Tax Diversification and Liquidity - Your 401(k) Might Be Too Much Of A Good Thing

A note from Josiah

I reached out to Tim Hamilton in July 2021, while in the initial stages of launching Flat Fee Advisors. He’s been a consistent supporter of our mission ever since. Tim founded FinancialFamilies as a wealth advisor in 2014. Prior to that, he had an extensive career in wealth management. He spent eight years reaching the Managing Director level at two boutique wealth management firms. Additionally, he broadened his industry exposure through three years with a Fortune 100 financial services corporation based in Central Ohio. When he is not in the office, he enjoys spending time with his family, and enjoys activities like traveling to the Rockies.

Many families dutifully contribute as much as they can afford to their employers’ 401(k) plans. In fact, plenty of families invest so faithfully into their 401(k) plans that they end up without flexible liquidity and with limited tax tools when it comes time to use their portfolios. This lack of diversification, from both a tax and liquidity standpoint, can create some unforeseen financial pickles.

In a world where tax brackets rise and fall and opportunities often appear well before retirement, it’s worth pausing to consider what types of accounts fill out a portfolio. While the tried-and-true 401(k) delivers valuable tax-deferral, it also locks up the investment assets until retirement and ensures every distribution is taxed as ordinary income. It’s essential to build out sensible liquidity and broader tax options through an emergency fund, a taxable brokerage account, and, when available, Roth contributions.

Big Beautiful Basket

Diligent and well-intended 401(k) contributions mixed with time, compounding returns, and employer matches can offer impressive and financially supporting account balances. However, that big beautiful singular basket does little to help with a change of residence, to pursue an immediate opportunity, or to enable a range of tax strategies when the time comes to use that basket.

A 401(k) timeline is informative here:

1. While there is a healthy list of exceptions, notably the age 55 rule, generally distributions prior to age 59 1⁄2 are subject to a 10% additional tax penalty.

2. Even after age 59½, distributions are subject to ordinary income taxation on the full amount of every distribution. Taxable brokerage accounts do generate taxable dividends and interest along the way, but receive favorable capital gains tax treatment, including a step up in cost basis to heirs, when utilized. Roth accounts, though requiring after-tax contributions, accumulate and can be distributed tax-free.

3. Then, under Secure 2.0 Act rules, required minimum distributions (RMDs) begin at age 73, moving to age 75 in 2033.

Building more than one basket matters. Variety is the key to balancing liquidity, opportunity, and tax efficiency. When the transmission fails, the medical bills arrive, or it’s time for a temporary bridge to a new job opportunity, an emergency fund proves useful. When it comes time to purchase that lot next door, finish the basement, or your furnace heats the home for the last time, the liquidity of a taxable brokerage account keeps untimely loans at bay. When you bump up against an unknown future income tax bracket threshold, tax-free Roth distribution options are a pleasant nod to the taxman. In all of these situations, it’s possible to end up with no choice but to generate taxable income or borrow when cash is called upon. Account type dispersion allows for strategically minimizing Social Security taxation, taking advantage of 0% capital gains rates, or ducking Medicare IRMAA surcharges.

Retirement’s Wiggle

Lower taxation is not a guaranteed retirement state. When employment income is low, perhaps at the beginning of a career, when one spouse retires, or during job transition, a couple can temporarily move into a lower tax bracket compared to what they might face in retirement. Pension payments, Social Security benefits, and required minimum distributions can add up for a retiree, who may ultimately find tax bracket increases hard to fend off.

Medicare IRMAA surcharges should also be considered. These quiet surcharges speak up when Modified Adjusted Gross Income exceeds certain thresholds. Large required minimum distributions can become an unforgiving adversary in this situation. Our nation, and certainly Medicare, face meaningful financial challenges. Evolving, less favorable, laws are likely across a range of yet to be clearly identified targets.

Tax rates themselves are regularly in motion. Rising tax rates are no friend to a portfolio overallocated to the ordinary income tax consequences of 401(k) plans. Given our two-party political system, portfolio strategies need all the flexibility they can muster as we weave in and out of dueling political priorities.

Tax Diversification and Liquidity Matters

Some couples position themselves to retire in their 50s and others want to start a new business. A modest emergency fund is insufficient for both purposes. A more substantial taxable brokerage account goes further to offer the often-forgotten liquidity half of the diversification puzzle.

