Author Topic: Why invest in Roth IRA or 401k if you plan to retire young?  (Read 9339 times)

firefergy

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Why invest in Roth IRA or 401k if you plan to retire young?
« on: September 25, 2012, 08:07:33 PM »
I enjoy reading this blog for the money saving and investment advice.  I am confused why investing in Roth IRA and 401k is recommended?  You cannot withdraw without penalty from either of these accounts until you are in your late 50's. If the point is to retire young then why would you invest in something you cannot use?

arebelspy

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #1 on: September 25, 2012, 08:09:22 PM »
Sure you can.  Google "72t".

And Roth principal can be withdrawn penalty free. So you can do Roth rollovers.

Google "backdoor roth".

You will want some taxable though.  But there are ways to access retirement accounts early, penalty free.

You just need to learn about them.  ;)
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Jamesqf

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #2 on: September 25, 2012, 09:49:30 PM »
The point of a 401k is to reduce your taxable income, and to get the usual employer match.  The point of a standard IRA is to reduce taxable income.  I have to admit that I've no idea what the point of a Roth IRA is.

If you think in terms of early retirement (I don't, as I actually enjoy my work), consider that your 'stash will have to last for your lifetime.  Assume you have part in 401k/IRAs, and part in other investments.  If you plan to retire at 45, say, you figure the other investment part should last 20 years, after which you can tap into the retirement funds, which have grown tax-free in the meantime.

arebelspy

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #3 on: September 25, 2012, 09:51:58 PM »
I have to admit that I've no idea what the point of a Roth IRA is.

...

Investing in an account which will have no tax liability.

Think of it as like a taxable account which you pay taxes on initially, but then you don't pay any taxes on gains, unlike a taxable account (or retirement account) where you will.
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Jamesqf

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #4 on: September 25, 2012, 10:08:13 PM »
I have to admit that I've no idea what the point of a Roth IRA is.

...

Investing in an account which will have no tax liability.

Think of it as like a taxable account which you pay taxes on initially, but then you don't pay any taxes on gains, unlike a taxable account (or retirement account) where you will.

That was my understanding: I'd pay tax on the money I put in at my current, pretty high, rate, then get to take it out tax-free later* when I would be paying a much lower tax rate on whatever I take out.  Which wouldn't be all that much, as I live fairly frugally now, and after the mortgage is paid off, could live comfortably on maybe $12K/year (in current dollars). 

As I said, I don't quite see the point.  It seems to make the same assumption that most conventional retirement planners do: that I spend most of my income now, and would want to maintain nearly the same spending level in retirement.

(*This is of course assuming that I trust government promises :-))

arebelspy

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #5 on: September 25, 2012, 10:34:46 PM »
As I said, I don't quite see the point.  It seems to make the same assumption that most conventional retirement planners do: that I spend most of my income now, and would want to maintain nearly the same spending level in retirement.

No, it doesn't make that assumption.

It makes the assumption that paying taxes now and not later is better than paying them now and later.

Say you max out your other retirement accounts, and have an extra 10k available.  You pay taxes on that extra 10k.  You can stick all 10k in a taxable account, and all gains are taxed later.

Or you can stick 5k in a taxable account and 5k in a Roth, and gains on that 5k are tax free later!

I'd prefer the latter, personally.

You also make the assumption everyone's circumstances (high tax rate now, potentially lower later) are the same as yours.  They're not.  That doesn't make the Roth worthless.  ;)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
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Lars

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #6 on: September 26, 2012, 12:03:18 AM »
The point of a 401k is to reduce your taxable income, and to get the usual employer match.  The point of a standard IRA is to reduce taxable income.  I have to admit that I've no idea what the point of a Roth IRA is.

