Why a Roth and a taxable account are a young saver’s best friend

Wood chair on beach
KJ: We recently wrote about: Financial independence: a new concept in lifestyle retirement planning, but how do you know where to save and how to save to reach financial independence? Especially if you are a young saver, some of the retirement account types might restrict you too much on how and when you can ultimately use the funds.

Only saving to a pre-tax account can cause you to lose flexibility
If you save ONLY to traditional retirement vehicles like a regular pre-tax 401(k), traditional pre-tax IRA, Simplified Employee Pension (SEP), etc. then you might find that you have the savings and ability to be financially independent, but you may not have the ability to live off of the money and withdraw funds from these account types before age 59 1/2 without incurring significant taxes or penalties. So, how do you build flexibility into your lifestyle so you can more quickly reach – and realize – financial independence, whether that is at age 35, 40, 50, or 55?

Save to Roth accounts
Roth accounts currently have a very nifty feature for young accumulators. If you were to ever need to withdraw funds from the account(s) before turning age 59 1/2, then you CAN withdraw some funds without taxes OR penalties. In fact, any withdrawals are treated as first coming from whatever money you put in before dipping into any earnings on the account. To illustrate, if you collectively had put $50,000 into a Roth account, and the account is now worth $75,000, then the first $50,000 you withdraw would be tax-free return of your capital contributed (read no taxes or penalties). If you began to dip into the remaining $25,000 before age 59 1/2, then you would of course have to pay hefty taxes and penalties.

Overall, it still builds a lot of flexibility in your plans to reach financial independence because your first dollar withdrawals are tax-free and can further push you closer to the 59 1/2 age where you would then be able to take remaining funds out without taxes or penalties.

Contrast this with regular 401(k) accounts or Traditional IRAs where any funds withdrawn would trigger income taxes as well as penalties if removed before age 59 1/2. Even after age 59 1/2 you still have to pay income taxes on withdrawals from a Traditional IRA, but at least you avoid the penalty!

For a Roth account, as long as your income is below a certain level (approximately $180,000 for married couples in 2014 ), then you can save up to $5,500 per person for a Roth IRA (with an extra $1,000 if you’re over age 50). If that’s not an option, save to your employer’s Roth 401(k) feature if they have it since that could allow you to save up to $17,500 each year (and an extra $5,500 if you’re over age 50). If that’s still not an option, look at the regular investment account outlined below.

Save to a regular investment account
Lots of people think that once they save to their 401(k) or 403(b) and/or an IRA that they can no longer save for retirement. This is NOT TRUE! Sure, you may not have any more specifically tax-advantaged ways to save for retirement, but you can still be setting money aside for retirement in what is called a regular, investment/brokerage account. With an investment account, you pay income taxes in the current year on certain gains and income generated, but you still have the ability to focus on more long-term growth strategies to keep the investments and account with some tax-efficiency.

Contributions are limitless. Seriously. There are not any maximum contributions (or distributions for that matter!) on what you can save to a regular investment account. If you get to the point where you’re bankrolling $100,000 per year in extra income (would be nice wouldn’t it!), then you could be setting it all aside in a regular investment account. The more quickly you set aside money, the sooner you will be able to reach financial independence. Plus, you can use the funds whenever and however you would like. Save enough to reach financial independence at age 45? Not a problem! Money you withdraw does not have penalties. Sure, if you sold an investment to be able to make a withdrawal you could have some gains or tax implications but generally much less so than a regular pre-tax account, AND there aren’t any IRS penalties.

No age restriction. Yep, you read that right. There are no age restrictions to when you can access the money or time waiting periods. You don’t have to keep the money in the account for even a year, and you can withdraw at age 25, 30, 40, 50, etc. as needed to fund your goals.

Talk about ultimate flexibility! So, even though the funds don’t grow as tax efficiently as they would in a pre-tax IRA, 401(k), 403(b), or a Roth IRA, you ultimately have 100% control of when and how you use the funds without Uncle Sam getting involved.

Especially for the young accumulator that is really building their portfolio for long-term success, this type of account will ultimately help you build the flexibility you need to reach financial independence at an accelerated rate.

So, are you convinced yet? What’s stopping you from opening and saving to a Roth or regular investment account?

    Are you taking advantage of an employer 401(k) or 403(b) Roth?
    Do you have a taxable investment account for long-term growth?
    Share with us what is stopping you from building more flexibility into your savings goals.

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2 thoughts on “Why a Roth and a taxable account are a young saver’s best friend

  1. Recently, I’ve been going back and forth between maxing out my Roth or maxing out my Traditional IRA. This definitely helped me to choose the Roth for more flexibility in the future! I also have a 401k, so I’m contributing to both a post-tax and a pre-tax account.

    • Thanks for sharing, Lisa! We just really like the Roth feature a lot since it has more flexibility. And, it’s a balance between certain taxes today versus the uncertain taxes (and tax rates) in the future.

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