Working toward financial flexibility

Question: I max out contributions to my workplace 401K and a traditional IRA (I no longer qualify for a Roth). Should I be doing more to save for retirement? Are there other retirement vehicles available to me or should I continue investing in non-retirement accounts (e.g., direct purchase of mutual funds and/or stocks through my brokerage account)? Sandra, Silver Spring, MD

Answer: Congratulations on saving so well for retirement. What I want to do is make a pitch for you to keep on saving, but outside of retirement savings vehicles. I would invest your additional savings in taxable accounts.

Savings should be geared toward funding transitions over a lifetime. Retirement is only one of those shifts, although it’s a big one. Savings shouldn’t be only about preparing financially for old age. Savings should be about funding career and lifestyle shifts throughout a lifetime.

The big advantage of putting money into taxable accounts is flexibility. Specifically, if you pull money out of a 401(k), you’ll pay a 10% penalty plus your ordinary income tax rate on the withdrawal. You could borrow from the plan, but that maneuver reduces the long-term return on investment.  

Yet with a taxable account you can tap the money at any time for any reason without penalty. It's a simple strategy that gives you flexibility. In practical terms, you could set up an automatic savings program that regularly puts money into a variety of taxable accounts, from online savings accounts to broad-based equity index funds. 

Of course, you'll pay Uncle Sam something every year on this savings. And you'll owe long-term capital gains taxes on your stock and bond holding when you cash them in -- assuming you've held them for more than a year. Still, the long-term capital gains tax rate is a lower rate than ordinary income tax rates.

A savings program like this gives you a measure control in an uncertain world. With flush taxable savings you get greater freedom of choice throughout a lifetime no matter what the state of the economy. And that's a hefty return on investment.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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