Taxable vs. Tax Advantaged Accounts for FIRE

[Mistah Cash Lion]

Would it make sense to skip tax advantaged retirement accounts to focus everything into taxable accounts that can actually be used without penalties before 65? I figure that I know that I will work in some capacity after FIRE and probably continue to earn and then I can put that money into some tax advantaged accounts at that point?

My goal is to accumulate 200-300k in investments to cover my expenses for FIRE. Leaning towards the lower end to speed things up.  My income is fairly low right now. About $2100/month net. I'm working on increasing that.  Currently I can save about $1000-$1200 / month and my goal is to FIRE at 30 (within 8 - 9 years).  I know I need to increase my income, but I figured if I focused everything into accounts that I can actually draw from I will be able to meet my goal much easier than diverting lots of funds to a traditional IRA. What do you say?

[MDM]

I know that I will work in some capacity after FIRE...

...if I focused everything into accounts that I can actually draw from....

Taking the second line first: if you could focus everything, that would be great.  But the IRS will take a cut.  Probably a larger cut if you skip the advantage of a tax-advantaged account.

If you are going to continue to work (and make enough to pay annual expenses?), then letting your investments grow without tax drag is best.

[Cathy]

Everybody will refer you to various threads addressing mechanics that, under current tax law, can be used to access tax-advantaged funds before old age. Of course, there is no guarantee that the law will be the same in the future. According to the Congressional Research Service, Congress can even change tax laws retroactively in most situations, so it's possible the tax savings you're realising now could be taken away in the future: http://www.fas.org/sgp/crs/misc/R42791.pdf


Aside from that, your overall plan may be unsound because $200k is not a lot of money to retire on. You may want to reconsider whether that is a really a large enough saving goal.

[Mistah Cash Lion]

If you are going to continue to work (and make enough to pay annual expenses?), then letting your investments grow without tax drag is best.

That's a good point and something worth considering.  Nevertheless, it slows down the actual savings that can be withdrawn and the idea is to have enough to cover bare minimum expenses that way I'm not obligated to work to cover expenses If I so choose.

Everybody will refer you to various threads addressing mechanics that, under current tax law, can be used to access tax-advantaged funds before old age. Of course, there is no guarantee that the law will be the same in the future. According to the Congressional Research Service, Congress can even change tax laws retroactively in most situations, so it's possible the tax savings you're realising now could be taken away in the future: http://www.fas.org/sgp/crs/misc/R42791.pdf


Aside from that, your overall plan may be unsound because $200k is not a lot of money to retire on. You may want to reconsider whether that is a really a large enough saving goal.

Interesting.  I'm not too worried about them changing things up.  I mean, yeah it's a possibility, but there really isn't anything I can do about it and worrying about it won't help.  Something to be aware of though.

Well, right now my expenses are right at or under $12k/year.  I could conceivably get them down to $9-10k/year by getting rid of my car and all car related expenses.  Yes, not much to retire on but I like the approach MMM advocates of "First retire, then get rich". http://www.mrmoneymustache.com/2012/05/14/first-retire-then-get-rich/

[MDM]

it slows down the actual savings that can be withdrawn

Don't understand this.  What is "it" and why does it do that?

[Mistah Cash Lion]

it slows down the actual savings that can be withdrawn

Don't understand this.  What is "it" and why does it do that?

"It" is putting my monthly savings into tax-advantaged accounts rather than taxable accounts. Therefore, taxable accounts will have a lower balance which, in turn, will push my FIRE date farther out.

[MDM]

Therefore, taxable accounts will have a lower balance which, in turn, will push my FIRE date farther out.

Exactly.  Take advantage of the advantages available to you, and FIRE can come earlier.

[Mistah Cash Lion]

Therefore, taxable accounts will have a lower balance which, in turn, will push my FIRE date farther out.

Exactly.  Take advantage of the advantages available to you, and FIRE can come earlier.

Maybe I'm missing something or not communicating things clearly.  Let's take an example.  Say I have 300k in a traditional IRA and 50k in taxable accounts.  I can't FIRE because the money in the traditional IRA is nearly useless to me unless I take unwise penalties, right?  Whereas the money in the taxable account can be withdrawn from each month in a FIRE scenario.

