Early retirees: Focus on taxable or tax-deferred?
Ok, so here's the dilemma of the day I'm looking for feedback on: for people like myself who intend on retiring around age 40, and will need to fund a lot of years before they can withdraw money from 401k/IRA/SS, etc., how much of your portfolio should you concentrate into taxable accounts to ensure you have enough money to "cross the gap" from age 40 to age 59 1/2? (Also, I'm not a big fan of the "72(t) exception", except in extreme circumstances.)When I first started engineering my early retirement, I thought a rough 1/3 tax-deferred allocation and a 2/3 taxable brokerage account allocation was a good rough target. At the time, my thinking was: since my ability to fund 401k and IRA accounts was throttled each year according to the government limits, I should fund those and stuff everything else I could afford into my taxable accounts. If anyone has used a different strategy, I'd be interested in hearing more about it.
There is one wrinkle however: since my joint income is too large to deduct my IRA contributions, I haven't been making post-tax IRA contributions. Since those IRA contributions will yield tax-free withdrawals later on, it may make sense to fund an IRA with $4000/yr post-tax. What do people think about this? Again, the trade off is: less money to "cross the gap", but more tax-free money after age 59 1/2. As Ben Stein put it: Retirees have little money early on when they need it, but lots of money later on [due to returns and compounding] when they start slowing down and don't really need it -- the Retiree Paradox, as he calls it.
I have a strong leaning to keep funding the taxable brokerage account and leave the $4000 post-tax IRA contribution out of the picture, given the good insight our old friend Ben.
posted by fin_indie @ 11/25/2006
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8 Comments:
At 11/25/2006 5:53 PM,
Anonymous said…
Fin: Very aggressive early retirement schedule. Best wishes. The benefit of the tax-free compounding of the Roth IRA is undisputed. May want to take another look. Also the 72(t) may work for part of your gap, it too helps to access that big retirement lump 5 or even 10 years early. Mangia!
At 11/26/2006 9:49 AM,
fin_indie said…
Anon: Thanks for the feedback. I wonder why you think my plan is aggressive? I should let you know that I do have deferred compensation that is not accounted for in my current net worth. Also, we save over 40% of our annual income, so I suspect we're pretty far ahead of most people in that respect. We set the plan several years ago and are tracking respectably to it so far, so it'll be interesting to see where we wind up.
Regarding the 72(t): I will certainly use it if needed, but would like to get to retirement without *having* to use it as a part of the plan.
At 11/27/2006 7:48 PM,
Anonymous said…
Just found your blog via NetworthIQ and like it a lot. I have thought about the taxable/tax-deferred dilemma too. My thinking is that I want to "front-load" my retirement accounts so as to maximize the benefit of the tax-deferral. This means maxing out our 401K and Roth IRA accounts and only then contributing to taxable accounts. Once the retirement accounts reach a respectable amount (such as $1M), I will switch gears and focus on the taxable accounts. Also, since the retirement accounts are harder to access, there will be less temptation to raid that money for any short-term needs.
At 11/28/2006 9:42 AM,
fin_indie said…
Nigel, thanks. I agree that front-loading pre-tax accounts is the way to go. The problem is that funding your pre-tax accounts to $1M+ is going to take a LOT of years. Assuming you are in the US, that could easily take 30+ years given the govt limits. I assume during those 30+ years, you'll save extra money somewhere. The question is where? Taxable brokerage or post-tax IRA?
At 11/28/2006 1:18 PM,
pfstock said…
There is no simple answer to your question. In a taxable account, each sale, re-balance, or re-allocation is a taxable event. Likewise, dividends and capital gains distributions are taxable. However, an IRA features tax-free compounding.
If you buy non-dividend paying stocks that go straight up for a number of years (don't you wish), then you are much better off in a taxable account because you only owe taxes at the (lower) capital gains rate. By contrast, if you do a lot of trading, or buy mutual funds that distribute short-term gains every year, you may be better off with an IRA. Assuming that you keep your money in the IRA for several years, there are situations where you are better (due to the tax-free compounding), even if you are subjected to a higher tax rate and an early distribution penalty. (You can either take my word, or run the numbers for yourself.) Also, less accounting is required in an IRA.
Looking at your public profile on NetworthIQ, I can tell that we are somewhat similarly situated. But, I don't feel anywhere near ready to retire at 40. If you don't mind my asking, are you planning on cutting back your lifestyle or keeping the moonlighting gig in retirement?
At 11/28/2006 5:06 PM,
Anonymous said…
Interesting topic. Found you through NetworthIQ. I'm here: http://www.networthiq.com/people/MrSmith
I too have thought about such a topic. Not sure if I've arrived at a correct answer. I generally:
A) tend to dump as much as I can/uncle sam allows & company will match.
B) Grow the "taxed now" bucket of assets as much as needed until income produced by such assets can sufficiently cover all expenses. (necessities+luxury+tax+charity)
*********
Things I've not done yet I plan on in my next part of the strategy:
a) real estate: seems like a good tax shelter + can be healthy returns.
b) incorporation/LLC/S corp/C Corp: seems like from what I've read it serves a good role for additional tax shelters by simply reversing the trend from the order of: income/Tax/invest to income/invest/TAX
At 11/28/2006 6:18 PM,
Anonymous said…
Another way to get at 401(k) money without the 10% penalty:
Roll over into a Roth IRA. After 5 years the rollover contributions can be withdrawn without the penalty.
Of course there are income limits at the moment on the Roth conversion but these are supposed to be lifted at least for a while soon....
Once I discovered that loophole and the 72(t) thing I became much more enthusiastic about US deferred tax accounts and just today completed the paperwork to maximize my 403(b) contributions.
I am projecting that even with these extra contributions, my taxable accounts can grow in the next couple of years to a level where I could replace a large part of my fairly modest salary ($75k) by active trading. And I only spend $25k a year at the moment anyway.
A lot of my money is in an Australian retirement account that really can't be accessed till age 60. It wasn't my choice to tie it up there...
When I am 60 there is going to be piles of money I think (retirement accounts + inheritance). Bringing the money forward is the issue as you say.... (I'm almost 42 now).
I don't think a lot of the PF Bloggers out there who talk about "early retirement" have thought all this through unless they mean retiring at age 55 (when you can get the money out without penalty if you retire from a job).
At 12/01/2006 8:31 AM,
fin_indie said…
@mOOm: I agree that most have not fully thought though the tactical details of funding an early retirement. We definitely have options: Roth IRA conversion as you mention, the 72(t) or just accepting the penalty outright. I'm hoping that all of these options are a last resort because I'd really like to fund the early years out of the taxable side. It's easier to grow given that there are not govt limits on contributions and it also gives the tax-deferred accounts more room to grow. Also, I expect my "income" requirements will be much, much lower in retirement. (that's a whole other debate -- I know a lot of people have a lot of differing opinions on that one.)
I have to say, I'm shocked that you get buy on only $25k. In retirement, my wife and I believe we can get by on expenses that are 35% of our annual income, which might seem modest by some measures.
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