Why use 401k's, Roth IRA's, or any kind of tax deferred account?

[Chocolatepancakes]

Long term lurker, first time posting.

In broad strokes, I would like to argue abandoning Define Contribution Plans or tax deferred accounts, especially for the FIRE aspirants like us Mustachians. At the very least, I think the Personal Finance community should stop telling people to use Defined Contribution plans or tax deferred accounts like 401k's, IRA's, or even TSP's. So much talk of tax deferral, but not of efficiency. Paying taxes later does not say much to tax burden. Tax deferred accounts are not tax efficient. A simple taxable account can be efficient with capital gains.With long term capital gains, a regular taxable  account can completely avoid the tax man. A reasonable person would say that the capital gains tax brackets are quite generous.

To wrap it up, I think that Mustachians would be better off avoiding 401k's, etc and use a regular self directed taxable account. My central argument is tax efficiency due to long term capital gains. Tax efficiency, so efficient, that someone could never have to pay capital gains.

For years, I have cursed retirement accounts by any name.

[Indexer]

Tax deferral:  I can use my 401(k) to defer taxes from right now, while I'm in the 24% tax bracket, until I'm post FIRE and in a 12% tax bracket.

How is that a bad thing?

Roth: I pay 0 taxes on the growth.

How is that a bad thing?


Sure, with a taxable account I don't pay any taxes on growth that I never touch, and I pay LTCG rates on any gain that's part of a withdrawal. This helps me get my taxes on growth close to zero. However, the Roth has no taxes on growth so you really lost me on why a Roth is bad.

If we were comparing a pre-tax account with a static tax rate(same while working and FIRE) to a taxable with ideal tax efficiency you might have a point, but ideally investors are taking advantage of pre-tax accounts when they are in higher tax brackets.

[MDM]

For years, I have cursed retirement accounts by any name.

Better to Light a Candle Than to Curse the Darkness.  In other words, it appears you don't have a full grasp of how tax-advantaged accounts may have an advantage over taxable accounts.

[Chocolatepancakes]

Thank you for the replies, I'll get to learning.

[Rob_bob]

Will your employer match your contributions to your taxable account?

[EvenSteven]

Thank you for the replies, I'll get to learning.

When you are looking into it further, I would encourage you to make a few examples with numbers and see what effect having investments in different accounts does to your after tax return. Make some reasonable assumptions that favor one, then the other.

[SailingOnASmallSailboat]

Will your employer match your contributions to your taxable account?

This. Free money? Thank you, yes.

[VaCPA]

You should definitely utilize your 401k at least up to the company match. In your order of investments that should be #1, then the discussion can begin. I think pretax vs taxable decision has a lot to do with your tax bracket. Obviously pretax is attractive to people in their peak earnings years in high income brackets who can shave 19.5-26k off their taxable income. Even for those people I'd recommend supplementing with something taxable as well, like a backdoor Roth so you'll have a little flexibility in retirement.

[ixtap]

How is taxable ever more tax efficient than Roth?

[iris lily]

How is taxable ever more tax efficient than ROTH?

You guys are likely better tax wonks than I am, but I think the old chestnut about tax brackets dropping in retirement is worth examining carefully.

I am not sayin it is wrong, but for us it was pretty much wrong. And neither of us had employer matches so the tax break was everything.

 

[ixtap]

How is taxable ever more tax efficient than ROTH?

You guys are likely better tax wonks than I am, but I think the old chestnut about tax brackets dropping in retirement is worth examining carefully.

I am not sayin it is wrong, but for us it was pretty much wrong. And neither of us had employer matches so the tax break was everything.

How does that address the difference between taxable and Roth?

[beltim]

How is taxable ever more tax efficient than Roth?

It isn't, ever.*  But I wonder if the OP understands Roths, given that they listed it as a tax deferred account.

* taxable is more efficient than a Roth if you sell for a loss.  But if that's the situation, you have larger problems than tax optimization.

[iris lily]

How is taxable ever more tax efficient than ROTH?

You guys are likely better tax wonks than I am, but I think the old chestnut about tax brackets dropping in retirement is worth examining carefully.

I am not sayin it is wrong, but for us it was pretty much wrong. And neither of us had employer matches so the tax break was everything.

How does that address the difference between taxable and Roth?

Isnt the thread about “ any kind of tax deferred” account? Isnt the base assumption here that tax deferral is always a strategy that must be employed?

 I have both Roth IRAs and regular IRA accounts, to address that.

