Monday, November 2, 2015

How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA

One of the biggest mistakes I ever made was not maxing out my 401 (k), IRA and HSA accounts between 2007 and 2012. As a result, I ended up paying tens of thousands of dollars in income taxes and taxes on capital gains and dividends. Those are tens of thousands of dollars in taxes that could have built up my networth and passive dividend income. Instead I ended up handing those over to the IRS and my state. The opportunity cost of these money is in the hundreds of thousands if not the millions over the next 30 - 40 - 50 years.

The reason why I never maxed those out is because I didn’t know a lot about them. I also prided myself with my success that I was paying a lot in taxes. When I was doing my 2012 tax return however, I was sick that my total tax liability exceeded the amount I paid on housing and food. In fact, the amount I paid in taxes was equivalent to what I can live on in retirement. I saw that a fellow blogger from the site Budgets Are Sexy had written about maxing out his SEP IRA and Roth IRA’s, thus saving tens of thousands of dollars in taxes just for one year. So I opened a SEP IRA and maxed it out, saving 30 cents in taxes from every dollar I contributed to. Here was I researching companies, competitive advantages, earnings and valuations, yet I had overlooked the simple power of tax-deferral and tax-deferred compounding of capital. As I kept researching, I I found the sites of Mad Fientist and Go Curry Cracker, which opened my eyes on the benefits of tax deferred accounts. These investors had managed to retire early by taking advantage of the tax code, and then were paying zero dollars in taxes during their early retirement. Another one I thoroughly enjoy is Justin from Root of Good, who retired at the tender age of 33 and paid pretty much zero in taxes.

My biggest misconception was the fact that I thought that the money is locked until the age of 59 and a half years, and that I cannot touch the money. This was wrong. I also see this misconception has deep roots in many dividend investors I have talked to. These investors mistakenly believe that you cannot withdraw money from retirement accounts when you are aiming for early retirement in your 30s or 40s or 50s. As a result of this misconception, these dividend investors will end up hundreds of thousands of dollars poorer over their lifetimes. This is the reason why I am writing this article. Ever since I had my awakening moment in 2013, I have tried to educate investors. I have been unsuccessful for some, but I will continue fighting.




I will discuss the rules on withdrawing money from each account, and how someone can circumvent them legally to withdraw money and pay no taxes in the process.

401 (k)

Almost everyone who works at a large company in the US has access to a 401 (k) plan. In 2015 you can contribute up to $18,000/year if under age 50, and $24,000/year if over the age of 50. If you contribute to regular 401 (k) with pre-tax money, you save Federal and State taxes on each dollar you put in those accounts. If you contribute to a Roth 401 (k), you pay taxes upfront, but are not taxed when you withdraw that money. The money compounds tax-free in both vehicles. The only difference is that with the pre-tax 401 (k), you pay ordinary income taxes when you are eligible to withdraw money. In my case, when I put money in a 401 (k), I save 25 - 30 cents on the dollar for each pre-tax dollar I contribute. I could essentially buy stocks at an immediate 25% - 30% discount.

There is also the after-tax 401 (k) contributions, which is an advanced topic I covered earlier. This makes sense only if you can convert those dollars immediately to Roth.

If you simply withdraw money from a 401 (k) when you quit a job, and you are not 55 and are not doing Substantially Equal Period Payment (SEPP), you will pay ordinary income taxes on the withdrawals and also pay a 10% early penalty. So that’s why I don’t advise simply withdrawing money. This is one of the main the reasons why I never maxed out my 401 (k), but merely contributed a little over the employer match (prior to 2013). I believed that the money was "locked in" - when in fact there are ways to get it out.

If you quit your job after the age of 55, and you retire, you can start withdrawing money from this account. The withdrawals from the regular 401 (k) will be taxed as ordinary income.

If you retire before the age of 55, you can withdraw money using Substantially Equal Period Payment (SEPP) formulas. This is a formula that is based on your age and life expectancy and interest rates. For a 40 year old male today, the withdrawal rate is around 2.50% - 3%. If you start SEPP, you have to continue doing it until you are age 59 and a half. Withdrawals are taxed as if they were ordinary income. This calculator from Bankrate could be helpful.

There are certain ways that you can withdraw money without incurring the 10% penalty, such as buying a house, education etc. But withdrawals will be still taxed at ordinary income tax rates.

