Common wisdom for the personal finance space is save your money in tax deferred accounts like 401(k) and Traditional IRAs so you can retire comfortably. This is somewhat illogical advice for reasonable people with a growth mindset. Wall Street is doing its job of selling dreams at the expense of the common person’s financial stability. Here’s my take.
Roth IRAs Might be a Better Option for Liquidity
I’d definitely consider using a Roth IRA to help fund your retirement AND have a place to have access to the capital you’ve contributed. The biggest drawback to tax deferred is that there is a penalty to withdrawing early. Typically this is a 10% early withdrawal penalty and the entire withdrawal is subject to income tax. 401(k) accounts often have a loan feature where you can take out up to ~50% of your balance, but the fees are often high and the consequences of losing employment and having to pay back the loan are not worth the risk.
There are some drawbacks here, though. If you do withdraw, you have to be incredibly diligent about record keeping to make sure you don’t start withdrawing capital gains. Those capital gains have the same early withdrawal and income tax penalties as traditional IRAs. The other drawback is that your ability to contribute phases out as your earned income grows. It’s a silly paradox. The more money you have to invest, the harder it is to do so.
Direct Investment could be Cheaper
401(k) management and asset fees can take a significant amount of your annual return. These two component can fees can add up. Management fees are typically relatively low. Mine charges $47 per year per individual. Asset fees are where the money is at. Typically as a very passive investor you would want to choose a Target Date Retirement Fund. However, the fees on these can be 3X higher (or more) than a typical index fund. This amounts to highway robbery, especially since the default investment for new enrollees is… a Target Date Retirement Fund!
Fidelity is particularly culpable in this practice. Their S&P 500 index fund has a tiny 0.015% fee which is fantastic. Their target date funds grow to 0.6%+! On top of this, the funds available in 401(k)s are typically limited. My prior plan had 10 options in not very good funds.
A more active and disciplined asset allocator could find that there are more cost-efficient ways to manage a portfolio through a discount brokerage account or other managed account. I use a combination of Robinhood, Schwab, Ally (formerly TradeKing), Wealthfront, and Betterment for my various IRA and taxable accounts.
Now to the big one. Assuming that you have a goal to grow net worth AND you only care about retirement AND you are certain that you are going to live that long OR you don’t mind passing your hard earned wealth down to other beneficiaries if you die early, THEN you should stop reading.
Most wealthy people that I know of generate some sort of passive income. Usually through business interests, real estate, dividends, or interest. Aside from some loopholes using things like self-directed IRAs, it is difficult to generate current income for yourself through 401(k) or IRA money. That leaves taxable accounts as the only practical way to invest in stocks or bonds if you’re looking to generate any meaningful usable income, whether that’s through dividends or interest.
Additionally, if you use a 401(k) or IRA, you will have to learn an entirely new skillset at retirement: How to generate income from a portfolio of stocks and bonds. This is a daunting task, compounded by the fear of drawing down your capital too early. There is the 4% rule (or is it the 5% rule?), but doesn’t it make sense to build this skillset over your lifetime instead of being forced into it all at once? Maybe I’m crazy.
So if your goals include things like using the capital you’ve saved to supplement and enhance your life while keeping and/or potentially growing your capital base, then it might make sense to reduce your pretax contributions and learn how to invest for income. I happen to like REITs. 🙂