 In retirement here for 5 years and am sick of living my financial life with the overarching theme of tax avoidance or ACA income monitoring for subsidies.


Mainly I’m just cranky because we owe $10,000 to the IRS this year. I can’t see that the tax avoidance strategies discussed in my household with the H were helpful. Last year our tax bill was about $400-ish. This year is making me go UGG. Last year I was embarrassed because it was so low and felt like I wasnt doing my part for America, rah rah.

Edited to remove inaccurate comment about ACA tax.

[VaCPA]

How is taxable ever more tax efficient than ROTH?

You guys are likely better tax wonks than I am, but I think the old chestnut about tax brackets dropping in retirement is worth examining carefully.

I am not sayin it is wrong, but for us it was pretty much wrong. And neither of us had employer matches so the tax break was everything.

For people who save/invest heavily you're right it doesn't always work out that way. I think that statement does apply pretty broadly across the general population though, where people invest less and spend more during their peak earning years and what should be the growth phase of their portfolio. It probably also comes from a time when social security could viably be your sole means of retirement income. People on this forum and forums like it who save/invest a large % of their income are unfortunately a small subset of the population. We also don't know what changes there may be to the tax code over the long-term.

[teen persuasion]

Long term lurker, first time posting.

In broad strokes, I would like to argue abandoning Define Contribution Plans or tax deferred accounts, especially for the FIRE aspirants like us Mustachians. At the very least, I think the Personal Finance community should stop telling people to use Defined Contribution plans or tax deferred accounts like 401k's, IRA's, or even TSP's. So much talk of tax deferral, but not of efficiency. Paying taxes later does not say much to tax burden. Tax deferred accounts are not tax efficient. A simple taxable account can be efficient with capital gains.With long term capital gains, a regular taxable  account can completely avoid the tax man. A reasonable person would say that the capital gains tax brackets are quite generous.

To wrap it up, I think that Mustachians would be better off avoiding 401k's, etc and use a regular self directed taxable account. My central argument is tax efficiency due to long term capital gains. Tax efficiency, so efficient, that someone could never have to pay capital gains.

For years, I have cursed retirement accounts by any name.

For those eligible for EITC, modest investment income (> $3600 or so) from taxable accounts could make you ineligible.  But contributions to traditional 401k accounts reduce both w2 wages and AGI, reversing the 21% phaseout rate as well as tax avoided.  Then add state tax advantages - my state matches federal EITC at 30%, so that's effectively another 6.3% phaseout reversed, plus 4% state tax avoided.

Remember, EITC is fully refundable, so this is additional income we get for utilizing traditional 401k contributions.  Even if we ultimately owe zero federal income tax due to nonrefundable tax credits, those traditional contributions increase our eligible refundable credits : 21% + 6.3% + 4% = 31.3% return on the contributions (within the EITC phaseout range).  Combining these refundable credits with other refundable credits (CTC, state CTC, AOTC), we have an additional source of income to use to fund Roth IRAs completely tax free.

Then there's the FAFSA advantages for college financial aid.  Investments in retirement accounts are not reported as Available Assets.  Investments in taxable accounts ARE reported as Available Assets, increasing your Expected Family Contribution (reducing aid).  While current year contributions to a tax deferred retirement account get added back to Available Income for a calculated EFC, there are 2 special cases where your AGI is used (which could be reduced by pre-tax retirement contributions): Special Needs Test, and auto EFC = 0.  SNT effectively skips the asset reporting if AGI < $50k.  Auto EFC = 0 skips all calculations if AGI < $26k.  Your EFC could look very different if utilizing only taxable accounts, vs utilizing tax deferred retirement accounts.

[jerseymark]

I completely disagree about Roth IRAs/Roth 401Ks because they are not tax deferred and they typically are better than taxable accounts.

However, I agree regarding tax deferred accounts that often times it is better to have a taxable account.  Most people automatically think deferring taxes is always best.  There are a few situations in which a taxable account is better:

1. Long term capital gains tax now may be lower than ordinary income at retirement.  So, if you have investments that are not bonds or dividend heavy, paying tax now may be better in the long run.

2. Fees - Often times 401K/403B fees are higher then a standard Vanguard/Fidelity, etc... account and the fees can negate any tax savings.  These can be sneaky - typically there is an overall account fee per month PLUS higher fees on funds within the account.

3. Variable treatment of tax deferred accounts by state: Some states may tax the "Tax Deferred Accounts" - for example NJ(where I live) taxes contributions to 403B accounts.

