The workplace-sponsored 401(k) is touted as one of the best places to save for retirement. And there's good reason for that. Contributions are pulled in from your paycheck and invested automatically. Withdrawal restrictions discourage you from reaching into those funds even as the balance grows to six figures or more. And tax deferrals eliminate the annual tax bite that can slow your investment growth.
Still, even with those perks, you may benefit from dropping your 401(k) in favor of a taxable brokerage account.
Threats to the 401(k)
Two outcomes of the coronavirus-prompted economic downturn of 2020 threaten to lessen the appeal of 401(k) investing. One is an increase in companies that are suspending or eliminating employer-matching contributions. And the other is massive stimulus spending by the federal government that could lead to higher income tax rates in the future.
A survey conducted in April by Plan Sponsor Council of America indicated that 16.1% of organizations had suspended employer-matching contributions due to the COVID-19 pandemic. In May, the Center for Retirement Research at Boston College published a list of 46 companies that had suspended matching contributions, affecting 410,313 retirement savers. That's only 0.69% of active 401(k) participants nationwide – which is no consolation if you're among those affected.
Employer-matching contributions are one of the most appealing features of 401(k) investing. The free deposits expedite your retirement savings growth and make up for some of the 401(k)'s disadvantages – namely, potentially high fees and poor investment choices.
If your employer-matching contributions dry up, you might carry on with your paycheck-funded 401(k) deposits just for the tax perks. You do get a tax deduction on those contributions, and your earnings grow tax-free. But if income tax rates rise before you retire, deferring those taxes won't be much of an advantage. You'll just be paying more later.
The case for retirement saving in a taxable account
Your retirement savings options outside of the 401(k) include the traditional IRA, Roth IRA, and taxable brokerage account. IRAs are limited by low contribution caps. In 2020, you can only deposit up to $6,000 across all your IRAs, or $7,000 if you're 50 or older. You can deposit as much as you want in a taxable brokerage account, but you'll get no tax perks in return.
The tax perks you give up are the deductions for your contributions and the deferral on earnings. That translates to higher taxes today and tomorrow, as you absorb the annual tax liability on interest, dividends and realized capital gains from year to year.
In return for paying your taxes, though, you get a lot more freedom to use your money as you wish. Since you're contributing to the account with after-tax dollars and paying taxes on the income, your withdrawals themselves aren't taxable. This is very different from a 401(k), where qualified withdrawals in retirement are taxed as regular income.
You're also not on the government's timeline for retirement. Tuck away enough in a taxable account to retire by age 50 and you can do that. Save to a 401(k), though, and you'll have to wait until you're 59 and a half to take penalty-free withdrawals.
Finally, you don't have to take IRS-mandated withdrawals from your taxable account. If you don't need the money, you can leave it there to grow or to pass on to your loved ones. In your 401(k), you have to start taking taxable withdrawals at age 72 to avoid severe penalties.
Who should save for retirement in a taxable account
Saving for retirement in a taxable account isn't right for everyone. You shouldn't ditch your 401(k) entirely if you still have an employer match, because that's free money. Saving to a taxable account is also a bad idea if you can't keep your hands out of the till. Sure, the 401(k) early withdrawal penalties are limiting, but that's a good thing if they discourage you from spending your retirement savings. No matter what happens with income taxes going forward, you're better off retiring with some savings versus no savings.
Taxable retirement investing is a good option, though, when your 401(k) isn't doing you any favors. That usually means you have no employer match and your only investment options are pricey mutual funds. You'll have to pay the annual taxes on your investment earnings and be disciplined enough to let the money grow over time. But in return, you can retire on your own schedule, manage your exposure to any future tax increases, and take distributions, or not, as you see fit.