There are required minimum distributions at age 70 ½ for money in a pre-tax 401 (k) or Roth 401 (k). If you do not withdraw a certain amount at least, there are steep penalties. If you are still working however in a company in which you do not own more than 5%, and you have your 401 (k) money in that company plan, you are not subject to required minimum distributions. I had a co-worker who recently retired at the age of 73. They were able to delay required minimum distributions for 3 years, allowing their money to compound tax-free for longer and grow their passive income stream even further in the process.

With a 401 (k), you are limited to investing in the menu of mutual funds that your employer workplan offers. Most large employers have a large pool of employees, which enables them to offer cheap index funds to plan participants. A few offer brokerage windows that allow employees to select their own individual investments such as dividend stocks, bonds, ETFs etc.

A few small employees offer expensive mutual funds that cost 1%/year. It might still make sense to max out a 401 (k) plan there, even if you are paying 1%/year, as long as you plan to stay at the place for less than 5 - 6 years. If you leave the employer, you could roll the money over to an IRA or to your next employer's 401 (k) plan. Unless your financial situation is desperate however, I would advise against cashing in a 401 (k) plan early when changing employers.

The thing I have not discussed is that most employers tend to add matching funds to the 401 (k) plans of employees who make contributions that exceed certain amounts. For the purposes of discussing taxes, this fact is not relevant. For the purposes of accumulating assets for retirement however, this employer match is an important part of your total compensation package. I for once have always taken advantage of the employer match, no matter how I disagree with the investment options in the plan.

Regular IRA

With a regular IRA, you can contribute up to $5,500 or $6,500/year, depending on whether you are younger than 50 or older than 50. Dollars coming in are deductible, and withdrawals are taxed as ordinary income. However, deductions phase out at moderate incomes, which makes it tough for people to max out 401 (k) and IRA. For high earners who are not eligible for a Roth IRA however, they can still put money in an IRA but they won’t get a tax deduction today. They can however immediately convert that amount into a Roth IRA, which we will discuss below.

There are required minimum distributions at age 70 1/2. If you do not withdraw a certain amount at least, there are steep penalties. This is similar to what we see for 401 (k) plans.

You can invest in pretty much anything with Regular IRA's - including individual dividend paying stocks, bonds, mutual funds, ETFs etc.

HSA

Health Savings Account is available to individuals in the US who have enrolled into a high-deductible health plan (HDHP). For 2015, individuals cannot contribute more than $3,350/year, while families cannot put more than $6,650. There is a catch-up contribution of $1,000/year for individuals who are older than 55.

An HSA allows people to save on Federal, State and Social Security and Medicare taxes. For every marginal dollar I put in an HSA, I save 25% Federal taxes, 5% on state taxes, and 7.65% on Social Security and Medicare Taxes. I can withdraw the funds at any time to pay for medical expenses without being taxed on them. I can also invest the money and let it compound for the long-term. If I pay non-medical expenses, there is a 20% penalty in addition to ordinary income tax being paid on the withdrawal.

After the age of 65, I can spend the money on anything I want, without paying a penalty. There are no required minimum distributions. While withdrawals after the age of 65 are taxed as ordinary income, withdrawals for medical expenses are never taxed. I would imagine that when I get to be 65, I will have some medical expenses. So maxing out this account today, getting all the tax benefits, letting the money compound for decades, and withdrawing the money for medical purposes down the road without paying any taxes is a no-brainer for me.

Roth IRA

This is the holy grail of retirement accounts. While money contributed to a Roth IRA do not provide any tax deduction today, money compounds tax free and can be withdrawn tax-free after 59 ½ years of age. Contributions, but not earnings from a Roth IRA, can be withdrawn at any age. The catch is that individuals who earn too much money cannot contribute to a Roth IRA They can do the backdoor Roth IRA described above, where they put money in a non-deductible IRA and immediately convert into a Roth IRA. The nice thing with a Roth IRA is that there are no required minimum distributions on money in that account. Translation – the account compounds tax free for years, and does not have requirements on withdrawals..

You can invest in pretty much anything with Roth IRA's - including individual dividend paying stocks, bonds, mutual funds, ETFs etc.

When you quit your job, you can convert the regular 401 (k) into a Roth IRA. After five years, you can withdraw that converted amount penalty free, even if you are younger than 55 years. The thing to consider of course is that this conversion will be taxed as ordinary income. So if you have $300,000 in your 401 (k) plan, you will pay a marginal tax of over 39%, which is prohibitively expensive.

