People who are looking to become financially independent and retire early have a lot of
questions that they need to answer for themselves.
When do I want to retire?
What do I want to do in retirement?
How much money am I actually going to need in order to make it through early retirement?
How and where am I going to get my money in early retirement?
How am I going to pay the rising cost of medical expenses?
And on and on it goes.
I’ve already made some videos dedicated to some of those questions and eventually
I'll have dedicated videos to all of them but today we're just going to focus on the
last one...
Where are you going to get your money in early retirement?
And, for the early retiree specifically, are 401Ks, IRAs, and other tax-advantaged accounts
really worth it?
Hey everyone Daniel here and welcome to Next Level Life a channel where you can learn about
investing, debt, retirement, and many other financial topics besides, because, let’s
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So as I covered in last week's video the HSA can be a great tool for those who are eligible
to have one when trying to tackle medical expenses both before retirement, whether early
or not, and during it.
I don't think that there is a whole lot of debate as to whether an HSA is a good idea
for those wishing to pay for medical expenses in retirement, the triple tax benefit of the
account is undeniable.
But for accounts like the IRA and 401k, both of which have restrictions on when you can
take out the money, the answer is somewhat less clear-cut.
Is it really a good idea to put what may be the majority of your savings into an account
that you cannot touch until you enter your 60s?
I mean sure they give you tax benefits either on the front end for traditional accounts
or on the back end for Roth accounts, but if you're looking to retire at 40 years old
or even earlier on than that you could be looking at 20-30 years or more that you will
have to fund on whatever you managed to save outside of your 401k and IRAs.
And that's a pretty tall task for most of us.
Unless of course, you have a side hustle to cover those early years, but not everyone
has a side hustle that is large enough to cover all that.
However, despite all of these seemingly negative points, I personally think that under most
circumstances it's still better to take make full use of these tax-advantaged accounts,
in large part because even with accounts like the IRA and 401K the money isn't as locked
away as you might think.
With a little planning ahead you can still access enough of that money in order to live
in the early retirement years using something called a ROTH IRA Conversion Ladder.
The ROTH IRA Conversion Ladder is a strategy that many early retirees use to access their
retirement funds early without paying that 10% early withdrawal penalty that the IRS
imposes on funds coming out of retirement accounts.
The strategy works because of the rules surrounding the traditional and Roth accounts.
When you retire you have the option of rolling your traditional or ROTH 401K from your employer
into an IRA in your name, just know that funds from a traditional 401K must be rolled into
a traditional IRA and funds from a ROTH 401K must be rolled into a ROTH IRA.
You also have the ability to roll money from a traditional IRA into a ROTH IRA, though
you will have to pay the taxes on the amount that you roll over in the year that you roll
it over.
The upside to doing this is that the money you roll over can experience tax-free growth
for the rest of the time that it sits in your ROTH IRA account.
The other upside for early retirees is that any amount that you contribute or roll over
into a ROTH IRA can be withdrawn tax-free and penalty-free before you’re past the
age of 59.5 as long as those funds have been in the ROTH IRA for at least 5 years.
So, just to make things simple, say if you wanted to retire in 5 years when you were
40 years old and wanted to withdraw $100 a year (in today’s dollars) to live on in
retirement (unrealistic numbers, I know, but this is just for the sake of illustrating
the concept).
You would have a couple of options.
Either A start a side hustle that will earn you that money in retirement, B invest in
a taxable account enough during those 5 years so that it can generate that $100 a year for
you to live on in retirement, C continue investing in your traditional IRA during those 5 years
and then just withdraw the money from the IRA each year when you retire and pay the
taxes on it then as well as the 10% early withdrawal penalty from the IRS, or D roll
over an inflation-adjusted amount of money so that you will have $100 available for you
to withdraw from your ROTH IRA when you retire 5 years from now.
There are actually some other options and possibilities depending on your specific situation
such as the rule of 55, IRS rule 72(t), and others but they deserve their own video.
Anyway, if decide to use the ROTH IRA Conversion Ladder and we assume that inflation is going
to be roughly 3% per year on average over the next 5 years then we would need to roll
over about $116 from our traditional IRA to our ROTH IRA this year in order to have that
$100 a year (in today’s dollars) to live on in your first year of retirement.
In year 2 we would repeat this process adjusting for inflation once again and roll over $119.41
since that would give us the equivalent of $100 inflation adjusted a year to live on
in year 2 of retirement.
So as long as you take a little time to plan ahead it isn’t super difficult to get enough
of your money out of your tax-advantaged accounts.
And as you'll see in a minute using those accounts and taking advantage of the ROTH
Conversion Ladder strategy can help us to solve the other remaining major fear I mentioned
earlier of not having enough money.
Let's take a look at a hypothetical example to show you how this works.
Let's say that John and Jane are 23 years old and want to retire in 12 years at age
35 on a $30,000 a year income in today's dollars.
Assuming a 3% annual rate of inflation that would mean that they would need to save about
$1,070,000 by the time they turn 35 to be able to live on $30,000 in today's dollars
in retirement following the 4% rule.