4. Tax-Loss Harvesting can increase long term gains on taxable accounts

5. Another benefit of taxable accounts is the ability to withdrawal anytime and contribute anytime

Overall, you need to analyze the options available to you to make a determination.
For most people, best to worst is:
1. Tax deferred up to company match
2. Roth IRA
3. Then either further Tax deferred or taxable account depending on fees/etc....

[MustacheAndaHalf]

OP posted twice on April 25th, and then never posted again.  So our replies are probably lost on them.

[dhc]

I know OP disappeared, but in case anyone else is still not sure about tax-deferred vs Roth, it's worth keeping in mind that by the very act of retiring early, you're pretty much guaranteeing that your yearly income will drop after retirement, and thus also your tax bracket.

Consider this naive example:

• Single. Current salary: $100,000.
• Save 50% for 10 years.
• Living expenses: the other $50,000
• By MMM's shockingly simple math, retire 17 years later with $1,250,000, enough to keep spending $50,000.
• Of this, $850,000 is what was saved, so $400,000 must be gains.

With only taxable investment (or with Roth accounts):

• Taxes now are $15,253/year
• Of the $50,000 in retirement $16,000 is capital gains (or less with Roth withdrawals), so $0 tax.
• Total taxes: $259,301

With $19,500 in a traditional 401(k):

• Taxes now are $10,890/year.
• Total tax before retirement: $185,130
• Of the $50,000 in retirement: $19,500 is from 401(k), taxed as regular income. Of the remainder, $9,760 is capital gains. Total taxe is $733/year.
• It would take 101 years of retirement to pay the additional $74,171 vs no deferral.

Tax estimates from https://www.ameripriseadvisors.com/assets/calculators/Tax1040.html because it was near the top of Google and offered the options I needed.

Not included in this approximation:

• Match (makes deferral better)
• Dividends (makes deferral better, as some are not taxed during the 17 higher-income years)
• Placement of asset classes for tax efficiency (makes deferral better if you can have more gains in taxable and less in 401(k))

All of the above are shared by Roth accounts, but those still result in more tax overall per the base calculation.

It is absolutely better in retirement to have capital gains than to withdraw from a tax-deferred account. But with early retirement, you more than make up for that difference on the front end, by not paying as much tax while working.

If you're planning to retire early and using a Roth or taxable account instead of deferring, I highly recommend running through a similar exercise with your own numbers. It was certainly eye-opening the first time I did so.

[rmorris50]

I wish I could find the study, but I thought not only was it best to use tax deferred accounts, but it even had the surprising result that using the tax deferral and paying the 10% penalty in early retirement was better than using a no tax deferral account and even the Roth. While generalized studies don't easily translate into personal specific circumstances, it made me realize that I don't have to have the mindset of working until 60 to avoid a 10% penalty, I'm still better off than if I had just put the money in a non-tax deferral account. It was definitely eye-opening study.

[MDM]

...the surprising result that using the tax deferral and paying the 10% penalty in early retirement was better than....

That conclusion will very much depend on the assumptions used.

[rmorris50]

...the surprising result that using the tax deferral and paying the 10% penalty in early retirement was better than....

That conclusion will very much depend on the assumptions used.

Naturally... all models are very assumption dependent. All models are wrong, but some are useful, as the old saying goes. Here's a link to that illustrates paying the penalty may not be as bad as it optically appears. One flaw of this example though is it assumes the person's budget is flexible, in other words the person isn't withdrawing extra to cover the extra tax so she can cover fixed expenses. So always good to model out your specific situation.

https://www.madfientist.com/how-to-access-retirement-funds-early/

[MDM]

...the surprising result that using the tax deferral and paying the 10% penalty in early retirement was better than....

That conclusion will very much depend on the assumptions used.

Naturally... all models are very assumption dependent. All models are wrong, but some are useful, as the old saying goes. Here's a link to that illustrates paying the penalty may not be as bad as it optically appears. One flaw of this example though is it assumes the person's budget is flexible, in other words the person isn't withdrawing extra to cover the extra tax so she can cover fixed expenses. So always good to model out your specific situation.

https://www.madfientist.com/how-to-access-retirement-funds-early/

Similar discussion (including a link to the same article) in How to withdraw funds from your IRA and 401k without penalty before age 59.5.

For details on the marginal rate comparisons that drive traditional vs. Roth results, see Traditional versus Roth - Bogleheads.

