Alright, so this may be one of my more controversial takes. But I really don’t think investment plans – IRAs, 401ks, etc. – have any distinct advantage over a normal, traditional trading account. There is one particular reason why I think this is true, but I’ll dive into the details within this post.
One caveat before this starts: I am not saying you would never want an investment plan. I have an investment plan in the form of a 401k, just like I’m sure many of you do. On an individual basis, there’s good reason to get 401ks. If you are a risk-averse investor – that is, you don’t like stock picking and you freak out every time the market fluctuates – you’re better off just getting a 401k because of the fact that you never really have to think about it in your 60s. You’ll see as I describe my case against investment plans that my case doesn’t work for everybody. Just want to make that clear right in front.
Another thing I want to point out is that I am not saying investment plans are inherently inferior to trading accounts. I just don’t think they’re superior to them, either. Like I said, this really depends on the person.
Alright, with that out of the way, let me get to my argument. The main crux behind why people say IRAs are better than an investment account is the tax advantage. In simple terms, a Roth IRA gets rid of capital gains tax. That means that you pay into the fund, the fund gains money, and when you cash out in old age you get all the money back plus gains. In a trading account, by comparison, you lose 15% of gains on sales past a year and 25% of gains if you sell within the year.
That number is nothing to scoff at! Over the span of 40 or so years, an investment account can gather quite a bit of gain – and the fact you don’t have Uncle Sam taking a 15% bite out of it becomes more and more beneficial.
But there’s a key issue here.
The stipulation behind most investment plans is that you can only withdraw the money at a certain date. For IRAs, that’s about 60 years of age. If you withdraw before this time, you pay the standard tax plus a 10% fee. In other words, you’re paying short-term tax for long-term gains!
It’s true that there are exceptions to this – for example, early withdrawals are allowed in order to supplement house purchases. But I think overall the IRA system makes the inaccurate judgment that you aren’t going to need to dive into your investments until after you’ve hit retirement age.
It is my philosophy that investments should be treated as savings. That is, you only take investments out when you need the money for an emergency case. A lot of the time, however, that emergency is going to happen far before you’re 60 years old – and often won’t be part of one of the IRA’s withdrawal exceptions.
With this in mind, my argument is that the 15% long-term tax premium is worth exchanging for liquidity (not the short-term tax premium, you should never sell investments in the same year). In my mind, I am willing to pay 15% on gains if it means I get to sleep easier at night knowing that if I become sick or lose my job tomorrow, I have easy access to a pool of funds in my investment account. I do not have this same promise with investment plans.
This, of course, is subjective. It’s the reason why I’m not saying investment accounts are superior to investment plans. But I think a reasonably large amount of people would agree with me here to the point that it’s worth writing about so that people know IRAs aren’t necessarily the great savior they’re made out to be. My recommendation (particularly to risk-conscious investors) is to always have an individual trading account that regularly deposits money to an index fund, and treat that as long-term savings. I would also still use both tools – it’s not a one or the other decision! Like I said I personally have a 401k, and I really do not look at it at all. I’m treating it as a nice little gift at old age, that perhaps I forget about and one day get the notification of “here’s a nice hunk of cash you now have access to, congratulations!”. But my focus, at least for now, will always be on liquidity in savings.