Retire Even Earlier Without Earning More or Spending Less
After finishing the Lab Rat and Assumptions post, I was anxious to start experimenting with the example scenario so I decided to apply some of the optimizations described in a few of my previous articles to see how they affected the lab rat’s journey to financial independence.
Triple Value of Income
In the Triple Value of Income article, I showed how to dramatically increase the value of your earnings by utilizing various tax-advantaged accounts and retirement incentives.
Let’s assume after reading this article, the lab rat decides to take advantage of his employer’s 5% 401(k) match. He knows he should contribute more than 5% though so he decides to fully max out his 401(k). This results in an annual contribution of $20,500 ($3,000 from his 5% employer match and $17,500 from his own pre-tax contributions).
Traditional IRA vs. Roth IRA – The Final Battle
Let’s also assume he decides to max out his IRA during his working years. Using what he learned in the Traditional IRA vs. Roth IRA article, he decides to fund a Traditional IRA, rather than a Roth IRA, because he knows he can convert the Traditional IRA to a Roth IRA after FI, tax free. Smart guy.
Ultimate Retirement Account
After reading the Ultimate Retirement Account article, he realizes that a Health Savings Account (HSA) is the Clark Kent of retirement accounts (it’s actually a super IRA, in disguise) so he decides to contribute the maximum of $3,250 to his HSA every year as well.
Graph
The following graph shows how these optimizations affect his path to financial independence. The green line in the graph is constructed using the unaltered data of the Lab Rat and Assumptions post, the bars in the graph are constructed with the updated data described in this article, and the dashed red line represents the amount he needs to achieve FI.
Retire Earlier
As you can see, it’s possible to retire over two years earlier, simply by taking advantage of common retirement incentives and tax-advantaged accounts! It’s pretty amazing that he can take years off of an already short working career without earning more, spending less, or taking on any additional risk!
Taxes
The reason these seemingly subtle changes have such a big impact is because they decrease the amount of money spent on taxes and therefore, increase the amount of money invested.
When we look at the graph representing the amount of tax paid in each of his working years, we can see he is paying nearly $5,700 less per year in the updated scenario than he was in the original scenario.
Combining these tax savings with his employer’s 401(k) match, the lab rat is able to invest almost $8,700 more per year than he did in the unoptimized scenario.
Eventual Taxation?
I can hear you ask, “Since most of his money is in tax-deferred retirement accounts, won’t that money be taxed eventually?”
No, actually.
Based on his living expenses and the fact that he won’t be earning any more money from employment after he reaches FI, he’ll be able to slowly convert his tax-deferred accounts (401(k) and Traditional IRA) into a Roth IRA, without paying any tax on the conversion (see the Traditional IRA vs. Roth IRA post for more information on this conversion). Based on the amount he will need for living expenses and the current tax laws, he would be able to convert over $9,750 per year, tax free.
Early Withdrawal Penalties?
Since most of his money in the updated scenario is in tax-advantaged retirement accounts, you may wonder if he will be forced to pay early-withdrawal penalties when he withdraws money from these accounts before standard retirement age.
No again!
Roth IRA Conversion Ladder
To access the money in the retirement accounts prior to standard retirement age without paying any penalties on the distributions, he can create something called a Roth IRA conversion ladder.
Thanks to the way Traditional IRA to Roth IRA conversions work, you are able to withdraw converted money five years after the conversion date, tax and penalty free. So in this example, assume that he converts his entire 401(k) to a Traditional IRA when he achieves FI and then, every year after that, he moves $9,750 from his Traditional IRA into his Roth IRA. He would only need to do this for five years before he could then start withdrawing $9,750 per year, tax and penalty free!
Since his taxable accounts will provide enough income to sustain his first five years of early retirement and the Roth IRA conversion ladder distributions will help ensure that he has enough money to live off of until standard retirement age, there’s no reason he shouldn’t max out all of the available retirement accounts and retire over two years earlier!
Surprised?
I don’t know about you but I was actually a bit surprised to see how much of an impact these changes had on this hypothetical scenario. I know tax-advantaged accounts can really help supercharge your retirement savings, which is why I’ve been maxing out mine for years, but I didn’t expect the strategies described in the various articles to take over two years off of an already extremely short working career.
I’m looking forward to experimenting with more optimizations in future articles, in an effort to make the lab rat’s career even shorter (and hopefully yours and mine as well).
