Help a Reader Retire Early

Here's a question I received from a reader recently:

I am 27 years old and my husband and I have been maxing out our Roth IRA's and heavily funding our 401k's. I currently contribute 20% of my salary with a 4% match and my husband contributes 5% with a 9% match (this is not able to be changed).  At this rate, I think that we should be able to support ourselves with the interest off our investments after about 15 years, and at that point could decide if one or both of us wanted to stay home, pursue other interests, etc. Nearly every financial advice book or article (including your blog, from what I've seen), even those about early retirement, says that funding these retirement vehicles is the most important thing you can do, but I wonder about the ease of accessing this money before age 59½.  I know about the 72(t) exemption and the ability of withdrawing Roth contributions penalty free, but I worry about the complexity of calculations, the possibility of a penalty if something is calculated wrong, and having to withdrawal the same amount for many years whether you need it or not.

I am wondering whether I should reduce my 401k contribution only enough to get the company match and then put the rest of the money I had been contributing (perhaps in addition to the $10,000 that we would have been putting in our Roth IRAs) into a non-retirement investment fund.  I would be paying extra income tax now, but only long term capital gains later, so I don't believe that the tax savings is significant enough to worry about, but I am not an expert and could be missing something. Have you thought about this situation or read any articles or books that address this?  Thanks in advance for your help.

So, what would you advise her to do?

Comments

[Brandon Barkley]

I preface my advice saying that I have never been in this situation:

1. Continue to get the 401k match. You mentioned this already, so I guess it is just a duh factor.
2. Continue to max out the Roth contributions. You can always take them out if you need the money, and the ability for it to grow tax-free is really not something I would want to pass up if I were you.
3. If you really want to consider retiring only a little past age 40, I would consider taxable accounts. The reason is because I believe the calculated distribution is probably going to be pretty small with such a long life expectancy ahead. I would consider saving enough in taxable accounts to make it from age 40 to the year you turn 54 1/2. At that point, you could either start calculated distributions until 59 1/2 (since you have to do it for 5 years, it would be wasteful to start it later) or tap the Roth, but I always imagine tapping the Roth as a last resort.
4. Put any additional money into tax deferred accounts again.
5. I would also look at paying down your mortgage if you have one. I know a lot of people recommend against this, but it is a guaranteed return on investment and will require you to have less money on hand in your early retirement.
6. I would consider investing in real estate for the purposes of earning rental income. This constant stream of income could come in handy as a vehicle during the pre-retirement period. Once you get tired of dealing with it, you can sell the house and get the renter subsidized equity that you have built as well. It helps cost-wise if you or your husband are handy enough to handle basic upkeep and are willing to do it during this early retirement phase.

One last thing that I think is important to note for this discussion is that you need to really consider when you can live off your investments only very carefully. Unless you want to get an ulcer watching the stock market go up and down, you're going to have to convert a large portion of your early retirement money into safer vehicles like bonds which obviously will not earn the same returns.

[Kirk]

It looks like only one of the spouses will leave the workforce. So the first question is can they live on the working spouse's income? If so, then I would continue to max out the retirement accounts. You can't make up retirement plan contributions if you don't use them during the tax year.

If you can't live solely on one income, then you are wise to start a taxable account. Taking tax free distributions from Roths and 72(t) is an option, but a complicated one if you are starting these at age 37. I am not a big fan of 72(t)distributions because the penalty for making a mistake is huge. You can't change the amount of the distribution. And, if you make a mistake with your distributions, the IRS re-characterizes all of your previous distributions so you owe the 10% penalty on them. If you do end up needing to use the 72(t) option, make sure you set up two rollover IRAs - one for the 72(t) and one other to be used in case you need more than the 72(t) calculated distribution.

I also like the idea of creating a taxable account because you are hedging the tax bet. I am in the camp that tax rates will be decidedly higher in the future. The government is facing a tsunami when social security begins to run a deficit, rather than the surplus it does now. If all of your savings are in tax deferred accounts, you will be pulling them out at higher tax rates.

I would determine how much additional income you will need above the working spouse's salary. Then I would focus on creating a taxable account to cover this shortfall (or as much as possible). At the least, I would look to reduce your salary contributions to retirement plans to 10% (or enough to get the max matching) and then focus on building a taxable account. Use tax efficient investments like ETFs, index funds, or even municipal bonds (if you allocate any of your overall allocation to bonds). Again, if you will be able to live on the working spouse's salary, then I would still focus on the retirement accounts. Good luck to you and you should be proud of yourself. Most 27 year olds are building their debt, not savings.

[Kirk]

It looks like only one of the spouses will leave the workforce. So the first question is can they live on the working spouse's income? If so, then I would continue to max out the retirement accounts. You can't make up retirement plan contributions if you don't use them during the tax year.

If you can't live solely on one income, then you are wise to start a taxable account. Taking tax free distributions from Roths and 72(t) is an option, but a complicated one if you are starting these at age 37. I am not a big fan of 72(t)distributions because the penalty for making a mistake is huge. You can't change the amount of the distribution. And, if you make a mistake with your distributions, the IRS re-characterizes all of your previous distributions so you owe the 10% penalty on them. If you do end up needing to use the 72(t) option, make sure you set up two rollover IRAs - one for the 72(t) and one other to be used in case you need more than the 72(t) calculated distribution.

I also like the idea of creating a taxable account because you are hedging the tax bet. I am in the camp that tax rates will be decidedly higher in the future. The government is facing a tsunami when social security begins to run a deficit, rather than the surplus it does now. If all of your savings are in tax deferred accounts, you will be pulling them out at higher tax rates.