To echo arebelspy points with a more personal anecdote, I contribute to a Roth IRA because

I live in a state with no income tax but probably won't retire in a state without one.
Due to lots of existing contributions to pre-tax accounts, kids, and state tax rates my marginal tax rate is pretty low. Traditional IRA and ROTH IRA seem likely to be a wash so I selected the ROTH for its extra flexibility on withdrawals.

bo_knows

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #7 on: September 26, 2012, 08:04:49 AM »
/thread hijack since we're talking about 72t

I know that the 72t is based on the IRS 120% rate, which is absurdly low right now.  When you decide to enact a 72t, do the payments reflect the rate at the time that it is started? Does the payment vary monthly based on the rate?

I'm trying to look ahead and see the possible situation where you're waiting for that 120% rate to go up so you can take the 72t worth taking.

arebelspy

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #8 on: September 26, 2012, 08:46:17 AM »
The former, I.e. it's fixed once you start it, I believe.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

bo_knows

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #9 on: September 26, 2012, 09:12:25 AM »
The former, I.e. it's fixed once you start it, I believe.

So, I'm guessing that there haven't been a lot of people starting 72t's in the past year... rates suck.

AJ

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #10 on: September 26, 2012, 11:15:09 AM »
/thread hijack since we're talking about 72t

I know that the 72t is based on the IRS 120% rate, which is absurdly low right now.  When you decide to enact a 72t, do the payments reflect the rate at the time that it is started? Does the payment vary monthly based on the rate?

I'm trying to look ahead and see the possible situation where you're waiting for that 120% rate to go up so you can take the 72t worth taking.

There are 3 different ways to calculate your 72t payment. You must select your method when you set it up and you can never change your mind. Only one of them is fixed for life, the other two recalculate every year based on the balance of your account and your life expectancy.

http://www.investopedia.com/articles/retirement/02/112602.asp

tooqk4u22

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #11 on: September 26, 2012, 12:07:16 PM »
You also make the assumption everyone's circumstances (high tax rate now, potentially lower later) are the same as yours.  They're not.  That doesn't make the Roth worthless.  ;)

To this point contributing to a Roth after you have retired (assuming you have some earned income) makes sense as well - not paying much taxes upfront and then as it grows you won't pay taxes later. 

All of these things are worthwhile to someone and maybe different ones at different times.

bo_knows

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #12 on: September 26, 2012, 12:24:55 PM »
/thread hijack since we're talking about 72t

I know that the 72t is based on the IRS 120% rate, which is absurdly low right now.  When you decide to enact a 72t, do the payments reflect the rate at the time that it is started? Does the payment vary monthly based on the rate?

I'm trying to look ahead and see the possible situation where you're waiting for that 120% rate to go up so you can take the 72t worth taking.

There are 3 different ways to calculate your 72t payment. You must select your method when you set it up and you can never change your mind. Only one of them is fixed for life, the other two recalculate every year based on the balance of your account and your life expectancy.

http://www.investopedia.com/articles/retirement/02/112602.asp

You say they are "recalculated".  That article mentions nothing really of that, and implies that the payment to you is the same over the life of the SEPP.  Is this incorrect?

Lars

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #13 on: September 26, 2012, 02:38:33 PM »
/thread hijack since we're talking about 72t

I know that the 72t is based on the IRS 120% rate, which is absurdly low right now.  When you decide to enact a 72t, do the payments reflect the rate at the time that it is started? Does the payment vary monthly based on the rate?

I'm trying to look ahead and see the possible situation where you're waiting for that 120% rate to go up so you can take the 72t worth taking.

There are 3 different ways to calculate your 72t payment. You must select your method when you set it up and you can never change your mind. Only one of them is fixed for life, the other two recalculate every year based on the balance of your account and your life expectancy.

http://www.investopedia.com/articles/retirement/02/112602.asp

You say they are "recalculated".  That article mentions nothing really of that, and implies that the payment to you is the same over the life of the SEPP.  Is this incorrect?

If you take the required minimum distribution method (life expectancy method), the yearly withdrawal calculation uses the account balance and life expectancy based on your age in the year of the withdrawal so the withdrawal amount varies between years. It doesn't vary for the other two withdrawal methods (which typically have much higher withdrawal rates).