[MDM]

Say I have 300k in a traditional IRA and 50k in taxable accounts.

Following the strategy one can find in http://www.madfientist.com/traditional-ira-vs-roth-ira/, http://forum.mrmoneymustache.com/ask-a-mustachian/help-me-understand-the-roth-conversion-pipeline-idea-and-its-benefits/, etc.
1.  Use your $50K in taxable accounts to fund your $10K/yr for five years.
2.  Meanwhile, you start converting your tIRA to a Roth at, say, $14K/yr.  In 2015, assuming nothing unusual, you would pay $370 in federal tax and whatever in state tax on that $14K.  Let's assume you cover the taxes from part time work.
3.  After five years you start withdrawing the $10K/yr (plus inflation) you need for living expenses from the funds you converted.
4.  Repeat steps 2 and 3 for 30 years and, assuming 5% growth/yr and 2% inflation, you will have covered living expenses for all 30 years and still have ~$300K each in the tIRA and Roth for a total of $600K.

Assume instead that you start with a total of $320K in a taxable account, pay no taxes on it, withdraw the same annual $10K plus 2% inflation and it also grows at 5%.  After 30 years you will have $500K in that account.

At least, that's what a quick 'n' dirty spreadsheet look says.  You should verify....

ETA: correct #2 to change typo of $11K to $14K the 2nd place it appears.   Calcs were done w/ $14K.  Reason to use $14K was to have enough Roth contributions to cover the 30 years of inflation-adjusted withdrawals.

[brooklynguy]

Everybody will refer you to various threads addressing mechanics that, under current tax law, can be used to access tax-advantaged funds before old age. Of course, there is no guarantee that the law will be the same in the future. According to the Congressional Research Service, Congress can even change tax laws retroactively in most situations, so it's possible the tax savings you're realising now could be taken away in the future: http://www.fas.org/sgp/crs/misc/R42791.pdf

Although it is good to always keep this devil's advocate point in the back of your mind, in my view it would be unwise to give up the bird in the hand today out of fear that remote possibilities will occur tomorrow.

[wtjbatman]

Also, it's 59 1/2 for an IRA, not 65. And 55 for a 401k if you leave your job in the same year.

Although I understand for a 21 year old who wants to FIRE at 30, 55 probably seems the same as 59 1/2 which seems the same as 65. Old.

[Dodge]

Say I have 300k in a traditional IRA and 50k in taxable accounts.

Following the strategy one can find in http://www.madfientist.com/traditional-ira-vs-roth-ira/, http://forum.mrmoneymustache.com/ask-a-mustachian/help-me-understand-the-roth-conversion-pipeline-idea-and-its-benefits/, etc.
1.  Use your $50K in taxable accounts to fund your $10K/yr for five years.
2.  Meanwhile, you start converting your tIRA to a Roth at, say, $14K/yr.  In 2015, assuming nothing unusual, you would pay $370 in federal tax and whatever in state tax on that $11K.  Let's assume you cover the taxes from part time work.
3.  After five years you start withdrawing the $10K/yr (plus inflation) you need for living expenses from the funds you converted.
4.  Repeat steps 2 and 3 for 30 years and, assuming 5% growth/yr and 2% inflation, you will have covered living expenses for all 30 years and still have ~$300K each in the tIRA and Roth for a total of $600K.

Assume instead that you start with a total of $320K in a taxable account, pay no taxes on it, withdraw the same annual $10K plus 2% inflation and it also grows at 5%.  After 30 years you will have $500K in that account.

At least, that's what a quick 'n' dirty spreadsheet look says.  You should verify....

Nice calculation.  In practice it will be even more tilted towards tax-advantaged accounts, since your tIRA calculation doesn't consider the larger account balance you'd have, by adding the tax deduction during accumulation years.  If you're in a 30% (combined state and federal) tax bracket, and you're maxing out the IRA each year ($5,500 maximum), that's an additional $1,650 per year saved ($3,300 per year if you're married).  Then if you max out your 401k ($18,000 maximum), that's an additional $5,400 per year saved ($10,800 if you're married).

