IRA/401K/Retirement Accounts

[recentcollegegrad]

Hello all:

I am starting to build up my tax advantaged retirement accounts (IRA, Roth IRA, Roth 401K). I am 23. In retirement accounts like those mentioned, I have about $28,000.

One question/concern I have is related to the minimum age to withdraw that money without the 10% penalty. I currently save 15-25% of my income, mostly (90-95%) in tax advantaged retirement accounts (mentioned above). While I do appreciate hard work, etc, I would eventually like to get out of the "rat race" a bit earlier than 59.5. This is the minimum age one can access the full balance (principal+earnings) in the aforementioned retirement accounts without the 10% penalty/additional taxes.

Do any of you have some sort of strategy in order to "access" your money in case you do decide to retire before 59.5, assuming some/most of your investable assets are in retirement accounts? Or do you just save in normal mutual funds and not put everything in retirement accounts?

For example (just using random numbers), if you're 43 and so happen to have $4 million (wouldn't that be nice...) in an IRA account. Theoretically you can't touch that until 59.5 unless you're willing to pay either A) the 10% penalty tax or B) only touch the cash amount originally invested - not any interest earnings.

Just wanted to hear what your thoughts on this were. Part of the reason I save so much now is so one day I can be financially independent. I don't want to reach that point but have everything in retirement accounts that I would have to take a big hit to touch before 59.5!

Thanks

[sblatner]

I believe there are rules that allow you to withdraw earlier from an IRA but I don't know what they are. Something about taking a certain amount out each year and then you have to take it out - no choice.

I really believe it is important to have a multi-prong approach to retirement. Pre-tax (401k), post-tax (Roth) and post-tax (regular savings/investing). If you did happen to have all of these different savings vehicles, then if you retired at 43, you could use your regular savings/investing to live on until you were 59.5.

Also, with a Roth, you can withdraw your original contributions any time. Just your earnings are subject to taxes/penalties.

[MakeAStash]

It is possible to make early withdrawals from a tIRA under what is called the 72t rule. This requires a "Series of Substantially Equal Periodic Payments" (SOSEPP). A SOSEPP has a reputation for being complex. A simpler method comes with a Roth IRA because a Roth allow withdrawals of contributions (but not gains) at any time, regardless of age.

[recentcollegegrad]

@MakeAStash: Yes, I have read up on that a bit. But I think then it still comes down to:

A) is it better to just contribute the minimum to 401K plans to get the match and then put all other savings in taxable accounts (i.e. mutual funds, raw stocks, etc)

OR

B) put as much as possible into tax advantaged retirement accounts and then follow the complex 72t distribution rules and potentially face penalties?


If you went with option A, you would have huge capital gains taxes to face if you let your money grow for 10-20 years. Obviously with option B you wouldn't have that, but your money would be much more tied up.

[MakeAStash]

Yes, in a non-retirement account you could have large gains on which to pay CG tax, but on gains in a non-Roth retirement account you'll pay tax at your ordinary income rate. CG tax rates are usually less than ordinary income rates.

To achieve early financial independence, you'll likely need to be saving more money than will fit annually into 401k plus IRA. So you might as well fund both to the max to take advantage of their tax-advantaged withdrawal options. You'll also be saving into non-retirement accounts, so before age 59.5 can withdraw from them.

[YLTL_Dan]

I'm like you but 7 years older

My retirement assets are split between my Roth IRA and 401k. If you can have access to a Roth 401k, this will be your best vehicle to retire early as you can pull our your contributions after five years. Since it's a 401k, your maximum contribution is $17k so you could build up a huge about in 10-15 years.

If you don't have access to a Roth 401k, your next best bet is to invest enough to receive a company match in your 401k (if offered) and put the rest in a Roth IRA.

The other thing to think about is how you're setting yourself up with everything else. For example, we're going to pay our house off this year, and we also invest in non-tax advantaged stock accounts. After we pay off the house, I'd like to start buying investment properties that will also help me get out of the "rat race" even faster.

[smk]

as a general rule, it is usually best to maximize your contributions to the various ira's, but which type will depend on a number of factors. particularly the tira is good if you expect your tax rate to go down at some point in the future. you can convert those funds to a roth in lower tax years whenever they occur. there are other tax free & deferral vehicles that can make sense. eg tax free bonds, series i or e savings bonds and certain insurance products. you can make a detailed analysis to see if any comes close to the benefits of the iras and use them as an alternative if your liquidity is an issue...