TLV

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #14 on: September 26, 2012, 02:39:26 PM »
(Edit: Ninja'd!)

The way I read it, the "Annuitization" and "Amortization" methods are fixed amounts, and tend to be higher amounts than the third. The "Required Minimum Distribution" method has a variable amount - a % of the current value of the account based on your life expectancy, usually less than what the other two methods would let you take. It tends to go up each year because your life expectancy decreases, but if there's a market crash and your account loses value then it would go down.

Also, if you start with either the annuitization or amortization methods, you are allowed to switch to the required minimum distribution method (thus lowering the amount of the withdrawal). You would do this if there were a market crash, in order to not deplete your principal as quickly. You can't change it back from RMD to either of the other methods.

velocistar237

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #15 on: September 26, 2012, 02:48:53 PM »
Many of us will have 401k-type accounts and taxable accounts. Even if the 72t rate is low, it still might be enough when you add in the taxable withdrawals. Or, just use the taxable account until the MAFR goes back up.

Is it possible to do both 72t and a backdoor Roth?

Cooperstown

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #16 on: September 26, 2012, 04:05:18 PM »
I would also argue the point of a Roth IRA is you are betting the current tax rates or going to be lower than the ones when you retire.  Taking a look at the current debt in the US it doesn't take a genius to figure out taxes need to go up or spending needs to be cut.  Realistically a combination of the two, with that said I'm betting my tax rate now will be lower than my tax rate then.  If my thought process on this is wrong what am I missing?

Jamesqf

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #17 on: September 26, 2012, 04:20:13 PM »
I would also argue the point of a Roth IRA is you are betting the current tax rates or going to be lower than the ones when you retire.  Taking a look at the current debt in the US it doesn't take a genius to figure out taxes need to go up or spending needs to be cut.  Realistically a combination of the two, with that said I'm betting my tax rate now will be lower than my tax rate then.  If my thought process on this is wrong what am I missing?

1) While tax rates may go up, your tax rate may go down.  E.g. you are paying a (marginal) 28% now (for a single person, that'd be roughly $85-178K.  After retirement, you go into what is now the 15% bracket ($8700-35K).  Even if the rate on that bracket is raised to 20% or more, you still wind up ahead.

2) For a conventional IRA, you've got the benefit of the deduction in your pocket now.  For a Roth IRA, you are betting on the government's promise that it will still be tax free when you go to withdraw your money.  Will a cash-strapped future government decide to raise tax rates on everyone, or will it decide to hit the smaller number of relatively well-off Roth IRA holders?

velocistar237

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #18 on: September 26, 2012, 07:16:33 PM »
If my thought process on this is wrong what am I missing?

Right now, the tax rate in question is your marginal rate. In the future, if you get all your income from tax-deferred accounts, the tax rate in question would be your total rate. A single person with a taxable income of $50K in 2012 has a marginal rate of 25% and a total rate of 17%. The difference gets even larger when you consider Jamesqf's point 1. A single person with a taxable income of $100K has a marginal rate of 28%, but if they retire at $40K, their total tax rate is 15%.

If you go ERE and survive on less than the standard deduction, you would pay 0%.

anastrophe

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Re: Why invest in Roth IRA or 401k if you plan to retire young?
« Reply #19 on: September 27, 2012, 09:37:56 AM »
I enjoy reading this blog for the money saving and investment advice.  I am confused why investing in Roth IRA and 401k is recommended?  You cannot withdraw without penalty from either of these accounts until you are in your late 50's. If the point is to retire young then why would you invest in something you cannot use?

My income is low, in the 15% bracket, but I'm a super saver. Traditional IRAs make no sense for me as I don't need the tax break now, I will need it later when my income is higher. Thus, the Roth already is appropriate, even without the tax-free gains. Your situation is not universal.