If you're married, it takes you 10 years to get to FIRE, and the market grows 7% a year, your net worth will be about $200,000 smaller if you ignored all tax advantaged accounts.  THEN start with the calculations MDM did above, with the taxable-only example having $200,000 less to start with, and you'll see a much larger difference.

[gobius]

Would it make sense to skip tax advantaged retirement accounts to focus everything into taxable accounts that can actually be used without penalties before 65? I figure that I know that I will work in some capacity after FIRE and probably continue to earn and then I can put that money into some tax advantaged accounts at that point?

My goal is to accumulate 200-300k in investments to cover my expenses for FIRE. Leaning towards the lower end to speed things up.  My income is fairly low right now. About $2100/month net. I'm working on increasing that.  Currently I can save about $1000-$1200 / month and my goal is to FIRE at 30 (within 8 - 9 years).  I know I need to increase my income, but I figured if I focused everything into accounts that I can actually draw from I will be able to meet my goal much easier than diverting lots of funds to a traditional IRA. What do you say?

You would get there sooner if you use tax-advantaged accounts, and you overall would probably save money.

Suppose you take MDM's example (the backdoor Roth) of withdrawing $14K/year from your tIRA and putting it in your Roth IRA.  S/he showed that you would pay $370 in federal taxes.  Even if you paid the 10% penalty, you would pay $1,400 + $370 = $1,770, which is 12.6% in income tax.  You are very likely in the 15% tax bracket now, and depending on how much you make in future years, you could potentially be in the 25% tax bracket.  So, you are able to avoid 15% taxes now (eventually even 25%) and pay 12.6% in taxes, max, in the future.  Plus, if your state has a progressive taxation system (mine does), you would save even more money by picking tax-deferred accounts.

Now, this is affected by the other income you would make while you transfer over your tIRA to a Roth, so you wouldn't want to do this while still working your job.  You'd want to live on the $50K taxable the first 5 years of retirement as MDM said, until your first backdoor Roth contributions have been in there 5 years.  Again, though, you will probably still be ahead if you had to pay the penalty, unless I'm missing something or you had to withdraw a lot more.

With a progressive taxation system and the personal exemption/deduction, the tIRA and 401(k) really help when you live on a small percentage of what you make, especially if you are a higher earner (25% bracket and above).

I am in the 25% bracket and thought the same way you did for awhile until I heard about the backdoor Roth.  I was just putting money into a Roth IRA (instead of traditional IRA) and getting the company match on the 401(k), then the rest was in taxable accounts.  I used to figure that I would be paying the same taxes either way, and with the 10% penalty I thought it didn't make sense to put so much in tax-deferred; that was until I read some of these forums and did the math.

Also, if you do end up being in the 25% bracket while working, you will have to pay more capital gains and dividend taxes on your taxable account.  In the 15% tax bracket, you pay no taxes on qualified dividends or long-term capital gains.  Having tax-deferred accounts helps keep you in those lower brackets; on top of that, you won't be paying taxes on the dividends or capital gains earned in your tax-deferred accounts at all.

[Mistah Cash Lion]

Thank you all for your detailed and helpful responses.  I'm definitely going to take a look at those posts MDM posted and I appreciate the example of how it could be done.  Looks like I have some more research to do.  I have yet to invest a single dollar, but at this stage I am just trying to gather the info and data for when I do have the opportunity to invest to make sure I am doing it in the most efficient and effective way possible while still being able to gain financial independence early.

[ioseftavi]

...I am just trying to gather the info and data for when I do have the opportunity to invest to make sure I am doing it in the most efficient and effective way possible while still being able to gain financial independence early.

The most efficient way possible to invest, is to get as much money as you can into tax-advantaged (retirement) accounts.  The difference between an account where you defer taxes (get a tax break for investing, and pay years later after the money has grown, at a low tax rate) and an account where you pay taxes as you grow is enormous.  Thousands and thousands of dollars.