The smart way to do this is to convert just enough from a 401 (k) to a Roth IRA, so that you pay the least amount in taxes today. For example, my plan is to convert approximately $20,000/year from a 401 (k) and Regular IRA into a Roth each year in retirement. The $20,000 assumes a married couple, filing jointly. It is comprised of two standard deductions and two personal exemptions. As long as my qualified dividends are below $75,000/year, I will not have to pay any Federal Income taxes.

So the plan is to convert $20,000 from an IRA/ 401 (k) into a Roth IRA when taxable income is low in order to be the least amount of taxes ( if any). The $20,000 will then be available for withdrawal in five years. The next year, I will convert another $20,000 from a IRA/ 401 (k) into a Roth IRA. That money will be available for withdrawal in 5 years penalty free. This can go on and on. When you have assets in a tax-deferred account, you have more flexibility, and can essentially "manage" your income tax bracket. This exercise is called the Roth Conversion Ladder, and has been extensively researched.  You do an IRA to Roth IRA conversion, and after five years, the money will be available for withdrawal, tax-free and penalty free. Who said you can't have your cake and eat it too?

Conclusion

All of this requires planning, and long-term thinking. This planning is well worth it however. As a buy and hold dividend growth investor, who plans to hold on to stocks for decades, I believe that I fit the requirements for long-term planning.

Let's assume that I earn $20/hour at a day job.  Let's also assume that I max out my 401 (k) and save $5,400 in taxes per year because of that. This means that the amount I saved in taxes in equivalent to me working at a day job for 7 long weeks. Yes, you heard that correctly - by maxing out my 401 (k), I do not have to waste 7 weeks of my life every single year by slaving away to pay the IRS. I am amazed how so many frugal people are willing to avoid paying for health insurance, inconvenience themselves by taking the bus to work, and eat cheap and unhealthy food to save a couple of dollars, when they are ignoring the big expense items like taxes.

If you are able to cut tax expenses to the bone, you will be able to accumulate more income producing assets in less time. This is a mathematical fact.

Not having to pay taxes on dividend income and realized capital gains will speed up the asset accumulation phase. Even if taxes on qualified dividend income increase over time, the dividend income in my 401 (k), IRA, Roth IRA and HSA will be shielded from taxation for three to four decades.

But yes, you read that correctly. For any dollar I put in a 401 (k) or IRA today, I reduce my tax liability by 25% at Federal level and about 5% at state level. So if I put $18,000 in a 401 (k), I also save $5,400 that I can put in a Roth IRA. If I convert my 401 (k) slowly into a Roth IRA, I will never have to pay taxes again on that money and the money that is generated from it. In addition, if a physical person inherits my money ( relatives, spouses, girlfriends etc), they will not have to pay taxes on that income. They will have to withdraw a certain percentage each year, but that is not a problem to have when you earn tax free income for life.

Do you take long-term tax planning into consideration with your investment plan?

Thank you for reading.

Full Disclosure: None

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investors
Health Savings Account (HSA) for Dividend Investors
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Should taxes guide your investment decisions?

37 comments:

  1. After compiling all of my tax information last month to get caught up on my tax spreadsheet I've been thinking more and more about long term tax planning. If you can find a way to reduce your taxes that's a big win because for lots of people that is one of their top 3 expenses. You really need to take a long term view of things to see what's better and the more I sit down and crunch the numbers the more I'm leaning towards at a minimum bump up my 401k withholding another couple % points and probably try and max it out for next year or at least get close to it. The biggest thing holding me back had been how to access the funds but after sitting down and learning a bit more about the tax code there's definitely ways around it. I was honestly quite surprised what our 72t distributions would look like but Bankrate strikes again with a very useful calculator. I didn't think they'd be as high as they are and that's just based off our current balance.

    I realize you aren't a tax professional but I have a few questions since I assume you've done more background research on the 72t route.

    (1) Can you choose just one tax deferred account to take 72t distributions from or does it have to be based off your full tax deferred accounts? For example I have a rollover IRA and 401k, whenever I leave my current job and roll that over into a separate Rollover IRA can I take 72t just from the new rollover or would it be based off both? Not that it really matters but it would make things much simpler if you can just do one since my original rollover is only like $15k.

    (2) With one of the requirements being that 72t's must continue for at least 5 years from the first distribution, can you stop them any time after 5 years? Can you increase or decrease depending on the "reasonable interest rate"?

    Thanks for your continued prodding into tax related issues. It's made me finally sit down and take a deeper look at things. Reducing our taxes would be a big win because that's such a big expense. I need to get my tax spreadsheet ready for 2016 so I can do better forecasting but 401k contributions will be increasing next year when we should be back up into the 25% or 28% bracket so it'll make a big difference to get that tax break.

