Thursday, December 20, 2007

What the Financial Planners will Never tell you

I have had an interest in Financial Planning for over 20 years and have read a lot of investment books, talked with Financial Planners, and more recently read a lot of Personal Finance blogs. If you have done this too, you probably realize that after awhile, they all seem to issue the same mantra about maxing out tax sheltered accounts like your 401(k) and/or IRA.

This is good advice, if you plan to retire at age 59 ½ or later. But, it falls short for those of us who would like to retire in our 40’s or even early 50’s. To retire early, you must invest in assets that are held in taxable accounts. Only in taxable accounts, can you access the money at any age without penalty.

When I started my career, I had very little knowledge about investing, but I knew I wanted to plan for my retirement. I followed the advice of the mainstream FP community to max out my 401(k) and to start a traditional IRA. At that time, I had no idea if it was possible to retire early or what it would take. Fortunately, I am a natural saver, so I accumulated a small starter nest egg in a taxable account. As I learned more about investing, I moved the cash out of a low interest savings account and into Vanguard funds.

Today, I have a much better handle on where I am going and what I need to get there. I plan to retire in my early 40’s. Now, that’s early retirement, not 55 or 59. I plan to live off my passive income (capital gains and dividends) only. I will have a pension that kicks in at 55, so my taxable accounts will need to provide the income “bridge” from now until 55. Of course, today, I know that had I directed more money into my taxable accounts as opposed to my 401(k), I would have been able to retire at 40. sigh.

But there’s even more unpleasant news. Not only is the 401(k) money trapped until age 59 ½ , but what is even worse is that we are forced to take Required Minimum Distributions (RMD) at 70 ½. Whether you need the income or not you must take RMD. RMD is calculated by dividing the value of your 401k by your remaining life span (in years) based on your life expectancy. Because, I have an overfunded 401(k), my projected RMD exceeds my current salary. So with RMD, Social Security, my pension and dividend income, I will be thrust into the highest tax bracket of my life for the last remaining, non-working years of my life. How weird is that?

The good news is that investing options have changed considerably over the years. Now, we can invest in a tax sheltered account like a Roth IRA and after 5 years access the money penalty free. In addition, this next year, many employers are offering a Roth 401(k). This is another investment alternative that can eventually be rolled over to a Roth IRA and accessed at any age without penalty. Both of these options provide tax free growth with free access to the money after 5 years and no RMD. Check them out – especially if you are interested in retiring early.;)


  1. Most individuals who wish to retire early will need to max out tax-advantaged accounts and save generously in taxable accounts as well.

  2. Its necessary to fund both types of accounts, but I would not max out a 401k. Invest to get the company match and put the rest in a taxable account to enable an earlier retirement.

  3. Earlier retirement account limits were so small most would have had to max them out as well as save after tax. For taxable accounts capital gains deferral is not bad. It amounts to half the benefits of deferred accounts if you don't turn over the money frequently. After tax savings is as important as tax deferral for early retirees.

    Options have improved. You can access retirement money early without penalty through a 72t although the rules are many. You may also want to convert some of those past contributions into a Roth while your income is low, but not if you have to pay a penalty to do it.

    The only one to complain about RMDs would be someone leaving an estate, something I consider to be in poor taste. Supporting your heirs after you die undermines their value of it and discourages their effort. Do them and yourself a favor and spend it. Hoarding is an unattractive trait.

  4. Thanks for the comments. Only after posting this, did I became aware of the 72(t) rule that allows for penalty free, early 401k withdrawals. It seems Financial Advisors like to use it to get at retirees 401k dollars to sell them annuities. There are lots of rules and restrictions on payouts. That is the same reason I do not like RMDs. The IRS setups RMDs to force you to deplete your account by the time they think your should be dead. I don’t think I am hoarding, I just want to be able to take care of myself since I will not have any heirs. And I am interested in leaving assets to a foundation or two.

  5. I do agree with you, if a person wants to retire earlier than they should be, investing on assets that are all held in taxable accounts to be able to access the money an any age they want without them being penalized. Great advice. I hope that soon, we could be able to read more about this kind of thing. Thank you so much and more power.


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