[rmorris50]

Thanks for the links, I've bookmarked for future reference. For my personal situation, I have a big rollover IRA ($1M), but I also have a small backdoor Roth, Pension, Deferred Comp, and of course SS. Between all these I'll have a very good income base for ages 55 and beyond. I'm now 46, and would love to retire and use the rollover IRA to bridge the gap to 55. I could do a SEPP but that provides a low payment, and I don't need a fat traditional IRA late in retirement. So determining the optimal way to access all these accounts this complicated, especially with a spouse who will keep working for the next 10-15 years. So I ideally would like to avoid the 10% penalty, but I'm not automatically discounting that path as an option, especially if I just want to tap the IRA on an ad-hoc basis as needed (again, cause spouse is working), but again I don't want the account to get to fat in retirement, all the while sacrificing quality of life now grinding away in a career.  First world problems I know.

[ixtap]

Thanks for the links, I've bookmarked for future reference. For my personal situation, I have a big rollover IRA ($1M), but I also have a small backdoor Roth, Pension, Deferred Comp, and of course SS. Between all these I'll have a very good income base for ages 55 and beyond. I'm now 46, and would love to retire and use the rollover IRA to bridge the gap to 55. I could do a SEPP but that provides a low payment, and I don't need a fat traditional IRA late in retirement. So determining the optimal way to access all these accounts this complicated, especially with a spouse who will keep working for the next 10-15 years. So I ideally would like to avoid the 10% penalty, but I'm not automatically discounting that path as an option, especially if I just want to tap the IRA on an ad-hoc basis as needed (again, cause spouse is working), but again I don't want the account to get to fat in retirement, all the while sacrificing quality of life now grinding away in a career.  First world problems I know.

Why not look into Roth conversions? That would simplify things quite a bit with that IRA.

[rmorris50]

Thanks for the links, I've bookmarked for future reference. For my personal situation, I have a big rollover IRA ($1M), but I also have a small backdoor Roth, Pension, Deferred Comp, and of course SS. Between all these I'll have a very good income base for ages 55 and beyond. I'm now 46, and would love to retire and use the rollover IRA to bridge the gap to 55. I could do a SEPP but that provides a low payment, and I don't need a fat traditional IRA late in retirement. So determining the optimal way to access all these accounts this complicated, especially with a spouse who will keep working for the next 10-15 years. So I ideally would like to avoid the 10% penalty, but I'm not automatically discounting that path as an option, especially if I just want to tap the IRA on an ad-hoc basis as needed (again, cause spouse is working), but again I don't want the account to get to fat in retirement, all the while sacrificing quality of life now grinding away in a career.  First world problems I know.

Why not look into Roth conversions? That would simplify things quite a bit with that IRA.

Last time I looked at this it was a wash as long as my spouse kept working. I think he'd have to retire too for it to make sense, but he wants to keep working (he says my FIRE dream is Peter Pan syndrome haha). He's actually 50 and in school for his Nursing Doctorate and he's working. He has no plans to retire soon. BUT life changes, and I would be ready to jump on this in years that pop up where we have low income. Who knows, I tell him he could wake up one day and want to say eff it all and just retire.

[TaronM]

How is taxable ever more tax efficient than Roth?

It isn't, ever.*  But I wonder if the OP understands Roths, given that they listed it as a tax deferred account.

* taxable is more efficient than a Roth if you sell for a loss.  But if that's the situation, you have larger problems than tax optimization.

When you aren't 59.5 yet, which, I thought a lot of the point of FIRE is the "E" - Early. Meaning, before 59.5 is when you plan to spend this money you've been saving.

Roth accounts charge income tax for all gains withdrawn, plus a 10% early withdrawal penalty, if you use them before 59.5.

Taxable accounts charge LTCG tax for gains, which has a very generous 0% tax bracket. A married couple could claim $78,750 capital gains PLUS $24,800 more from standard deduction in a single year. That's just gains, not total amount pulled from the account. If using basic stock market index funds, the vast majority of dividends also are taxed as "qualified" so fall in the same category as LTCG.

No frugal person retired early should ever have to pay any tax from a taxable brokerage if these tax laws stay in place.

But let's say you started investing at 20 and primarily used a Roth, and then you wanted to retire at 40. Sure, you can get the original contributions back out without penalty, but all the gains over the last 20 years? Locked behind a 10% early withdrawal penalty AND income tax rather than LTCG tax.

