4 Ways Your IRA Beats Your Savings Account
You may wonder why you should save money inside a retirement account.
The simple answer is that retirement assets are treated differently than regular assets. The federal government, many institutions, and probably even you tend to consider the money set aside to sustain yourself in your old age as sacrosanct. And there are real benefits to having this perception. (See also: 3 Reasons Not to Save for Your Child's College Fund)
Here are four big reasons to stash funds in a retirement account of your choice instead of a regular savings or investment account.
Retirement Assets Are Not Included in Calculations for College Aid
Even if you have hundreds of thousands of dollars combined in your 401(k) and IRA, your child could qualify for federal aid based on Free Application for Federal Student Aid (FAFSA) calculations. However, if this same amount of money is held in a regular account, then the likelihood of getting aid is greatly diminished.
Federal aid calculations are based on a variety of factors. Colleges and universities may have their own formulas, but these typically mirror federal guidelines. The Expected Family Contribution (EFC) considers regular assets but not retirement plans. Sure, a base level of assets is protected and a relatively small percentage is considered available to pay college expenses, but substantial holdings can increase this number to the point that your EFC easily exceeds the Cost of Attendance (COA).
Such a scenario may seem unlikely. If you have $500,000 or more saved or invested outside of retirement, then you might think that you would have a high income, a fully funded educational accounts; and a well-stocked retirement portfolio.
But you could have easily been a steady saver and accumulated significant wealth without the benefit of a high income, or you could have a high income for much of your working life but experience a career setback when your child enters college. So, putting money in an official retirement fund now can help your family qualify for federal aid in the future.
Tax Benefits Are Available With Retirement Accounts
Whether you have a traditional or Roth IRA account, you enjoy several tax benefits over a regular savings or investment account:
- Reduction in the present-year tax liability for contributions made to a traditional IRA or 401(k) plan
- Exemption of income taxes for qualified distributions from Roth accounts
- Freedom from taxes on capital gains, interest, dividends, and other earnings while funds are held within the retirement account
Note that you’ll pay taxes on distributions from traditional accounts (that is, taxes are deferred until retirement rather than eliminated). However, no taxes on earnings are owed on Roth accounts prior to and during retirement.
Embedded in the benefit associated with deferring or avoiding capital gains taxes is the bonus of being able to diversify and rebalance your portfolio without tax consequences.
For example, if you have a large amount of your employer’s stock in your 401(k) plan or a concentrated position of one company in your IRA, you can sell these holdings to fund the purchase of index fund shares (or other investments that would diversify your portfolio) without having to pay capital gains tax. All of the proceeds can be plowed back into your retirement fund. However, if you sold a similar amount in a regular account, you would lose a percentage of your earnings to taxes (unless you qualified for 0% capital gains tax) and have less to reinvest.
Retirement Accounts Enjoy More Protection
Retirement funds are safer than non-retirement assets if you ever have to declare bankruptcy or shield yourself from a creditor’s claims.
Hopefully, you will never have to face these situations. But if such problems arise, money held in most employer-sponsored plans is protected from creditors in bankruptcy under federal law (with notable exceptions of the IRS and former spouses). Money in an IRA is also exempted to an extent (up to $1 million plus cost-of-living adjustments).
For non-bankruptcy situations, employer-sponsored plans compliant with the Employee Retirement Income Security Act (ERISA ), such as 401(k) plans, provide the best protection. IRAs may or may not be sheltered from claims based on state laws.
As an added precaution, no matter where your money resides, consider increasing liability coverage by getting an umbrella policy and boosting coverage associated with homeowners’ and auto insurance policies. These steps may help you pay claims in the event of a lawsuit without tapping retirement or non-retirement funds.
Retirement Funds Are Off Limits for Regular Expenses
You might think that if you mentally designate certain funds for retirement, then you won’t ever spend these dollars except in an extreme emergency.
But in the decades between setting aside money in your 20s and 30s and full retirement in your 60s and 70s, there are likely to be many opportunities to spend money earmarked for retirement but held in a regular account. These might include anticipated events such as your children’s college education or wedding; unexpected setbacks from medical expenses or long periods of unemployment; or hoped-for opportunities such as a backpacking trip out west, an extended overseas visit, or a bargain-priced vacation house.
Even money put in retirement plans isn't entirely safe. Certainly, many people withdraw funds for hardships, such as the down payment on a purchase of a home or those medical bills I mentioned earlier. And a recent study indicated that about 25% of employees are tapping 401(k)s for regular expenses.
Generally, though, money placed in a retirement account should stay there because you consider those dollars off limits. Tax penalties associated with taking retirement distributions early are often so high that forgoing opportunities, delaying spending, and finding alternative funds are often simpler and preferred solutions.
The main point of contributing to a 401(k), IRA, or similar plan is to accumulate assets that generate a stream of passive income, which helps you pay expenses when you are no longer working. You can build wealth in a manner that creates this income without opening an IRA or transferring money from your paycheck to an employer-sponsored retirement plan. But even beyond the basic tax advantages, there are tangible and intrinsic benefits to putting and keeping money in a retirement account instead of a regular one.
Where is your money? Have you thought about putting more in a retirement account?
Disclaimer: The links and mentions on this site may be affiliate links. But they do not affect the actual opinions and recommendations of the authors.