes and a tax penalty equal to 10% of the amount you withdraw. The 10% penalty may be waived on a 401(k) withdrawal if you leave your employer at age 55 or older.

Some people figure they can get around the early withdrawal penalties by structuring the withdrawal as a loan, but that’s problematic because the IRS rules are complicated.

Sure, you can take out actual loans against a 401(k) in many circumstances. But that money generally must be repaid within five years.

Mandatory withdrawals on retirement accounts

The IRS requires you to start withdrawing money from a traditional IRA or 401(k) at age 70½; Roth IRAs have no such rule, but Roth 401(k)s do. The requirement to take money by age 70½ could be a problem for someone who may not retire as early as the tax laws assume.

If you have money in a tax-deferred plan and are in a very high tax bracket in a year after you turn 70½, you’ll have to withdraw money from the plan and pay taxes on it whether you want to or not.

The uncertain future of tax rates

The benefits of tax deferral assume that future tax rates will be significantly lower than today’s. Given the deficits faced by the federal government and by most states, however, it’s difficult to say that that will be the case.

If the marginal tax rate you’ll pay in retirement is higher than the one you face today, you’re better off paying the taxes now.

Keeping your retirement savings in investments with different tax treatments is one way to hedge the risk of costly tax-law changes.