This strategy is unintuitive if you're not familiar with ways to get at your retirement accounts early.  However, those strategies can be learned and used intelligently - the vast majority of early retirees plan to use them.

I would echo Cathy's thoughts about your overall plan.  $200,000 is a very, very small sum of money to retire on, let alone early retire.  You're talking about $8,000 per year in income, and that assumes a 4% SWR.  While 4% of the portfolio is sustainable for 65 year old retirees, it would very likely not work for a 30 year old who retires early.

I agree that you should "retire first, then get rich", but don't retire in a position where you can just barely support your absolute minimum expenses and there's no margin for error.

[Mistah Cash Lion]

...I am just trying to gather the info and data for when I do have the opportunity to invest to make sure I am doing it in the most efficient and effective way possible while still being able to gain financial independence early.

The most efficient way possible to invest, is to get as much money as you can into tax-advantaged (retirement) accounts.  The difference between an account where you defer taxes (get a tax break for investing, and pay years later after the money has grown, at a low tax rate) and an account where you pay taxes as you grow is enormous.  Thousands and thousands of dollars.

This strategy is unintuitive if you're not familiar with ways to get at your retirement accounts early.  However, those strategies can be learned and used intelligently - the vast majority of early retirees plan to use them.

I would echo Cathy's thoughts about your overall plan.  $200,000 is a very, very small sum of money to retire on, let alone early retire.  You're talking about $8,000 per year in income, and that assumes a 4% SWR.  While 4% of the portfolio is sustainable for 65 year old retirees, it would very likely not work for a 30 year old who retires early.

I agree that you should "retire first, then get rich", but don't retire in a position where you can just barely support your absolute minimum expenses and there's no margin for error.

Thank you for the advice. Based on what I have read here and other places I am going to start with a traditional IRA and other tax-advantaged options.  Yes, I think the 200k is probably too low and would be much wiser to shoot for 300k - 400k where I would have some wiggle room. 

The idea behind the 200k was to reach my goal even faster, but it really is cutting it too close.  I'll just have to figure out how to make up for the bigger target with a bigger income. It's funny because it feels so far away and yet I realize that I will be able to retire decades before most people. Gotta keep the bigger picture in mind I suppose.

[ioseftavi]

Sounds like your journey is off to a good start - you're learning and earning, and hammering out a solid plan.  Good on you for quickly understanding the retirement account advantages - most people figure that out after decades in the workforce.

$300 - $400k sounds much more solid for your spending level.  If your expenses stay where you mentioned, you can likely retire with that level of assets and have some breathing room while you figure out how you want to go get rich. 

And yes - it'll feel far away, even though it's decades faster than the vast majority of the population. 

The best thing I did in my 20s was to not even think of retiring at a specific date.  Simply learn all you can, earn all you can, and cram as much into tax-advantaged accounts as you can.  Once you've been at it for 5+ years, you can stop for a moment and assess where you're at.  When you've been at it ~10 years, you are likely close enough that you can toy with some calculators and try to put a specific date on FI/RE. 

Good luck!

[Mistah Cash Lion]

Sounds like your journey is off to a good start - you're learning and earning, and hammering out a solid plan.  Good on you for quickly understanding the retirement account advantages - most people figure that out after decades in the workforce.

$300 - $400k sounds much more solid for your spending level.  If your expenses stay where you mentioned, you can likely retire with that level of assets and have some breathing room while you figure out how you want to go get rich. 

And yes - it'll feel far away, even though it's decades faster than the vast majority of the population. 

The best thing I did in my 20s was to not even think of retiring at a specific date.  Simply learn all you can, earn all you can, and cram as much into tax-advantaged accounts as you can.  Once you've been at it for 5+ years, you can stop for a moment and assess where you're at.  When you've been at it ~10 years, you are likely close enough that you can toy with some calculators and try to put a specific date on FI/RE. 

Good luck!

Thanks again!

Also, for anyone else following this I found the following article to be extremely helpful in figuring all this out:  http://livingafi.com/2014/05/18/drawdown-part-3-strategy/

[Doulos]

After reading your journal, etc.