Kept all that money in a taxable brokerage instead? Unlikely to ever pay any tax on it at all. Can even use capital gains harvesting to further increase likelihood of never paying tax. Or capital loss harvesting, but I wouldn't recommend it for classic total stock market index fund investing (too risky to have to leave the money out of a stock index fund for the 30 days to avoid a wash sale, IMHO).

The only advantage a Roth has, IMHO, is for Bonds, and as a vehicle for getting money out of a Traditional account via Roth Laddering, for as long as that remains legal.

Traditional accounts, do, however, have distinct advantages over taxable accounts, by deferring income from high-income earning years to later, as well as lowering AGI to enable access to stuff like better rates for ACA health plans and so on.

But Roth? I made the mistake myself of thinking they sounded great on paper, but once doing the math, I realize there is no good reason to ever contribute to a Roth account. The only reason your money should ever be in a Roth is for Roth Ladders or maybe to hold Bonds (and only if your income was already low enough that year that you wouldn't have been better off using a traditional pre-tax account). I regret all the money I put into Roth accounts in the past and now that I am retired early, am stuck trying to figure out how to get as much out of them as possible as quickly as possible so future gains end up in my taxable account where I have immediate, tax-free access to them.

[beltim]

How is taxable ever more tax efficient than Roth?

It isn't, ever.*  But I wonder if the OP understands Roths, given that they listed it as a tax deferred account.

* taxable is more efficient than a Roth if you sell for a loss.  But if that's the situation, you have larger problems than tax optimization.

When you aren't 59.5 yet, which, I thought a lot of the point of FIRE is the "E" - Early. Meaning, before 59.5 is when you plan to spend this money you've been saving.

Roth accounts charge income tax for all gains withdrawn, plus a 10% early withdrawal penalty, if you use them before 59.5.

Taxable accounts charge LTCG tax for gains, which has a very generous 0% tax bracket. A married couple could claim $78,750 capital gains PLUS $24,800 more from standard deduction in a single year. That's just gains, not total amount pulled from the account. If using basic stock market index funds, the vast majority of dividends also are taxed as "qualified" so fall in the same category as LTCG.

No frugal person retired early should ever have to pay any tax from a taxable brokerage if these tax laws stay in place.

But let's say you started investing at 20 and primarily used a Roth, and then you wanted to retire at 40. Sure, you can get the original contributions back out without penalty, but all the gains over the last 20 years? Locked behind a 10% early withdrawal penalty AND income tax rather than LTCG tax.

Kept all that money in a taxable brokerage instead? Unlikely to ever pay any tax on it at all. Can even use capital gains harvesting to further increase likelihood of never paying tax. Or capital loss harvesting, but I wouldn't recommend it for classic total stock market index fund investing (too risky to have to leave the money out of a stock index fund for the 30 days to avoid a wash sale, IMHO).

The only advantage a Roth has, IMHO, is for Bonds, and as a vehicle for getting money out of a Traditional account via Roth Laddering, for as long as that remains legal.

Traditional accounts, do, however, have distinct advantages over taxable accounts, by deferring income from high-income earning years to later, as well as lowering AGI to enable access to stuff like better rates for ACA health plans and so on.

But Roth? I made the mistake myself of thinking they sounded great on paper, but once doing the math, I realize there is no good reason to ever contribute to a Roth account. The only reason your money should ever be in a Roth is for Roth Ladders or maybe to hold Bonds (and only if your income was already low enough that year that you wouldn't have been better off using a traditional pre-tax account). I regret all the money I put into Roth accounts in the past and now that I am retired early, am stuck trying to figure out how to get as much out of them as possible as quickly as possible so future gains end up in my taxable account where I have immediate, tax-free access to them.

Besides the fact that you're not taking into account taxation of dividends, all your problems with Roths disappear if you use 72(t) withdrawals:
https://www.bankrate.com/retirement/using-72t-rules-for-penalty-free-income/

Another consideration you didn't mention is state taxes, which push the needle in further favor of Roths as well. 

[MDM]

Besides the fact that you're not taking into account taxation of dividends, all your problems with Roths disappear if you use 72(t) withdrawals:
https://www.bankrate.com/retirement/using-72t-rules-for-penalty-free-income/

Another consideration you didn't mention is state taxes, which push the needle in further favor of Roths as well.

+1

Also, if one receives SS benefits, capital gains (even if not taxable themselves) may cause more of the SS benefit to be taxable.  Roth withdrawals have not effect on SS benefit taxability.

[seattlecyclone]

When you aren't 59.5 yet, which, I thought a lot of the point of FIRE is the "E" - Early. Meaning, before 59.5 is when you plan to spend this money you've been saving.

