I'm at the point in my financial life we're I'm ready to start investing for retirement in earnest, and I'm planning to invest 15% of my income into retirement accounts, but I hear a lot of stories about people who get in trouble, and can't access their money without taking big penalties. How do I balance the risk of having so much of my wealth tied up and put out of reach?
Congratulations on deciding to save for retirement. Since you cite Dave Ramsey as the source of your 15% number, what does he have to say about where to invest the money?
If you want to have instantaneous penalty-free access to your retirement money, all you need to do is set up one or more ordinary accounts that you think of as your retirement money. Just be careful not to put the money into CDs since Federal law requires a penalty of three months interest if you cash in the CD before its maturity date (penalty!) or put the money into those pesky mutual funds that charge a redemption fee (penalty!) if you take the money out within x months of investing it where x can be anywhere from 3 to 24 or more.
In Federal tax law (and in most state tax laws as well) a retirement account has special privileges accorded to it in that the interest, dividends, capital gains, etc earned on the money in your retirement account are not taxed in the year earned (as they would be in a non-retirement account), but the tax is either deferred till you withdraw money from the account (Traditional IRAs, 401ks etc) or is waived completely (Roth IRAs, Roth 401ks etc). In return for this special treatment, penalties are imposed (in addition to tax) if you withdraw money from your retirement account before age 59.5 which presumably is on the distant horizon for you. (There are some exceptions (including first-time home buying and extraordinary medical expenses) to this rule that I won't bother going into). But
You are not required to invest your retirement money into such a specially privileged retirement account. It is perfectly legal to keep your retirement money in an ordinary savings account if you wish, and pay taxes on the interest each year. You can invest your retirement money into municipal bonds whose interest is free of Federal tax (and usually free of state tax as well if the municipality is located in your state of residence) if you like. You can keep your retirement money in a sock under your mattress if you like, or buy a collectible item (e.g. a painting) with it (this is not permitted in an IRA), etc.
In short, if you are concerned about the penalties imposed by retirement accounts on early withdrawals, forgo the benefits of these accounts and put your retirement money elsewhere where there is no penalty for instant access. If you use a money management program such as Mint or Quicken, all you need to do is name one or more accounts or a portfolio as MyRetirementMoney and voila, it is done. But those accounts/portfolios don't have to be retirement accounts in the sense of tax law; they can be anything at all.
A couple of things you can do to structure your accounts include:
- having an independent emergency fund (around $20k or six months' expenses) in savings accounts and other highly liquid instruments, so you don't need to dip into the retirement funds to begin with
- putting some portion of the money in a Roth IRA, which will permit penalty-free pre-retirement withdrawals not in excess of the principal invested
- having at least some of those assets (the ones you'd access first in an emergency) in low-risk instruments like short-term high-credit-quality bond funds (which earn less return but are less likely to crash in value during a financial crisis or inflation event).
I am going through this right now. We recently moved and learned the lesson of needing a good bit of wealth in easily accessible accounts. In our case for a down payment on a new house. So we have decided to increase our emergency fund to $50,000.00 minimum. Then throwing the rest in retirement accounts seems like a safe bet.
So my rule of thumb is think of how much a 20% down payment would be on a new house if you needed to move. That way you can avoid pmi while also avoiding penalties for withdrawing from your retirement accounts.
It's all about access to capital:
You can borrow against 401ks up to an extent.
You can borrow against CDs outside of tax sheltered retirement plans.
You can't borrow against an IRA, although there is a situation with a very small time frame that would still be state sanctioned with no tax penalties. I wouldn't recommend it.
Annuities come with penalties.
I've looked at many possibilities of accessing retirement capital without penalty, and 401k's offer that ability, but its also good to just have savings accounts and investments that are not tax-deferred.
Borrowing against 401k
Outside of your general expenses and play money, money you put toward - say... - a house should be non-tax deferred. Because if you like borrowing, you can always borrow against the house, or any property. The root of the problem is liquidity and access to capital, understanding those fundamental concepts will answer most questions. "Am I liquid? Yes/No" "Can I be liquid without losing money? Yes/No"
As usual, more is more, adjust your priorities accordingly.