In order to reach that lofty goal, they're going to need to save quite a substantial
chunk of money during their 12 working years.
Thankfully for them, they're making decent money, and are eligible for an HSA.
Together their salaries are roughly $72,000 per year and John has a side hustle that he's
been working on since college flipping items that he finds at his local discount store
online for a profit.
In a typical year, his side hustle allows him to bring in $12,000 in profits.
So in total, the household is bringing in about $84,000 a year, not bad.
In addition to that, they've also made sure that they're playing good defense in their
financial plan by taking advantage of rent hacking and living in a low cost of living
area.
Their budget looks like this: $450 per month to their share of rent thanks to their rent
hacking techniques, $50 a month for their share of utilities again largely thanks to
their rent hacking techniques, $100 a month to car insurance, $250 a month for health
insurance, $240 a month for food for the two of them thanks in large part for their decision
to shop at discount stores such as their local Aldi, $30 a month for eating out, $45 a month
for their phones, $100 a month for gas, $40 a month for their car maintenance, $20 a month
for their share of the internet bill, and $50 a month for other miscellaneous expenses.
In total, this brings them to about $1,375 a month or $16,500 a year in expenses.
Under these circumstances, John and Jane should be able to accomplish their goal fairly easily,
especially if John is willing to keep up his side hustle after leaving the workforce since
that would help immensely to cover some of their expenses in early retirement.
So obviously John and Jane have a couple of options here.
As I said they can use the ROTH IRA Conversion Ladder to fund their early retirement and
lower their tax bills by maxing out all of their tax-advantaged accounts or they could
ignore the 401Ks and IRAs available to them and just invest in a taxable account and their
HSA to help cover their medical expenses in retirement.
If John and Jane decide to just go with the HSA and taxable accounts they will have a
tad over $44,300 a year or almost $3,700 a month left over to invest in their taxable
account after paying their expenses of $16,500 a year, putting the max of $7,000 a year towards
their HSA, and setting aside roughly $16,200 a year as an estimate for their taxes.
So in total, John and Jane are investing about $51,300 a year toward their retirements or
about $4,275 a month.
If, on the other hand, John and Jane decided to max out all of their tax-advantaged accounts
and later use the ROTH IRA Conversion Ladder to fund their early retirements, they would
be investing more.
Given their income and expense levels they would be able to max out a 401K and an IRA
for John and Jane (and possibly even a little extra into a Solo 401K or SEP IRA for John’s
side hustle, but that’s also a video for another day), in addition to their $7,000
investment into their HSA and still likely have some left over for taxable accounts because
their tax bill for the year would drop from roughly $16,200 to less than $7,500 thanks
to all these deductible investments.
And in total, John and Jane are investing about $60,000 a year toward their retirements
or about $5,000 a month.
How much of a difference does this make to their retirement nest eggs?
Let's first look at how things turn out if they don't take advantage of their 401ks and
IRAs.
Assuming an average 8% annualized rate of return over the long haul on their Investments
John and Jane will not actually meet their $1,070,000 retirement savings goal by the
time they turn 35, although they will be very close.
In the end, they would retire with nearly $900,000 in their taxable account about $140,000
in there HSA and a total retirement nest egg of about $1,040,000, $30,000 short of their
goal (which isn’t all bad as it would only take a few months to close that gap).
This would, as I said, not be quite enough for them to live on in retirement unless John
kept up his side hustle.
If he did they would have enough to live on and even have a bit of cushion in case a market
downturn occurs early on in their retirement.
However what if they took full advantage of their 401Ks and IRAs?
Using the same assumptions as before, John and Jane would end up with balances of $775,000
between their traditional IRAs and 401Ks, the same $140,000 in there HSA and about $45,000
in their taxable accounts by the time they retire at 35 years old.
In addition to those accounts, they also have a ROTH IRA, thanks to their use of the ROTH
Conversion Ladder that has over $226,500 in it by the time they reach retirement.
This means that, in total, their retirement nest egg is nearly $1.2 million, which is
actually enough for them to live on in retirement with or without John’s side hustle and is
a decent amount more than they had in the previous scenario.
And that's not to mention the fact that they now have the freedom to choose where they're
getting their money from.
Money from a Roth IRA can be withdrawn tax-free, money from an HSA can be withdrawn for qualifying
medical expenses tax free, they can also use their money from their taxable account if
they want and if things got really, really bad they could still withdraw from their IRAs
and 401Ks and just eat the penalty but hopefully that wouldn't happen and they’d be able
to just keep converting money from those traditional accounts into their ROTH IRA until they’ve
passed the age of 59.5 and were able to start using all of their accounts in the more conventional
manner.
So in the end I believe that even if you plan to retire early it's worth considering taking
advantage of your tax-advantaged accounts because at the very least you end up delaying
paying your taxes by several years which, all else being equal, will usually lead to
you having a slightly bigger nest egg in retirement and you also give yourself more freedom on
where to withdraw your money in retirement.
And when it comes to something like your financial future, more options can never hurt.
But that'll do it for me today once again if you enjoyed this video be sure to smash
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