A savvy investor can choose investments that pair nicely with the liquidity of a taxable brokerage account. Some stocks make smaller or zero dividend payments and municipal bonds are tax-free. Properly positioning these investment options within the context of a larger portfolio, that surely includes other investment options in still important tax-deferred accounts, allows for a range of liquidity and tax strategies.

Inheritance Impact

Each account type also behaves differently when inherited. For beneficiaries, there are requirements regarding timing and taxation of distributions. A mix of account types can offer survivors a range of options.

In common law states, when spouses inherit a taxable brokerage account, they receive a step up in cost basis to the value at time of inheritance for half the account. If sickness clarifies what spouse is likely to pass away first, a full step up in cost basis can be pursued with a change of account ownership. This step up effectively wipes out unrealized capital gains, allowing heirs, in this case a spouse, to sell inherited assets immediately without triggering years of accumulated capital gains tax. A spouse can treat an inherited IRA or 401(k) plan as their own. This is possible with Roth accounts, too. Roth accounts offer this advantage and do not have required minimum distributions so their favorable tax treatment can continue.

When a nonspouse inherits a taxable brokerage account, they receive a full step up in cost basis. An IRA, either traditional or Roth, requires complete distribution of the inherited account within ten years by nonspouse beneficiaries. An inherited Roth account can be held for the ten-year period and liquidated tax-free at the end, allowing tax-free growth to continue for the duration. A traditional IRA or 401(k) may require distributions during the ten-year period. If the original account owner began required minimum distributions during their lifetime, they must be continued by the beneficiary. This requirement forces ordinary income taxation and makes it unlikely that most beneficiaries will choose to hold sizable balances until the tenth year. If they do, the entire account value would be subject to income tax in the year of distribution.

Case Study

Consider two families, each with a $1,000,000 portfolio. One family, let’s call them the Goodwins, has 90% of their wealth in their employers’ 401(k) plans. The other, the Prudence family, has an even mix of deferred, Roth, and taxable investment accounts.

During their lifetimes, they experience a series of common events. They want to purchase a piece of land upon which to build their dream home. The Goodwins either need to borrow to fund the land, at potentially unfavorable interest rates, if they can even afford the down payment, or move into a temporary housing situation to free up their housing equity while their dream home is built. The Prudence family, who prioritized access to liquid capital, can make the capital available to purchase the land which can be replenished when their housing equity is freed up at a time of their choosing.

Then, both families do well for themselves and wish to retire in their mid-50s. At best, the Goodwins might be able to take advantage of the age 55 rule permitting access to their considerable 401(k) funds, though tiptoeing around marginal tax brackets will not be a luxury they’ll enjoy. Meanwhile, the Prudence family does not need to rely on the age 55 rule, which may not be available when the time comes. They also have the flexibility to generate income in a range of ways that are adaptive to the tax laws in force when they transition into retirement.

Lastly, the Goodwins and the Prudence family are fortunate to have left a sizable inheritance. The beneficiaries of the Goodwin estate largely inherit an uncompromising 401(k) plan with required minimum distributions that are not sensitive in the least to their taxable income realities. The Prudence beneficiaries receive a full-step up in cost basis of the investment assets held in the taxable brokerage account, the luxury of retaining the Roth investments and its tax-free accumulation for ten years before distribution, and a more manageable 401(k) value with its ordinary income implications.

Conclusion

Give some thought to your personal approach. Are you dutifully contributing all you can to your 401(k). Have you left room for life’s twists and turns with liquidity and tax diversification? Here is a quick checklist of next steps:

• Go get the corporate match available in your 401(k), then consider your investment account type options as you build out your all-weather financial approach.
• Build some liquidity, with a taxable brokerage account. Don’t think, what do I need to get through a rough weekend? Think, what do I need to call the shots? $100,000?
• Remember the Roth, after-tax contributions with tax-free accumulations and distributions. Some balance between traditional and Roth is sensible.

Through decades of experience, flat fee financial advisors, like FinancialFamilies, understand the many nuances of our financial world and the impact on the families that must navigate them. It’s not necessary to allow surprises to catch you financially unaware. True financial strength comes not just from saving more, but from saving smarter – with tax and liquidity flexibility built in.

Up Next

If you're earning $250,000+, this High Earner's Year-End Financial Checklist for 2024 is your essential guide to tax-saving strategies that could save you thousands before December 31st. From maxing out retirement contributions and backdoor Roth conversions to tax-loss harvesting and equity compensation optimization, numerous high-impact moves expire at year-end. Discover the time-sensitive actions that matter most for high earners—but only if you act now.