4 of the Best Reasons to Consider Retirement Investments Outside of a 401(k)

4 of the Best Reasons to Consider Retirement Investments Outside of a 401(k)

The most popular retirement plan is the 401(k), which is generally set up with minimal effort through your employer. A 401(k) provides great tax advantages and often comes with matching contributions from your employer, not to mention automated deposits.

For the most part, finance experts recommend that people focus on saving through a 401(k) until they max out their company match. However, in some circumstances, it makes sense to open different retirement savings accounts before reaching this point. Once the match is maxed out, you should start to consider other savings options for a variety of different reasons, including:

1. Tax diversification

A 401(k) provides some great tax advantages. Money put into the account is not subject to income tax, and the principal grows without any taxes due until retirement. Once money is withdrawn from the account, it gets taxed as regular income. For the most part, this deferral of taxes works to the advantage of the retiree. Most individuals will be in a lower tax bracket once they retire, so they will pay less in taxes during these years.

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Even so, you should make sure that you keep your tax bill low, which means diversifying your retirement accounts in terms of taxation. In retirement, many people live on a fixed income, so keeping the tax bill low is critically important.

A way to keep the tax bill low is saving monthly with a Roth IRA. Money put into a Roth account comes from post-tax income, so it is not subject to taxes upon withdrawal in retirement. Moreover, money from a Roth account does not count toward taxable income. If you come close to the line between tax brackets, you can start using your Roth account to avoid moving into the higher bracket and save on taxes.

2. Easier inheritance

The IRS requires that people take minimum distributions on their tax-deferred accounts, including a 401(k), once they turn 72. These distributions must be taken whether or not you need the money, which is the federal government’s way of ensuring tax income from the tax-advantaged account. Otherwise, you could defer taxes on your income indefinitely.

The required minimum distribution depends on your age and account balance. Once you pass away, the remaining 401(k) funds go to named beneficiaries. Depending on your age and that of your beneficiaries, minimum distributions may be imposed on the inheritance, and these withdrawals count as taxable income for the person who inherited the balance.

Funds in a taxable account, meaning an investment account not specifically designed for retirement, are not subject to required minimum distributions, so assets can accumulate in them and then get passed on to heirs without any forced withdrawals. This is an advantage of taxable accounts over even a Roth IRA. While Roth accounts do not have required minimum distributions during the account holder’s life, beneficiaries usually do have to take forced withdrawals, although they will not have to pay income tax on them. For a taxable account, taxes are due when assets are sold rather than when they receive distributions. The taxes are based on the value of the assets when the account holder dies rather than the purchase price.

3. Increased liquidity

While a 401(k) has great tax advantages, the trade-off is that the IRS makes it difficult for you to withdraw money before you reach the age of 59 1/2. Before this age, you will pay a 10 percent penalty on any withdrawals on top of the normal income tax. For that reason, people planning an early retirement should look into other savings options since they will not have access to their 401(k) when they plan to retire. Even those who plan to retire at the traditional age may want more liquidity in their savings, so the early withdrawal penalty can become problematic.

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To increase liquidity, you don’t need to avoid a 401(k) altogether. Rather, you should simply add additional accounts to your portfolio. Not all wealth needs to be held in restricted accounts, especially if those rules do not align with your plans for the future. Increasing liquidity generally means opening a taxable account, which will not have any sort of withdrawal restrictions, although the same tax advantages do not apply. A Roth IRA can also help with liquidity since you can withdraw your contributions at any time. However, withdrawing earnings will result in a penalty.

4. Better investments

The other thing that you should keep in mind when it comes to 401(k)s is that investments can be quite limited. For the most part, these accounts offer between 10 and 20 different mutual funds, target-date funds, or index funds. While these options are generally low-cost and reliable, they are not always the best choices. Pay close attention to the investment choices offered by a 401(k) and determine whether it makes sense to invest elsewhere.

Opening a second account can often grant access to not only better investments but different types to improve diversification. This second account could be a traditional or Roth IRA, or even a taxable account with a brokerage. First, figure out what kind of account serves your other needs and then search for the option that provides the best investment options. Some investment options to look for include exchange-traded funds, debt securities, mutual funds, and stocks.