When planning for Early Retirement there are three kinds of savings to consider: After-tax (AT) Savings, Pre-Tax Savings (PT), and savings that is in-between the two or Some Tax Savings (ST).
- In the first category, after tax(AT), you have: bank savings accounts, personal brokerage accounts, and everything that you save from money you have already paid tax on.
- In the second category pre-tax (PT), you have: 401-k, 403-b, the SIMPLE IRA, SEP and personal pre-tax savings, the IRA.
- In the third category, some tax savings (ST), you have an annuity (that you did not put in an IRA or Qualified Employer Plan) and some parts of the Roth IRA. The money going in to this type of account is money you have paid tax on. The gains coming out (the part that grew over the amount you deposited), will be taxed as ordinary income and penalized before age 59 ½, and not penalized after 59 ½.
After Tax Money for Retirement
My favorite method of saving for retirement, particularly if you want to catch F.I.R.E., is to pay your taxes now, use a personal brokerage account and a Roth IRA. While no one knows where taxes are going, I would hazard a guess that with a government that needs more of your money, your tax bill will be rising. Therefore, paying your taxes now could avoid a higher tax bill later.
My personal experience with clients who were good savers is that their tax bracket did not drop in retirement. It is my opinion that, since the new 24% bracket is so large, and the next largest bracket is the 22% bracket most of us will not see an appreciable drop in our taxes when we retire. You also need to consider that there is no “standard deduction,” under the new tax law taking effect in tax year 2018. Talk with your advisor before making tax or investment decisions.
That said, you cannot ignore (PT) any “match” given in a 401-k or 403-b or other Employer plan. The “match” is something you get for your work and while called a “benefit” should be considered as much a part of your pay as you do your pay check! But you must remember that if you are fortunate enough to catch F.I.R.E., any money put in a “qualified” employer savings account will have a penalty for withdrawal before 59 and ½ years old. That penalty is 10% of the money withdrawn early, then your normal ordinary income tax. There is a way around that. It is called Rule 72(t).
The rule of 72
Rule 72(t) allows you to withdraw money early, provided you take the money out over the rest of your “Lifetime.” The IRS has an exact schedule for this withdrawal but for these purposes I will explain it this way.
Let’s say you have $100,000 in your 401-k. You have “retired’ early and have moved the 401-k in a “Custodian to Custodian” transfer to your own IRA without incurring tax. Good job! Since you are less than 59 ½ you hope to use some of that money for early retirement cash-flow.
You are 52 years old. You have approximately 30 more years to live. Take the $100,000 divide by 30 (years), then divide by 12 (months) and you have $277.78 per month that you can withdraw without penalty. It will be slightly more because the IRS “factor” includes interest. Suffice it to say that you cannot live on that. In my opinion, this is the biggest reason for considering after-tax savings and your Roth IRA deposits as the best places to go for “early retirement” income.
The first place to look for early retirement monies should be your after tax personal brokerage account. More on that later. Your Roth IRA (ST) is the second place to look for “early retirement” income, in my opinion.
The Roth is largely overlooked for early retirement planning, because it was designed for use after age 59 ½. Because of the lax withdrawal rules (on the after-tax deposits) into the Roth IRA using it “pre or early retirement” makes sense for our purposes. Remember you have paid tax on all your Roth IRA deposits. To avoid penalty, you must have held your Roth IRA for five years. Please consult your financial advisor for ways of withdrawing your deposit pre-59 1/2 without penalty. The gains from your Roth IRA should not be considered “available,” until you reach 59 ½ years of age. After 59 ½ the Roth IRA moves into its own category: NT or no tax.
One of the best things about the Roth IRA is that you can balance out taxable income monies (PT) with non-taxable income monies (AT and ST) to control your taxes. This makes AT and ST savings very important for your future.
Social Security
Your retirement plan might be divided into two parts: Pre-Social Security and Post Social Security. The reason for this is to provide two distinct periods for planning purposes. Planning only for tax purposes would also have two periods: Pre-59 and ½, and Post 59 and ½. Either way a great deal of your and your advisor’s efforts will be put into income planning and tax planning for the period before 59 ½ and before Social Security.
Financial Independence – Retire Early is a wonderful goal to strive for and I will talk more about that in the next article. Retirement may well be the best time of your life. It is for me.
Right now, you need to Budget, to control your Debt and your Credit Rating and to start a savings plan regardless of how small. A bit of discipline, a bit of effort and your goal of catching F.I.R.E. is closer than you think.
I wish you well…
