I usually tell people that they should be putting money into their IRAs or 401(k)s to save for retirement. And while for many people I still think that’s a good idea, after this past tax season, I’m having second thoughts. Here’s why:
If you are not retired you should not be receiving income from your IRA or 401(k).
Now I understand life happens and sometimes people need to tap into those funds. But if you need to tap into your retirement funds for something other than retirement, then it means that you don’t have enough funds in your regular savings.
Here’s what happens—people tap into their 401(k) when they wind up in financial trouble. It doesn’t really matter how they got there, maybe its medical bills, maybe it was a tornado. The point is they needed money and the retirement fund was all that was available.
They get hit with taxes on the money they withdraw and they also get dinged with a penalty for early withdrawal of the funds. So they wind up being double taxed when they’re already in financial dire straits. Often, the withdrawal bumps them into an even higher tax bracket, making the hit even worse. If they would have had that money is a savings account that they could access—then there would have been no tax implications for getting at that money.
Okay I can hear you now, “Look, Sherlock, I already tapped out my savings account before I went to the IRA. I’m not stupid, I was desperate.” And yes, I do hear you. Where I’m coming from is that as a country, we all don’t put enough money into savings. We all, as a nation, are better at putting money into our IRAs and 401(k)s. We get tax incentives to do it. Sometimes our employers sign us up without our even realizing it. And it makes the IRS happy because they wind up getting more money out of us by giving us a tax break.
What’s that? Yes, the IRS makes more money off of us by giving us a tax break on our 401(k)s because we break into them so often. The sales pitch is put money into your 401(k) and you don’t pay tax on that money. Then, when you take it out, you’re supposed to be in a lower tax bracket so you “win”. The reality that I’m seeing these days is—people are putting their money into their 401(k)s while in the 25% tax bracket and taking it out while still in the 25% tax bracket and paying an additional 10% penalty on the money. The only winner I see here is the IRS!
So what’s the solution? Put money into a savings account. A real savings account—not a “this money is for our Disney vacation account“ — I mean this money is for “Dorothy and Toto blew away with the house and Auntie Em is in the hospital” account.
Savings accounts aren’t sexy. You don’t get any tax incentives to have one. Heck, you don’t even get a toaster anymore! (I still use a frying pan that my mom got for opening a bank account back in the late 40’s or early 50’s. It’s a great frying pan.)
But if it makes you feel better, think of your savings account as your way of cheating the IRS out of a little unearned bonus money. That might be all the incentive you need.