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    1. I just had my CPA research this:

      1) All your tax deferred accounts must take the 72t distribution. You cannot pick and choose.

      2) Five years or until you reach 59 1/2 whichever is longer. If you're 50, then it's 9 years of distributions. You could potentially run out of assets to distribute. Be careful here.

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    2. Hi PIP,

      Taxes are one of my largest expense. I maxed out my 401 (k) right away after the awakening. I agree with the Anonymous poster above. Thank you anonymous poster above for responding.

      Actually, I am leaning more towards the Roth Conversion Ladder strategy, where I move $20,000 or so per year from 401 (k)/IRA in retirement/when income is low into a Roth Ira, and pay little if any taxes in the process.

      Best Regards,
      DGI

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    3. Anon,

      Thanks for the replies. It's a bummer you can't stop them after 5 years. If I go FI at say 40 that's 19 years for those assets to last. Although I'd guess more research would need to be done. I need to check BR's calculator again to see their assumptions on the cash flows/portfolio balance.

      DGI,

      Ideally I would like to use the Roth conversion ladder strategy. It would allow me to have around the same amount as the 72t route. Although I need to figure out ways to reduce our MAGI to make sure I can contribute to my Roth IRA each year in the meantime and then be able to withdraw the contributions once FI. Lots to think about for sure but taxes are such a big expense we all need to do a better job at managing them.

      Thanks again.

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  2. Great article once again. My question is, through my work I have a Roth IRA, 457 (deferred compensation) and a 401, the problem is they only offer a couple of index funds and mainly mutual funds with higher fees (0.80%+) thus defeating the whole purpose of dividend investing and reinventing. Should I open a Roth IRA through a discount broker that offers more options, say like a Scottrade? I plan on retiring at 51 years and the standard Roth can't be accessed till 59.5 unless I set up a SEPP. Thanks for your input and knowledge.

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    1. I cannot provide individual investment advice, since I don't know anything about you. I can only talk about myself and how I plan to utilize different tools to achieve my goals and objectives.

      Good luck in your retirement journey!

      DGI

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  3. Excellent points made in this article. All about working smarter not harder. Couple points to mention - 72t must continue one of 3 distribution methods for 5 years or 59 1/2 whichever is longer. If you are 58 must take until 63 etc. Also RMD method which is most simple and likely to increase over time pays out 2.5-3% of portfolio a year, may not be enough maybe it will. Also dictates you have to take out every year vs when you need to, which could impact safety of sustainable withdraw strategy vs bucket strategy. Higher risk of sequence risk of return. Still think it's a solid option if 2.5-3% is enough to cover expenses.

    One point to mention on 401k to roth conversion is that it becomes trick when to turn on. If still working any amount converted is taxed ordinary income could put you above 15% bracket I would assume. So your faced with retiring and then converting however you can't withdraw conversions tax free from roth until 5 years so that ladder strategy works if you can get some income to bridge the first 5 years. The flexibility of a roth can never be underestimated. Hope this helps

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    1. Hi Matt,

      Thanks for commenting on the SEPP requirements. The IRS site is helpful on this: https://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments

      As far as withdrawing, I expect that I will not be earning much ordinary income at some point in the near future. This would allow me to slowly convert money from 401 K to Roth IRA. I am not going to do this rollover now, as I am working and paying so much in taxes.

      In addition, I have a large portion of money in taxable accounts for now. If I were starting over, I would put $18K in 401 (k), $5,500 in IRA/Roth IRA and 3.3K in H S A. Anything left over will go into taxable accounts.

      Very good comments!

      DGI

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  4. When looking into rolling over my 401k into an IRA, I discovered that the IRS made changes recently that prevent someone from rolling over only the pretax contributions into a Roth IRA. Any after tax monies have to be rolled over into both a Rollover IRA (basically a traditional IRA) with a corresponding amount of pretax monies into a Roth IRA. I believe that the IRS calls this the pro-rata rule. So let's say that my 401k is 70% pretax and 30% after tax. If I wanted to move $100K out of my 401k, then $70K would go to a Rollover IRA and $30K to a Roth IRA. The funds can then be (but don't have to be) further transferred from the Rollover IRA to the Roth IRA, but the appropriate taxes would have to be paid.