Roth accounts charge income tax for all gains withdrawn, plus a 10% early withdrawal penalty, if you use them before 59.5.

The solution to this "problem" is simple: don't spend your Roth gains before you turn 59˝.

Backing up a bit, the way you avoid getting into this situation is to not save 100% of your money in Roth accounts if you're retiring much earlier than 50 years old. That doesn't mean you eschew retirement accounts entirely! Do contribute as much as you can to these, but choose some pre-tax contributions. This is probably a good idea anyway since retiring with 100% of your money in Roth accounts means you'll have $0 income in retirement, at least in years when you're not withdrawing the Roth gains early. Why pay tax at a non-zero rate while working, if you're predicting zero income in retirement? That's not a good trade! Might as well save enough in pre-tax accounts to at least fill the standard deduction with Roth conversions every year. This will help replenish your Roth basis and ensure you don't need to dip into the gains early.

Taxable accounts charge LTCG tax for gains, which has a very generous 0% tax bracket. A married couple could claim $78,750 capital gains PLUS $24,800 more from standard deduction in a single year. That's just gains, not total amount pulled from the account. If using basic stock market index funds, the vast majority of dividends also are taxed as "qualified" so fall in the same category as LTCG.

No frugal person retired early should ever have to pay any tax from a taxable brokerage if these tax laws stay in place.

A few points in response to this:
1) The 0% capital gains rate has only existed since 2008. It is far from guaranteed to exist forever.
2) Even if it does, this 0% rate only applies to federal taxes. Most states do tax this income.
3) Even at the federal level, if you plan to purchase health insurance through your state marketplace the untaxed capital gains still count as income for the purpose of calculating your ACA subsidy. The phaseout of these subsidies acts as a 10-18% marginal tax in addition to whatever other tax rates may apply.

But let's say you started investing at 20 and primarily used a Roth, and then you wanted to retire at 40. Sure, you can get the original contributions back out without penalty, but all the gains over the last 20 years? Locked behind a 10% early withdrawal penalty AND income tax rather than LTCG tax.

Sure, this is why you should retire with less than all your money in a Roth IRA. Save those tax-free gains for your "old person money."

But Roth? I made the mistake myself of thinking they sounded great on paper, but once doing the math, I realize there is no good reason to ever contribute to a Roth account. The only reason your money should ever be in a Roth is for Roth Ladders or maybe to hold Bonds (and only if your income was already low enough that year that you wouldn't have been better off using a traditional pre-tax account). I regret all the money I put into Roth accounts in the past and now that I am retired early, am stuck trying to figure out how to get as much out of them as possible as quickly as possible so future gains end up in my taxable account where I have immediate, tax-free access to them.

I contributed quite a lot to pre-tax retirement accounts and also took full advantage of (backdoor/mega backdoor) Roth contributions where pre-tax wasn't an option. I absolutely don't regret putting that money in Roth instead of taxable. If I had put it in taxable I would have paid quite a bit of tax on the dividends while I was still working, and my income for ACA purposes would be quite a bit higher now that I'm retired. Instead I have a solid cushion of Roth basis to start me on my Roth ladder once my taxable savings are spent down, and that existing basis plus the new basis to be created over time from Roth laddering should be more than enough to see me through to 59˝.

[seattlecyclone]

Besides the fact that you're not taking into account taxation of dividends, all your problems with Roths disappear if you use 72(t) withdrawals:
https://www.bankrate.com/retirement/using-72t-rules-for-penalty-free-income/

While the 72(t) withdrawals do allow you to avoid the 10% early withdrawal tax, I don't believe they get you out of needing to report the withdrawal as income once your basis is exhausted. Once you're past the standard deduction, this factor will cost you more than the early withdrawal tax would anyway.

[TaronM]

Besides the fact that you're not taking into account taxation of dividends, all your problems with Roths disappear if you use 72(t) withdrawals:
https://www.bankrate.com/retirement/using-72t-rules-for-penalty-free-income/

Another consideration you didn't mention is state taxes, which push the needle in further favor of Roths as well.

No, I mentioned taxation of dividends, twice. Once in referencing the fact that dividends ALSO get preferential 0% tax treatment IF they are from stock market index funds that tend to have very low turnover (so far every year 95%+ of my dividends have been "qualified" and thus not taxed, and the rest easily fall within Standard Deduction), and secondly that the one place a Roth is superior is for holding Bonds (though I didn't explicitly state the reason for that is because of the dividends generated by Bonds which are not "qualified", I felt that was implied).