Were you surprised by the impact of these optimizations? Will it make you think twice about taking full advantage of retirement accounts in the future?
Traditional IRA vs. Roth IRA – The Final Battle
Many people have written about Traditional IRAs and Roth IRAs but when asked which one is better, the common response is, “it depends”.
One of my objectives as the Mad Fientist is to analyze common investment vehicles and financial advice, focusing on how they pertain to someone pursuing FI, and use what I learn to create optimal strategies to help both you and I reach financial independence as quickly as possible. A few months ago I investigated HSAs in the Ultimate Retirement Account article and today, I’m going to tackle the Traditional IRA vs. Roth IRA debate and show that one actually is better than the other for future early retirees.
Types of Retirement Accounts
Before I get into the specifics, let me first recap the two major types of retirement accounts.
Tax-Free Contribution Accounts
The most common type of retirement account is one in which you use pre-tax dollars to fund the account, the investments grow tax free, and the withdrawals from the account are taxed as ordinary income. Traditional IRAs, 401(k)s, and 403(b)s are all examples of this type of retirement account.
Tax-Free Withdrawal Accounts
A tax-free withdrawal account, on the other hand, accepts after-tax dollars, grows tax free, and then allows completely tax-free withdrawals. A Roth IRA is an example of this type of account.
They Both Sound Good
Both are good because they provide some tax benefits that allow your investments to grow faster than they would if they were invested in a normal taxable account.
When choosing between a Traditional IRA and a Roth IRA, you are effectively choosing when you want to pay tax on your money. If you decide to go with a Traditional IRA, you pay your tax when you withdraw the money and if you go with a Roth IRA, you pay the tax up front.
There are some other differences between the two types of accounts but rather than go into it all, feel free to check out this article for a nice comparison.
Get the Best of Both Worlds
What I’m going to show you today is that, with a little bit of planning, it’s possible to get the best of both worlds!
Here’s the strategy…
Step 1: Contribute to a Traditional IRA During Your Working Years
While you are working, your taxable income is likely higher than it will be after FI so it makes sense to shield as much of that income from the taxman as you possibly can by contributing to a tax-free contribution account.
Step 2: Slowly Convert Traditional IRA to Roth IRA
Once you begin your early retirement, you will be earning less than you were when you were working so use this period of lower income to convert your Traditional IRA to a Roth IRA. Determine how much of your Traditional IRA you can convert each year, tax free, and then slowly convert to a Roth IRA until your entire balance has been converted (IRA conversions count as ordinary income so adjust the amount you convert each year based on how much you withdraw from your taxable investments for living expenses).
Step 3: Enjoy Your Completely Tax-Free Retirement Money
When you reach 59.5, your conversion should be complete so you’ll be able to withdraw money from your Roth IRA completely tax-free!
How is This Possible?
You may be wondering why everyone doesn’t do this? Well, there are a few reasons this strategy is only feasible for early retirees.
Low Living Costs
Early retirees are usually able to live on modest amounts of income that generally come from tax-efficient sources like long-term capital gains and dividends. Long-term capital gains and dividends aren’t taxed at all unless you are in the 15% tax bracket or above. That means someone could happily live off of $45,000 of long-term capital gains and dividends without paying income tax.
Long Conversion Timeframe
Since conversions from a traditional IRA to a Roth IRA are taxed as ordinary income, it is beneficial to spread your conversion over a large timeframe so that you don’t increase your taxable income too much in any given year. Since normal people work full time until they reach retirement age, any amount converted will increase the amount of tax they have to pay. However, an early retiree can comfortably live off of $30,000 per year, for example, and gradually convert $9,000 to their Roth IRA per year without having to pay any tax on their income or conversion.
Check out this tax calculator to see how much you can convert (ordinary income) and earn (long term capital gains, dividends, etc.) before you have to pay any tax. I plugged in $9,000 of ordinary income, to account for the Roth IRA conversion, and then $30,000 divided between long-term capital gains and dividends and it correctly computed $0 of tax owed.
So What’s the Big Deal?
An example will help clarify how this works and will highlight how much money this could save you over the long run.
Imagine two 30-year-olds who hope to retire by the age of 40. To make things simple, assume they each start with nothing, make $60,000 a year, and can happily live off of $18,000 per year.
Investor A decides to max out his Roth IRA between now and when he retires at 40. Investor B instead decides to max out his Traditional IRA and then slowly convert it to a Roth IRA after he turns 40. Both invest all additional income into taxable accounts.
