Most financial experts push using retirement accounts like 401(k)s and IRAs.
And for good reason – they generally offer some powerful tax benefits to their users. They definitely should be considered in any long term financial plan.
Common wisdom might suggest that you should always max out your contributions to these accounts.
But is that really the case? What about someone on the road to early financial independence? Do these accounts really help for that?
Everyone’s situation is different, and using an IRA or 401(k) may not always be the best option for someone’s financial goals.
Let’s take a look at the advantages and disadvantages of retirement accounts to see what role they can play in one’s portfolio.
Advantages of an ira and 401(k)
The advantages of IRAs and 401(k)s are overwhelmingly tax based.
Most advantages are within two distinctions: tax savings now, or tax savings later.
With a traditional IRA or traditional 401(k), you get a tax deduction in the year of your contributions. The contributions lower your taxable income for the year.
Another advantage is tax free growth with Roth accounts. With a Roth IRA, you pay taxes on your initial contributions. Afterwards, the growth within the account is tax free.
This makes planning for retirement easier, as the money isn’t taxed when you withdraw it during retirement as it would be with a traditional account.
Some people take the tax advantages a step further with a backdoor Roth IRA. This is where a person rolls his or her traditional retirement account into a Roth IRA. While this usually triggers a taxable event in the year that the rollover is done, it allows someone to roll relatively huge amounts of money into a Roth account without having to worry about contribution or income limits. There are some complexities, so definitely talk with a tax professional before trying something like a backdoor Roth.
Employers will often offer contribution matching on 401(k)s.
That is, you employer matches a percentage of your contributions when you invest into the account.
You might consider this “free money” if you were going to contribute to the plan anyways.
While not everyone has this opportunity, it is something to consider if you have the option.
The money in the account is subject to many of the same disadvantages, however, as a normal contribution. But those drawbacks can be well worth it thanks to the instant “return” of getting the match.
Speaking of disadvantages, let’s go into some more detail on those:
Disadvantages of an ira and 401(k)
The disadvantages of these accounts are often overlooked. However, there can be some pretty severe drawbacks to using these accounts, especially as they relate to flexibility.
• Time & Penalties
One of the biggest disadvantages to these accounts is the time limit set for withdrawals without penalties. Currently, the minimum age requirement for penalty free withdrawals is 59 and a half years old.
If you need access to the money in an IRA or 401(k) before then, or if you want to retire early, then you can’t use that money without paying large penalties in most situations.
Notably, with a Roth account, you can withdraw your contributions before 59.5 years old without penalty, but not the gains. Roth gains still face penalties when withdrawn.
Traditional accounts face both taxes and penalties when withdrawn early.
With the penalties due, it is rarely worth early withdrawal. Consider money in these accounts locked away until retirement age.
In any event, do speak with a tax professional before making the decision to withdraw from your accounts early.
• Required Minimum Distributions
On the flip side, with some retirement accounts, you’ll be forced to make withdrawals after a certain age.
These are called required minimum distributions.
Not all retirement accounts will have required minimum distributions, but many do. You should check your plan restrictions before assuming there aren’t any.
As the IRS states, “You generally have to start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 72.” Roth IRAs do not require minimum distributions until after the owner dies.
If you do not want to make a withdrawal in a particular year because of taxes or some other reason, you won’t have a choice in many cases thanks to required minimum distributions.
• Contribution Limits
Another disadvantage to retirement accounts are contribution limits.
In general, you can only invest a limited amount of money into these accounts.
The current limitations are $6,000 per year for a Roth IRA, and $19,500 for a traditional 401(k).
And those limits are an aggregate total for all accounts. So you can’t have three Roth IRAs and expect to triple your contribution limit for the year. It’s $6,000 total across all the IRAs you might have, whether they be Roth or traditional.
As mentioned earlier, something like a backdoor Roth IRA can be a way to navigate around the contribution limit, but this is usually an advantageous option only in niche situations.
Roth accounts even have an income ceiling. A single person’s gross income must be less than $129,000. A married couple filing jointly must have gross income below $204,000.
Simply put, there are plenty of restrictions to pay attention to when using these accounts.
F.i.R.E and retirement accounts
Almost all of the restrictions on retirement accounts limit your flexibility in some way.
For someone working to achieve early financial freedom or early retirement, is a 401(k) or IRA worth it?
Since the money in these accounts is locked up until the investor is 59 and a half years old, these accounts do not always make sense those folks.
However, if they place their investments in taxable accounts, then they lose the potential tax advantages of retirement accounts.
Depending on your financial goals, the flexibility of keeping your money outside of an IRA or 401(k) could be important to you.
If your goal is to build passive income through investments to cover your living expenses well before typical retirement age, then you may want to think twice before using these accounts.
My approach with retirement accounts
The approach I am taking with these retirement accounts is to use them as a “fall back” plan for retirement.
I am currently 24 years old, and I’m aiming to have around $100,000 invested in these tax advantage accounts by the time I am 30 (between my IRAs, 401(k), and some other tax advantaged accounts like an HSA).
From there, my tax advantaged accounts would have enough time to compound over 30 years and still be a good nest egg with no further contributions by the time I reach traditional retirement age.
Then, I could scale back on contributing to these accounts and could invest more of my money towards my taxable investments, like real estate.
It’s a sort of “coasting financial independence” approach to retirement accounts. I’ll invest a lot of money up front, and then let the compounding growth handle much of the rest.
Assuming an annual return of 8% with no further contributions, my nest egg in these retirement accounts would be over a million dollars by the time I’m in my 60s.
That would still provide me with a half-decent retirement on its own, even if all of my taxable investments fail in the meantime.
Meanwhile, I’ll be able to use the money from my taxable investments before I reach 59.5 years of age.
In any event, I’ll still be investing consistently and aggressively. It’s simply a question of where to allocate that money, whether inside or outside of my tax advantaged retirement accounts.
Conclusion – Are retirement accounts worth it?
When it comes to retirement, you need to be clear on what your goals are. If you’re just beginning your career, and want to work to achieve financial independence before you’re 60, you might think twice about using these accounts.
While they do offer some great tax advantages, they lack some serious flexibility.
However, in many cases, even with the restrictions, the accounts can be well worth it.
Maybe the idea of coasting financial independence is attractive to you, where you invest a lot into these accounts up front and then let compounding growth handle the rest. Meanwhile you can focus on other investments outside of the accounts to achieve total financial independence before typical retirement age.
These types of accounts are not the only way to save for retirement. If your goal is to be truly financially independent before the age of 60, where your investments cover your expenses today, then you’ll likely need to explore other options.
Above all, have a plan for your retirement investing.
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