So, if you are following MMM's advice of throwing all your investments into total stock market index funds, dividends are not going to be a tax concern in your taxable brokerage account. If you are using bond funds or doing fancier stock market stuff, than it could be an argument for using a Roth (though, since you probably should be using a Traditional anyway for the benefits of deferral, just hold your bonds and such in one of those and in the Roth when doing Roth Laddering).

As for 72(t), have you really looked closely at that? Because I have. Not only is it locking you into something for an extended period of time, possibly screwing you over if you change your mind later and decide to start a new lucrative career or something (or in my case, having highly variable post-retirement extra income from royalty checks that are at the whim of a fickle market), but the amount you can pull out is severely limited. No way you can use the 4% rule if the vast majority of your investments is in a Roth using 72(t), that is much higher than what is allowed. Also, that just avoids the early withdrawal penalty, not the fact that the gains count as income and not LTCG's.

72(t) does not remotely make "all my problems with Roths disappear".  It is pretty much useless for a lean-FIRE like mine.

As for state taxes - well, you have me there, I'm in a no-income-tax state so sometimes forget that's an issue for some people. Even some states that do have income tax follow the same pattern as federal and give preferential treatment to LTCG though (judging from helping my mother-in-law with her taxes in such a state).

And as for Social Security, again if you are leading a frugal lifestyle and retiring early, and practice capital gains harvesting before SS kicks in, I really, really doubt you would have a problem with your capital gains causing taxation of SS benefits. A mustachian shouldn't need to pull out enough money that the gains alone would be an issue.

....

You guys are pointing out ways to get around problems with the Roth, but that doesn't change my overall point - that the assertion that "Roth accounts are always more tax efficient than a taxable brokerage" is WRONG.

There are cases, like mine, where I put too much into a Roth and now have to potentially pay more in taxes than I would have if I had left some of that money in a brokerage. Could I have avoided this by being better with how much I put in Roth vs Traditional vs Brokerage and set up an earlier Roth Ladder and so on and so forth? Sure, but I only heard about this whole FIRE thing after I already had the savings saved up and lost my primary income stream. So I'm having to adapt on the fly after the fact, whereas most people here still seem to be in the "earning" phase and have time to set up stuff.

But this isn't about me and my situation, I'm just an example, and you only need one counter example to disprove a blanket statement that taxable accounts are always less tax-efficient than Roth accounts.

[TaronM]

1) The 0% capital gains rate has only existed since 2008. It is far from guaranteed to exist forever.

That's true, and was one of the reasons I originally thought keeping a bunch of my portfolio in the Roth was a good idea, but you could say that for practically anything discussed here. Who's to say Roth Ladders will remain legal, for example? There's already been talk in congress of removing that option. If they go away then suddenly all that money in a deferred account is a lot harder to get in early retirement, and would be a situation where you'd be better off having some of your money in a taxable brokerage and not 100% in IRA's with early withdrawal penalties attached.

Possible change in tax laws is why it is probably a good idea to hedge your bets and have some in Traditional, some in Roth, and, yes, some in a taxable Brokerage, and don't assume that in all situations one is superior to the other. Which was my main point here.

Personally, this won't be an issue for me regardless. Standard Deduction alone is sufficient. We live on $30k a year, which is above SD but of course you can't sell stocks at 100% gains so not hard to keep the gains below it. Dividends could be an issue, but I would obviously use those before selling anyway, so not a problem until I make more than $24.8k in dividends per year, and if and when that happens, I don't think I'll care about paying more taxes!

But, obviously something for others to consider that are going for a more FAT-FIRE.

[beltim]

Besides the fact that you're not taking into account taxation of dividends, all your problems with Roths disappear if you use 72(t) withdrawals:
https://www.bankrate.com/retirement/using-72t-rules-for-penalty-free-income/

Another consideration you didn't mention is state taxes, which push the needle in further favor of Roths as well.

No, I mentioned taxation of dividends, twice. Once in referencing the fact that dividends ALSO get preferential 0% tax treatment IF they are from stock market index funds that tend to have very low turnover (so far every year 95%+ of my dividends have been "qualified" and thus not taxed, and the rest easily fall within Standard Deduction), and secondly that the one place a Roth is superior is for holding Bonds (though I didn't explicitly state the reason for that is because of the dividends generated by Bonds which are not "qualified", I felt that was implied).