...After paying off the loan, I started saving to increase my emergency fund. Only a month later with around $1500 in savings I was temporarily laid off from my job (building websites and small web apps) for 2 weeks. Knowing I had an emergency fund and my general philosophy of life about not stressing out and my faith which is grounded in the Bible, I was not worried at all.  I spent my days working on building an HTML5 game for fun, walking around town, reading books in the park, and working out.  It was very relaxing and I tried to look at it as a mandatory vacation rather than a lay-off. Now that I'm writing this down I can see these activities being incorporated into my early retirement schedule.  ...

I am going to suggest you have the flexibility to make it on $240k (5%), maybe even less.
- Pursue that web development as a side job!  Since this was listed as fun enough that you want to do it post FIRE, I say that makes your safe stash much lower.

Looking at your $12k yearly expenses, and a maxed out Roth, and 9 years you have planned right now; 12x5=60, 5.5x9 = 49.5.  That almost pays for your 1st 5 years by itself.  You are looking to have plenty of cash-on-hand to pull that trigger at 30.
- You would need to get 10.5+ into a taxable.  Interest should take care of inflation for you.  That is just a little over $100 a month.
- Also you are talking about lowering your already Mustachian $12k per year!

If I was a betting man, I would put money on you jumping ship and going 'retired' as a web game developer years early.

Following up on your actual totals.  Assuming you have access to an HSA and/or 401k...  Your savings would like something like this...
Total income (right now) ~$33k.
401k/HSA $11k
Taxes $3.3k  - I believe you are in the 15% tax bracket?
Expenses $12k
Roth $5.5
Taxable $1.2k

My numbers do not add up quite right.  I must be missing social security or state tax or something.  But the point is, you will be saving more suddenly when you put some of that money into an HSA or 401k and start spending tax money on retirement instead of paying those taxes.  A lot more if you get matches from your company.

[Mistah Cash Lion]

After reading your journal, etc.

I am going to suggest you have the flexibility to make it on $240k (5%), maybe even less.
- Pursue that web development as a side job!  Since this was listed as fun enough that you want to do it post FIRE, I say that makes your safe stash much lower.

Looking at your $12k yearly expenses, and a maxed out Roth, and 9 years you have planned right now; 12x5=60, 5.5x9 = 49.5.  That almost pays for your 1st 5 years by itself.  You are looking to have plenty of cash-on-hand to pull that trigger at 30.
- You would need to get 10.5+ into a taxable.  Interest should take care of inflation for you.  That is just a little over $100 a month.
- Also you are talking about lowering your already Mustachian $12k per year!

If I was a betting man, I would put money on you jumping ship and going 'retired' as a web game developer years early.

Following up on your actual totals.  Assuming you have access to an HSA and/or 401k...  Your savings would like something like this...
Total income (right now) ~$33k.
401k/HSA $11k
Taxes $3.3k  - I believe you are in the 15% tax bracket?
Expenses $12k
Roth $5.5
Taxable $1.2k

My numbers do not add up quite right.  I must be missing social security or state tax or something.  But the point is, you will be saving more suddenly when you put some of that money into an HSA or 401k and start spending tax money on retirement instead of paying those taxes.  A lot more if you get matches from your company.

Thanks!  I'm hoping to be able to do the 401k at some point since you can save so much more than an IRA, but the company I work for right now doesn't offer that which leaves me with just a Roth IRA or traditional IRA. Also, not too keen on the HSA since I can't really get to that money until decades down the line.  As far as I know there is no backdoor Roth option on that one.

Any other good options?  I know there is the solo 401k, but I don't have enough side work to pull it out of the "hobby"  level to qualify for that.

[Doulos]

HSA is the only purely 100% tax free account I know of.  Which is why I believe it is advocated so strongly here.
- At the very least do the match if your company offers an HSA+match.  A match is free money.

The total yearly contribution limit for an HSA is $3350 right now (including any match).

If you never ever get sick in your entire life and never need to use that money.  I would be thankful, not sad.
And then you can spend it just like a 401k after 65. (ie, pay taxes on money taken out).