I would determine how much additional income you will need above the working spouse's salary. Then I would focus on creating a taxable account to cover this shortfall (or as much as possible). At the least, I would look to reduce your salary contributions to retirement plans to 10% (or enough to get the max matching) and then focus on building a taxable account. Use tax efficient investments like ETFs, index funds, or even municipal bonds (if you allocate any of your overall allocation to bonds). Again, if you will be able to live on the working spouse's salary, then I would still focus on the retirement accounts. Good luck to you and you should be proud of yourself. Most 27 year olds are building their debt, not savings.

[mjmcinto]

Nothing against FMF or the readers here, but I think this is something that would best be handled by a good financial adviser (fee only, and someone you can trust). The reason is that early retirement involves a lot of variables, including health insurance, kids (and possibly college for them), and all the laws and regulations surrounding retirement accounts. Without knowing your all of your details, I think it would really be hard to devise an accurate plan for this person, and in those two paragraphs, there's just not enough information to devise a thorough plan, and I doubt they'd be comfortable giving out all of the information on the web to people they don't know, which is why I think a financial adviser is warranted here.

[jimbo]

I am 70 years old now and have been retired since my 50's. I like the advise above,but would keep th 10% going into the 401. I would pay down the mortgage. One of the best investments is still real estate. When you have a large equity, then take out a loan on this and purchase a rental property. Get one with a positive cash flow. A big expense after retirement is the health coverage. Hopefully the gov. will do something about that by the time you are retired. Make your kids work through college and take out some college loans to pay after they are on their own. If you are lucky,the kids may move out of your house by the time they are 30.Read the book on tough love and apply it. good luck to you,and I know you can do it.

[mjmcinto]

@jimbo - Is there a particular book you are referring to? If so, I would like to know so I can read it.

[Jacob]

I am not a financial advisor, however I could support myself from the interest of my investments(*) without having to work again and I'm 32. I did not inherit, win the lottery, start a dotcom or flip any housing. I did however save about 3 times as much or close to 75% of my income starting when I was 25 and became financially independent when I was 31.

To me the hassle of squeezing extra dollars out of tax laws is just too much trouble. If I was you, I would therefore try to solve two problems.

1) Invest enough in taxable assets to carry you from early retirement to age 59.5.
2) Invest enough in retirement assets to carry you from 59.5 to death.

The form of these assets depend on your desired lifestyle, investment skills, and risk tolerance.

As an early retiree risk becomes more important to you than it is to those who work until they're 60. Note that index funds can have a fairly low Sharpe ratio compared to managed funds. Since your horizon is short (you said 15 years), you could get in on the wrong time. For instance, if you consider historic index stock charts, imagine if you had started investing in 1971 with the intent of retiring in 1986. Also consider that the equity duration of the SP500 is currently over 50 years e.g. much longer than 15 years. In short, if you are going to retire early, I would recommend becoming very savvy on investment matters since those are going to be your major income.

*) I'm invested for total return since I'm still working. I'm a scientist, I can't help myself if there's an interesting problem to be solved :-) However, I could easily change my portfolio for income.

[jimbo]

I mentioned the book about tough love. This is how to deal with children in a strong but loving way. To not be an enabler to them. Tough Love by Phyllis and David York. I think they may have a series dealing with different situation. It is a great book and my wife and I used it well. Check amazon books. good luck.

[Laura]

I am the reader with the original question. Thank you all for your suggestions. Kirk - those are exactly my concerns about 72t. Here are some points of clarification:

We will always put enough in 401k's to get the company match.

We are aggressively prepaying our mortgage so that will be paid off before any early retirement. I hesitate to invest in any other real estate because there isn’t a big demand for houses for rent in my area. I suppose we could fix them up and sell for profit.

It is likely that one of us will work at least until age 55 in any case, and even likely that we both will since I enjoy my job - I am just investigating the possibilities - I don't want to be in a situation where I could retire based on my net worth but not without paying penalties to access the money.

In the time between age 40-something and 55, we may be able to live off one salary, and maybe not. I am thinking we may need to withdrawal ~$10k/year.

I don't feel I need a financial adviser unless I were to rely on the 72t exemption. We are both educated in business, it's just that you don't often hear about saving for retirement outside of traditional methods, so I was wondering if anyone actually did it.

Keep the suggestions coming!

[Lord]

Good advice. As to the tax benefits of retirement accounts, for equities with a 10% return and a 15% marginal capital tax rate, the benefit of tax deferral is (1+10%)/(1+10%*(1-15%)) - 1, or 1.4% a year if fully realized, but deferring capital gains over the long term, it can be reduced to about half this.

[Kris]

Yes, if you want to retire early you should fund your taxable accounts. I would continue to fully fund the Roth since that money can be accessed after 5 years.

I am in my early 40's and plan to resign from my career in one year. Thats early retirement, not 55 or 59. I will live off of my passive (cap gains and dividend) income only. No side work, or consulting. If I had directed more money to my taxable accts as opposed to my 401(k), I would have retired at 40.

You are right there are no Financial planners, books or bloggers that can tell you how to really retire early - meaning in your 40's. They like to regurgitate the same mantra about maxing out tax sheltered accounts.

As for taxes, I think its a safe bet that tax rates are going to increase in the future. Currently, income tax rates exceed capital gains rates, but it hasnt always been that way and could change.

I feel overtaxed now, but it will be nothing compared to the day I turn 70.5 and must take RMD from my overfunded 401k. My projected RMD exceeds my current salary. So with RMD, SS, my pension and dividend income, I will be thrust into the highest tax bracket of my life, which will surely exceed any tax rate that we have today. Its frustrating, but there are worse problems. ;)