The following graph shows the value of the accounts of these two investors.
Investor A is represented by the light green lines and Investor B is represented by the dark green lines. The solid lines represent the investors’ normal taxable accounts, the dashed lines represent the investors’ Roth IRA accounts, and the dotted line represents Investor B’s Traditional IRA account.
As you can see, at age 40, both investors stop contributing to their accounts and begin withdrawing $18,000 per year from the taxable accounts. Investor B also begins converting his Traditional IRA into a Roth IRA at this time. Thanks to the fact that he is able to live on a reasonable income and has time to slowly convert the Traditional IRA into the Roth IRA, he is not taxed on the conversion and therefore ends up having exactly the same amount of money in his Roth IRA as Investor A does when they both reach standard retirement age.
What you’ll notice though is that Investor B actually has quite a bit more in his taxable account. Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A when he reaches retirement age!
It’s pretty incredible that a simple choice between two good options could result in a six-figure difference in retirement savings!
Why Stop There?
In the Ultimate Retirement Account article, I described how an HSA could be used as a completely tax-free retirement account. In this article, I’ve shown how a Traditional IRA could also become a completely tax-free retirement vehicle when combined with a Roth IRA. What about the other major retirement accounts like the 401(k) and 403(b)? Yes, they can also potentially become completely tax free!
Tax-Free 401(k)
Thanks to the ability to convert your 401(k)/403(b) to a Traditional IRA, it is just one extra step to get get your 401(k)/403(b) money into a Roth IRA.
Suba at Wealth Informatics just wrote a post on how to convert your 401(k) to an IRA so take a look at that article to see how it works. Once you get your money from your 401(k)/403(b) into a Traditional IRA, you can then slowly convert it into a Roth IRA using the method above!
Conclusion
To summarize the strategy, max out your tax-free contribution accounts while you are working, use your early retirement years to slowly convert those accounts into tax-free withdrawal accounts, then enjoy your standard retirement years knowing that most of the dollars you spend are completely tax free!
So, what do you think? Will this strategy work for you? Do you expect your income after FI to be low enough to allow for completely tax-free conversions?
Image: thrumyeye
The Ultimate Retirement Account
It’s that time of year again when most employers allow their employees to change their insurance plans and benefits.
This year’s open enrollment period will be particularly interesting for me because it will be my first as a married man so I will need to see if it’s worth adding my wife onto my insurance, or vice versa.
Ultimate Retirement Account
Because some of you may be researching health insurance options like I will be, I thought it’d be a great time to talk about America’s ultimate retirement account. It’s not actually described as a retirement account but if used wisely, it could be one of the best places to put funds, not only for standard retirement but also for early retirement.
So what is it?
The ultimate retirement account is better known as a Health Savings Account, or HSA.
An HSA is a tax-advantaged savings account available for people who are enrolled in a high-deductible health insurance plan.
Since people with high-deductible health plans could face more out-of-pocket costs, due to the higher deductibles, the government provides tax incentives to motivate people to save for these expenses. HSA account holders can contribute pre-tax dollars to the account and can then withdraw money from the account, tax free, when paying for qualified medical expenses.
Why is it so great?
So how does a health savings account get the incredible honor of being named the ultimate retirement account?
Before answering that, let’s first briefly touch on some of the benefits of other types of retirement accounts.
401k/403b/Traditional IRA
These are the most common retirement accounts and are great for two reasons:
- Your contributions to these accounts are pre-tax contributions. This means that you don’t pay any income tax on the money you contribute. So, for example, if you make $100,000 a year but contribute $15,000 to your 401k, the IRS treats you as if you only made $85,000.
- The money in these accounts is able to grow tax free.
You eventually have to pay tax when you withdraw money but since you receive a tax break when you put money in and the money is able to grow tax free, it is usually worth maxing out these accounts to take advantage of these benefits.
Roth IRA
A Roth IRA is different because you have to pay tax on your income up front, like you do with income that you spend, but the money grows tax free and you do not have to pay any tax when you withdraw the money after you reach the age of 59.5. So using the salary in the above example, if you contribute $5,000 to a Roth IRA, you will still initially pay tax on your full $100,000 salary but you don’t have to pay any tax when you withdraw the money.
So what about the HSA?
For most of the population, an HSA is simply a savings account for medical expenses that provides some tax benefits.