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    1. Hi Keith,

      Thanks for stopping by. What I am discussing is that I would convert only a portion of money each year, depending on income ( I assume my income will be low at some point in the future)
      So in your example, if I had $100K in a 401 (k), I would rollover $30K out - $21K in a Regular IRA and $9K into a Roth IRA.
      The mechanics of the actual step by step procedure will be dictated on your 401 (k) plan’s guidelines. When I had an old 401 K plan, I could have rolled over a portion into an IRA, which to convert to Roth. But this 401K didn’t allow a 401K to Roth 401K conversion – I had to go though an IRA to get to Roth

      I found out a few months ago that my current 401k allows after-tax 401 (k) contributions to be converted into Roth 401 (k) twice per year ( though gains from pre-tax money could be taxable as ordinary income, which is why I need to convert to Roth from pre-tax ASAP). My 401 (k) plan also allows me to convert a portion of my money into Roth 401 K. I am not doing it now, since I make too much, but this is a nice option to have in the future.

      From a safety point, it looks like money in a 401(k) are safer than IRA assets. Which is why I am leaning towards building up the 401 (k) side of the equation, rolling pre-tax 401K into Roth as I go, and then as I retire and earn little income I will convert slowly 401K into Roth 401K if possible within the 401k plan.

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  5. For someone who is still working and earning a large salary, tax efficient investing in taxable accounts is a must if you want to keep what you've earned. It is quite difficult to beat a buy and hold index fund strategy under those circumstances.

    Deferred taxes is a form of float Warren Buffett exploits.

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    1. I agree that deferred taxes are a form of float. For someone in their 20s or 30s, this float is a liability to the IRS which is not due for 40 – 50 years ( and it can also be somewhat avoided by careful tax planning)

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    2. I am the anon poster from 5:54.

      I can tell you it was a big mistake for me to contribute to a traditional IRA. Under the current tax code, capital gains and dividends can potentially be exempt from taxes in a taxable account once early retirement begins and ordinary income goes away. Mandatory RMDs could shift what would have been zero tax liability into a much higher bracket taxed at ordinary income rates. Converting to a ROTH still subjects what could have been tax free income to some tax liability. Of course in the early 80s, there was no way to know that dividends and capital gains would receive more favorable tax treatment. I was never eligible for contributions to a Roth IRA.

      All I can say is beware when partnering up with the federal government in a retirement plan...and make no mistake that is what the IRS is, a silent partner in your retirement plan who eventually gets their cut one way or another.

      I think it is important for folks to take a hard look at taxable investing.

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    3. Hello poster from 5:54.
      I see a lot of holes in your comment. When you respond again, I would appreciate if you please provide a detailed spreadsheet that proves that IRA was inferior to taxable investing for the past 30+ years.
      Thirty years ago, the higher marginal tax rate was something like 50% ( plus state tax). A $2,000 contribution to an IRA would have resulted in $1,000 savings which could have been invested. The IRA would have compounded tax-deferred for 30 years. The highest marginal tax rate today is lower than the highest rate 30 years ago. But I do know that you don’t have to withdraw all the money at once at high tax rate – with tax planning one can minimize the tax bite. If you are smart about it, you won’t have to pay more than 15% tax on conversions/RMDs. This is why you need to do tax planning – if you haven’t done it, you have no one to blame but yourself.

      You also have the 1,000 in savings compounding for you ( though you had to pay steep taxes at 30% on dividends and capital gains for 20 years, and then 15% - 20%). So the way I see it, an IRA contribution in the 1980s is much better than simply putting the money in a taxable account and paying high taxes for decades.

      I expect to defer money at 25% - 30%, and then be able to roll it over to Roth at almost no tax. I also expect to be living in a state with no income tax.

      On the other hand, if you put the $2,000 to work in 1980s, you would have had to pay taxes on capital gains realized and dividends every single year. Those taxes were quite high up until the early 2003. So for 20 years, you would have ended up paying over 30% in taxes on the money every single year. If you are really earning that much, you would be paying 23% on dividends and capital gains .

      The real question is why haven’t you used a CPA before for tax planning? I find hard to believe that you would have so much money accumulated, and never really talked to an accountant to do some basic tax planning. My article is very basic, and just touches on the surface of things. I know there are loopholes that could minimize/defer taxes.

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  6. Be careful about putting too much in tax deferred accounts (IRA and 401(k)) because you (especially you DGI) likely will be in a higher tax bracket when you retire. If you can afford to save what Financial Advisers tell you to save, you are unlikely to need the amount of retirement income the tell you you will need. I speak from experience.

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    1. Most people including most Financial Advisers do not know about penalty free IRA distributions before you are 59 1/2. And even if the advisers do know about them, they don't want you to reduce the money they manage for you. Thanks for telling us about SEPP.

