Retirement Accounts and Short Timelines

February 19th, 2024
Sometimes I talk to people who don't use retirement accounts because they think the world will change enormously between now and when they're older. Something like, the most likely outcomes are that things go super well and they won't need the money, or things go super poorly and we're all dead. So they keep savings in unrestricted accounts for maximum flexibility. Which I think is often a bad decision, at least in the US:

  • Even if you're especially optimistic or pessimistic, the chance that you'll want money at retirement is large enough to be worth planning for.

  • The money is less restricted than it sounds: there are several options for using the money before retirement age.

  • The money is more protected than if you save it normally.

I think the cleanest comparison is between investing through a regular investment account and a Roth 401k. This is a plan through your work, and they may offer matching contributions. If your employer doesn't offer a 401k, or offers a bad one (no low-cost index funds), you can use a Roth IRA instead.

When people compare a Roth 401k to keeping the money in a non-retirement account the normal presentation is something like:

  • Pros: you're not taxed on growth.
  • Cons: if you need the money before age 59.5 there are penalties.

This isn't exactly wrong, but it's missing a lot. Additional considerations:

  • When people say "growth" is tax free they mean nominal growth, not real growth. This favors retirement accounts, because capital gains taxes apply to nominal growth, so the savings are larger than they look and get larger the larger inflation gets.

  • If you want to withdraw your contributions without taxes or penalties you can convert ("roll") your Roth 401k over to a Roth IRA.

  • Five years from when you open your account there are options for taking gains out tax-free even if you're not 59.5 yet. You can take "substantially equal periodic payments", but there are also ones for various kinds of hardship.

  • The first ~1.5M in your retirement account is protected from bankruptcy.

  • Means testing generally ignores retirement accounts but does include conventional ones. College financial aid that uses the more thorough CSS PROFILE is a partial exception here: the college does still look at the information, but often ignores them and is less likely to ask for them than if the money is in a conventional account.

  • If you lose a lawsuit, your 401k (but not an IRA) is protected from judgement creditors.

  • In future cases where people are trying to come up with rules about what counts as money you have right now, they're much less likely to count retirement assets than regular ones, which is usually what you want.

Some caveats:

  • This is for long-term savings. If you expect to need the money soon, say for buying a house, then it wouldn't make sense.

  • Some options for taking money out require your employer to allow it, or would need to wait for you to leave the company.

  • This is all about Roth 401ks (and a bit of Roth IRAs); depending on your current tax bracket and the rest of your financial situation you could do better with some combination of Traditional account, HSA, or other tax-advantaged plan.

  • I'm not a financial advisor, and the right choice depends on your situation. Don't read only this one post before making a decision!

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