[violet80907]

I'll take a different approach to the answer. In the IRA, your money compounds tax free, but you may have to pay a penalty if you access the funds early. Compare that to the the non-IRA where you pay capital gains each year, which reduces your effective interest rate. Clearly, if you make 0% interest, the IRA has a problem related to early withdraw. But if you earn a "high" interest rate, it is possible to make so much money due to NOT paying the capital gains each year, that you are still better off with the money in the IRA even if you pay the penalty.

Here are some numbers I ran. The table shows IRA compounding, IRA compounding minus 10% penalty and the final capital gains payment, and a non-IRA balance. Each is computed using the assumption that the money compounds for 30 years, at the shown interest rate (far right), and that capital gains is 15%.

With these assumptions, you are better off in the IRA IF you think you will earn 6% or better for the 30 years.

Also keep in mind that if you did retire at 59, you would likely NOT withdraw all of the money right then. You would only pay the penalty on what you withdraw until you hit official retirement age. That makes the IRA even more favorable.

(P.S. I tried posting a picture, but since I am new, I cannot have an external link in my post. So please excuse the text and poor formatting.)

capital gains tax rate 15%
years 30

interest rate, IRA compounding , IRA, minus 10% penalty and taxes, non-IRA
1 $1.00 $0.90 $1.00
1.01 $1.35 $1.16 $1.29
1.02 $1.81 $1.51 $1.66
1.03 $2.43 $1.97 $2.13
1.04 $3.24 $2.58 $2.73
1.05 $4.32 $3.39 $3.49 ^ Less than 5% interest, and the non-IRA wins
1.06 $5.74 $4.46 $4.45
1.07 $7.61 $5.86 $5.66 v More than 7% interest, and the IRA wins, even with penalty.
1.08 $10.06 $7.70 $7.20
1.09 $13.27 $10.10 $9.13
1.1 $17.45 $13.24 $11.56
1.11 $22.89 $17.32 $14.61
1.12 $29.96 $22.62 $18.43
1.13 $39.12 $29.49 $23.20
1.14 $50.95 $38.36 $29.17
1.15 $66.21 $49.81 $36.60
1.16 $85.85 $64.54 $45.85
1.17 $111.06 $83.45 $57.34

[smk]

capital gains tax rate 15%
years 30

interest rate, IRA compounding , IRA, minus 10% penalty and taxes, non-IRA
1 $1.00 $0.90 $1.00
1.01 $1.35 $1.16 $1.29
1.02 $1.81 $1.51 $1.66
1.03 $2.43 $1.97 $2.13
1.04 $3.24 $2.58 $2.73
1.05 $4.32 $3.39 $3.49 ^ Less than 5% interest, and the non-IRA wins
1.06 $5.74 $4.46 $4.45
1.07 $7.61 $5.86 $5.66 v More than 7% interest, and the IRA wins, even with penalty.
1.08 $10.06 $7.70 $7.20
1.09 $13.27 $10.10 $9.13
1.1 $17.45 $13.24 $11.56
1.11 $22.89 $17.32 $14.61
1.12 $29.96 $22.62 $18.43
1.13 $39.12 $29.49 $23.20
1.14 $50.95 $38.36 $29.17
1.15 $66.21 $49.81 $36.60
1.16 $85.85 $64.54 $45.85
1.17 $111.06 $83.45 $57.34

this is a good start for this sort of problem. can't exactly hit your ira after tax calculation but seems about correct. however, it seems you taxed stocks held outside the ira as if capital gains were paid every year. if he just buys and holds a basket of 0 dividend stocks, the roth should be have the same nominal value as the the taxable account, except the roth would have a 10% penalty and the taxable account would not. clearly the taxable account would be much better. i think you need to make some assumptions about how much are dividends and the harvest rate for capital gains in the taxable account argue the roth is better at some point. then you need to check the trad ira as well...

the formula for the taxable account is =(1+$I$6*(1-$H$6)+(F$8-$I$6)-(F$8-$I$6)*$G$6*$J$6)^$E9-((1+(1-$J$6)*(F$8-$I$6))^$E9-1)*$G$6

i6 - dividend yield
h6 - dividend tax rate
f8 - total return
g6 - capital gains tax rate
j6 - % of capital gains taken each year
e9 - number of years

formulas from
Financial Analysts Journal
Volume 62 • Number 4
©2006, CFA Institute
PERSPECTIVES
After-Tax Asset Allocation
William Reichenstein, CFA

[violet80907]

however, it seems you taxed stocks held outside the ira as if capital gains were paid every year. i

Correct - I did assume capital gains are paid each year...

[smk]

with a 2% dividend and a 20% rate to harvest capital gains and a 10% total return, the value of the taxable account would be 14.24, or 1 greater than the roth, whereas if you tax it fully it comes in at 11.56