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