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4 Reasons Only Investing Through Retirement Accounts Is a Bad Idea

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Flexibility and liquidity are among the biggest issues to consider

You’ve probably heard financial experts stress the importance of investing through retirement accounts like an IRA or 401(k) to get tax-deferred or tax-free growth on investment returns or to take advantage of employer-matching contributions. 

While these accounts offer significant advantages, especially for long-term retirement planning, relying solely on them for all your investments might not be the best strategy.

Focusing exclusively on retirement accounts can limit your financial flexibility, liquidity and access to certain investment opportunities that could be valuable outside of retirement.

Here are four reasons why investing only through retirement accounts could be a bad idea.

1. Retirement funds are generally illiquid

Retirement account funds are generally illiquid because they’re designed specifically for long-term retirement savings. While you technically have access to your money at any time, withdrawing it before the age of 59 1/2 usually comes with a steep cost: a 10% early withdrawal penalty in addition to any income taxes owed on distributions.

There are exceptions — such as for medical expenses, the birth or adoption of a child or other qualified situations — where you can avoid the penalty. However, unless your situation falls under one of these IRA exceptions, you’ll be hit with the 10% penalty if you tap into your retirement savings early. Roth IRA contributions — not earnings — are always accessible without taxes or penalties since you already paid taxes on this money. 

So, while early access is possible, it can involve a significant financial drawback, limiting your flexibility if you need the money for non-retirement-related expenses.

2. You can’t offset gains with losses in a retirement account

Both retirement accounts and taxable brokerage accounts play important roles in a tax-efficient investing strategy, and combining them can maximize tax benefits.

Retirement accounts like 401(k)s and IRAs offer tax advantages like tax-deferred or tax-free growth. Traditional contributions may reduce taxable income in the year they’re made, while Roth accounts allow for tax-free growth and withdrawals, providing future tax savings.

On the other hand, brokerage accounts offer flexibility and control over when you realize gains and losses. Capital gains taxes are lower if you hold assets for more than a year, and strategies like tax-loss harvesting help offset gains to lower your overall tax burden.

By combining both types of accounts, you can manage withdrawals strategically in retirement. Using taxable accounts for liquidity and retirement accounts for long-term tax advantages helps you minimize taxes over time.

3. Retirement account investment options may be limited

Some retirement accounts, particularly employer-sponsored plans like 401(k)s, offer a limited selection of investment choices compared to the wider array available in taxable brokerage accounts. 

Most 401(k)s primarily offer mutual funds, often consisting of target-date funds or index funds, which can limit your ability to diversify into other asset classes like stocks, bonds, exchange-traded funds (ETFs) or alternative investments. More 401(k)s have recently begun letting participants invest in a broader range of assets, though this feature isn’t yet common.

Additionally, while IRAs typically offer more flexibility than 401(k)s, the range of available investments still vary by brokerage. Some providers may not offer the same assets in an IRA as they do a taxable account. For example, a brokerage might allow options trading or cryptocurrency investments in taxable accounts but restrict them in an IRA.

This lack of flexibility may be a significant drawback for investors seeking greater control over their portfolios, making taxable brokerage accounts an important complement to retirement accounts.

4. Retirement accounts have contribution limits

The IRS sets annual contribution caps on retirement accounts, limiting how much you can invest each year.

For 2024, the contribution limit for an IRA is $7,000 for those aged 50 and below and $8,000 for those 50 and older. The 401(k) limit is higher, set at $23,000. 

Plus, high earners whose income exceeds the IRS’s limits cannot contribute directly to a Roth IRA. The backdoor Roth IRA is a workaround to this limit, but you should understand the tax implications and complexity before doing it.

In contrast, taxable brokerage accounts have no contribution limits, allowing you to invest as much as you like without restriction. 

This feature makes taxable accounts an essential tool for investors who want to grow their wealth beyond the confines of retirement account caps and maximize investment opportunities during high-earning years.

Bottom line

While retirement accounts like IRAs and 401(k)s offer valuable tax benefits, relying solely on them for your investment strategy can limit your financial flexibility, liquidity and access to certain investment opportunities. 

By combining retirement accounts with taxable brokerage accounts, you can enjoy tax-deferred or tax-free growth and immediate access to funds while taking advantage of opportunities like tax-loss harvesting and uncapped contributions.

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