The Dark Side of Tax-Favored Savings Plans

In a few recent posts, I have extolled the benefits of saving inside the shelter of tax-favored retirement plans, and discussed ways to move more of your savings from a taxable investment account into a tax-favored one. But all is not sweetness and light! There are some downsides to weigh against the benefits before you go full bore. Here is a summary. (Alert readers should please let me know, by comment or email, if I have left anything out.)

Restricted access. When you contribute to an employer plan (such as a 401(k) plan), you can’t get access to your account any time you want it. The terms of the plan describe the limited times when you can get at your savings—typically termination of employment; sometimes financial hardship. This consideration does not apply to IRAs, which are freely available to you anytime you want.

10% penalty. If you take funds out of an IRA or 401(k) or other tax-favored retirement plan before you reach age 59-1/2, the amount distributed is subjected to a 10% tax penalty unless an exception applies. (Who came up with that age?) In a future post, I will briefly describe the exceptions to this penalty.

Income tax. Distributions from traditional pre-tax retirement accounts are generally subject to income tax. This is fair, of course, since you didn’t pay tax on those dollars going in. Nonetheless, it’s often hard to remember that when you’re actually faced with the burden of paying the tax.

Negative tax rate arbitrage. If you’re lucky enough to be taking a large enough distribution, there’s the possibility of paying a greater rate of tax coming out than you saved going in. This could be the result of events unique to you, or due to a legislated tax rate increase. It might well be the case that the benefits of compounding your investment earnings at a pre-tax rate of return, as discussed in January 30’s post, exceed the detriment of a higher tax rate on distribution. But it still won’t feel good to pay that tax. (Side note: Many people benefit from retiring to no-income-tax states like Florida. They saved state income tax on contributions in the state they worked in, e.g., New York, but then pay no income tax upon distribution because they then reside in a state without an income tax. All that, and palm trees, too!)

Roth income tax. Distributions from a Roth account are supposed to be totally tax-free. But if you take a distribution before age 59-1/2 and at least five years from when you started contributing, the earnings portion of your distribution will generally be subjected to tax.

Investment control. When you contribute savings to an employer plan, like a 401(k) plan or 403(b) plan, your investment flexibility is constrained by the options offered by the plan. Your employer’s plan might limit the investments offered or the frequency with which you may make investment changes.

Investment no-nos. Some types of investments are inappropriate for any tax-favored retirement account. With retirement accounts, certain types of investments are prohibited (e.g., investments resulting from self-dealing); some are penalized (e.g., works of art); some generate income tax (e.g., leveraged investments); and some are just too awkward to house within a retirement account (e.g., real estate).

Spouse’s rights. When you contribute to an employer plan, such as a 401(k) plan, federal law gives your spouse certain rights to be named death beneficiary of those accounts, perhaps restricting how you would have liked to leave your assets upon your death. Not a problem for most people, but perhaps for some.

Most people, I suspect, can live with these restrictions. But they should be taken into account when considering how much of your savings is housed within a tax-favored retirement plan.