So, if you are following MMM's advice of throwing all your investments into total stock market index funds, dividends are not going to be a tax concern in your taxable brokerage account. If you are using bond funds or doing fancier stock market stuff, than it could be an argument for using a Roth (though, since you probably should be using a Traditional anyway for the benefits of deferral, just hold your bonds and such in one of those and in the Roth when doing Roth Laddering).

This is only true for those with taxable income less than $38k for single and $77k for married couples.  And even so, taxable isn't better – it's the same as a Roth.

As for 72(t), have you really looked closely at that? Because I have. Not only is it locking you into something for an extended period of time, possibly screwing you over if you change your mind later and decide to start a new lucrative career or something (or in my case, having highly variable post-retirement extra income from royalty checks that are at the whim of a fickle market), but the amount you can pull out is severely limited. No way you can use the 4% rule if the vast majority of your investments is in a Roth using 72(t), that is much higher than what is allowed. Also, that just avoids the early withdrawal penalty, not the fact that the gains count as income and not LTCG's.

Yes.
https://forum.mrmoneymustache.com/ask-a-mustachian/why-do-we-want-to-max-out-401k/50/
https://forum.mrmoneymustache.com/ask-a-mustachian/retiring-on-pensions-versus-savings/msg463528/#msg463528
https://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-pensions-social-security-and-early-retirement/msg234754/#msg234754
https://forum.mrmoneymustache.com/ask-a-mustachian/too-much-money-in-401kira/msg342267/#msg342267

The question is, have you looked into how much you can withdraw via 72(t) withdrawals?  You might be pleasantly surprised.

[TaronM]

The question is, have you looked into how much you can withdraw via 72(t) withdrawals?  You might be pleasantly surprised.

Of course I have, and I was unpleasantly surprised about how low the maximum is after initially thinking it could be the answer to my problems (I thought you could just pick an amount yourself...nope!). Not only that, but once you start taking out 72(t) distributions from an account, the entire account is locked from any other kind of distributions. So even if I could pull out enough to live on with it (which I can't), if I have a year where I need more than the 72(t) allows, I have no option to pull out extra from that account. Also, I can't pull out less either, so if we get bored with this whole RE thing and want to go back to full time jobs, it becomes an income tax bracket issue.

72(t) is a pretty big, long-term commitment with severe restrictions. Heck, two of the methods don't even let you adjust your withdrawals for inflation! It is far less palatable than just having the money in a taxable brokerage and having 100% control over it and STILL paying 0% in taxes.

[beltim]

The question is, have you looked into how much you can withdraw via 72(t) withdrawals?  You might be pleasantly surprised.

Of course I have, and I was unpleasantly surprised about how low the maximum is after initially thinking it could be the answer to my problems (I thought you could just pick an amount yourself...nope!). Not only that, but once you start taking out 72(t) distributions from an account, the entire account is locked from any other kind of distributions. So even if I could pull out enough to live on with it (which I can't), if I have a year where I need more than the 72(t) allows, I have no option to pull out extra from that account. Also, I can't pull out less either, so if we get bored with this whole RE thing and want to go back to full time jobs, it becomes an income tax bracket issue.

72(t) is a pretty big, long-term commitment with severe restrictions. Heck, two of the methods don't even let you adjust your withdrawals for inflation! It is far less palatable than just having the money in a taxable brokerage and having 100% control over it and STILL paying 0% in taxes.

So what did you come up with, as a percentage of your portfolio?

[TaronM]

So what did you come up with, as a percentage of your portfolio?

It varies by the year how much I need, due to continuing but unstable income from prior work (royalties on software sales). Some years, as much as 5.5%. Some years I haven't needed any at all. With 72(t), I can't take that 5.5% in years I need it because an extra withdrawal is considered a modification of the payment schedule, meaning that I would then be back-taxed on the 10% early withdrawal penalty for any previous 72(t) SEPP distributions. In other years where I needed little, I would be forced to take the whole amount, and the distributions do not count as income allowing me to counter that by contributing to a traditional IRA or anything (plus that would still lock the money behind a penalty anyway). And, as seattlecyclone pointed out, 72(t) doesn't protect from income tax on Roth gains, only for the 10% penalty, unlike taxable brokerage which has that sweet 0% LTCG tax rate (currently).

[MustacheAndaHalf]

Be careful with 72(t) plans.  The rules are tricky, and a mistake can involve IRS penalties.  At least read up on the most common mistakes people make, so you have a lower chance of doing the same.