For fientists, however, I suggest you disregard the medical aspect of the account and simply think of the account as a special retirement account that you are able to contribute to when you are enrolled in a high-deductible health plan.
When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA combined. With an HSA, you are not only able to contribute pre-tax dollars, like you can with a 401k/403b/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth IRA provides!
That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out!
How is this possible?
Well, this is all possible because of the fact that there is no rule stating that you must use your HSA to directly pay for medical expenses or that you must withdraw money from your HSA within a certain amount of time after paying for a medical expense. As long as the qualified medical expense occurred after the HSA was opened, you can withdraw money from the HSA at any time after incurring the expense to reimburse yourself.
Example
Let’s assume that I only spend $200 a year on medical expenses. It doesn’t make sense to pay a lot of money for a fancy, full-service health insurance plan, since I rarely go to the doctor, so I instead decide to get a cheaper, high-deductible health plan with a lower monthly premium.
Since I have a high-deductible health plan, I am able to open a health savings account so I elect to put $3,000 into the account every year and I invest the account’s money in a total stock market index fund.
Because contributions to the HSA are pre-tax, depositing $3,000 into my HSA decreases my taxable earned income by $3,000.
When I go to the doctor, I can pay for my $200 yearly visit with my HSA debit card or I can pay for it with cash or with another credit or debit card instead. If I pay with my HSA debit card, that money is extracted directly from my HSA and that’s the end of the story. I just used tax-free dollars to pay for the expense and there is nothing else I can do.
If I instead pay with cash or with another card, however, I am able to withdraw that $200 from my HSA and deposit it into my normal checking account at a later time, to pay myself back for the qualified medical expense. The great benefit of having an HSA is that I can decide when to pay myself back. Since I live well below my means and have ample savings, a $200 payment isn’t going to break the bank so there is no rush to get paid back from my HSA. Instead, I am able to leave that $200 in my HSA and can sit back and watch it grow, tax-free, until I decide to withdraw it!
As long as I keep my receipts, I can withdraw the money for qualified medical expenses from my HSA at any time, in a similar way a retired person over age 59.5 can withdraw money from a Roth IRA…tax free!
So at the end of the year, I have saved myself from paying income tax on the $3,000 of income I used to fund the account, I now have $2,800 that is growing in the HSA tax free, and I have another $200 that is in the HSA growing tax free that I can withdraw whenever I want to!
Worst Case (or Best Case?) Scenario
I can hear you saying, well what if I put all this money into my HSA but I don’t have any health issues…how will I ever get my money out?
In this case, the account will simply act like a Traditional IRA with an increased distribution age (65 instead of 59.5 for a Traditional IRA). Like a Traditional IRA, your contributions to the HSA are pre-tax contributions and your contributions are allowed to grow tax free. If you don’t use your HSA funds for medical expenses, you can begin withdrawing money from your HSA account for any expenses after you turn 65, without penalty. Like a Traditional IRA, you’ll have to pay income tax on any distributions that aren’t for qualified medical expenses but you won’t incur any additional penalties or fees. Therefore, after the age of 65, an HSA is nearly identical to a Traditional IRA!
So to describe the above example in another way, the HSA at the end of the first year is like a Traditional IRA with a balance of $2,800 and a Roth IRA with a balance of $200. As I incur additional medical expenses, I can continue converting my “Traditional IRA” money to “Roth IRA” money without having to pay tax on the conversion!
Extra Tax-Advantaged Account
The HSA is particularly useful for someone like me who maxes out all of the other tax-advantaged accounts available.
Since I’m in the wealth accumulation phase of my journey to financial independence, I try to limit my taxes as much as possible so that I can make as much of my money work for me as I can. The HSA allows me to contribute more of my income to tax-advantaged accounts, which results in a lower income tax burden and a higher savings rate.
Conclusion
If your annual medical costs are low and you don’t expect to reach your deductible in an average year, you can reap some amazing benefits by choosing to enroll in a high-deductible health plan. Not only will your monthly costs be lower, you’ll be able to take advantage of a health savings account and all the benefits that come with it.
Let me know in the comments if you have any questions and as always, I am not a medical or tax professional so please do your own research before making any changes to your health coverage or retirement investments.
Ultimate?
What do you think? Do you agree that an HSA is the ultimate retirement account? If not, what type of account gets your vote?
Image: rosmary