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    2. Actually, putting money in deferred accounts is better than putting money in taxable accounts, because you do not have the drag of paying taxes every single year for decades in the accumulation process and in retirement.

      Deferring taxes in retirement accounts, and letting it compound tax-free for decades is the smart move. I can manage my tax bracket in retirement with tax-deferred accounts as I have discussed in the article. I will actually have a lower tax bracket than today - possibly it will be 10% or 15% - which is 10% - 15% lower than tax bracket today. With taxable accounts, I will have to pay taxes as I go and there will be no way out - and those taxes will increase.

      I do not know enough about financial advisers to have an opinion on them as a whole.

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  7. Great article and good comments/questions.

    However, we are all "preaching to the choir". We should all be out talking to young people about saving for retirement; especially Roth IRA's.

    Also, young people need some sage and unbiased advice on how and where to open an account. Stocks are pretty much out of the discussion for many so at least getting a bank CD for a Roth is better than nothing.

    Some people in my discussions think they need to pony up $5,500. I suggest they start with $500 or $1,000 if they can afford it. Another idea for them: ask an older relative who may have experience about retirement accounts. Some grampa's like me will even gift a little to start the ball rolling.

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    1. Hi Richard,

      Thanks for stopping by and sharing your comments. Starting a Roth IRA for a child after it has some earned income is a smart way to get them started, even if the money is put in a CD. Unfortunately, many do not have those financial resources to contribute for retirement ( I know I didn’t when I first earned a paycheck)
      If that teenager can max out a Roth IRA from their summer/after-school jobs for several years, and put it into a mix of stocks/mutual funds, and compound tax-free, that would be awesome.

      Any time I present this idea to a coworker/friend who has kids that are working summer jobs however, they always ignore my suggestions. So I just shut up – many parents lack knowledge about finances.

      I slightly disagree about preacher to the choir however. There are plenty of investors out there who are totally against investing in tax-deferred accounts. While this makes investing easier, they are paying an insane amount of taxes in the accumulation stage. That is crazy.

      Best Regards,


      DGI

      PS I am curious to learn how did you teach your grandchildren/children about finances?

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  8. Wow. Great article. So much to digest here. This information will be very useful to my situation. My employer puts us in an odd situation. I have to work until 62 years old to collect full pension. Every year worked is approximately 100$ a month in retirement. For example. If you work 30 years you'll receive 3000.00 a month pension. If I don't work until 62 than every year I leave early they impose HEAVY penalities to the tune of 6% a year for every year left prior to 62. (Unless of course I retire early and don't access the pension until 62. This is where I hope dividend paying stocks can float my income for those years.)
    On the flip side they pay approximately 18% of gross wages into a stagnate money-market-like-return fund within my 401k. These funds are not available for investment into mutual funds. Only funds available for investment in the vanguard mutual funds that are offered are my contributions. Last year I received an overpayment check back from vanguard because one can only contribute a certain amount combined employer and employe to a 401k. This now goes on this years tax return. After reviewing 2015 tax brackets this can push me into the 33% bracket which would be a big tax hit. Seems like sometimes investing in tax deferred accountants can still bite you on the butt. Regardless. I greatly appreciate this article because I'd love to access 401k funds early so I don't have to work until 62.

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    1. Well, this overpayment was likely because you contributed too much to the 401K. if you hadn't, you would have been taxed on that money anyways. I agree though that you have to be careful and try to learn as much about the rules to formulate your strategy ( or hire a good CPA)

      It is interesting that your employer doesn't let you do anything with that 18% of gross income. I have never seen anything like that ( until I exchanged emails with you a few weeks ago)

      But yes, it is pretty nice to get a tax break today on contibutions to tax-deferred accounts, and have money compound tax free.

      DGI

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  9. Very good advice, DGI, thank you.

    A quick story of how I advised some of our employees regarding the 401K our company made available.

    Quite a few of our employees were not involved in the 401K the company offered. Their typical reason was that did not trust Wall Street with their money. The example I'd give them was to contribute $100 a month and put it in the money market option to avoid the "market". Since it's a pre-tax contribution, there would only be about $75 taken out of your check for the $100 contribution. The company would match 50% of the contribution ($50) so you end up with $150 from a $75 investment. You double your money without taking any market risk.

    Some understood others not so much.

    SAK

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    1. SAK,

      This is a good story. The 401 (k) match is part of the total compensation package - not taking advantage of it is like turning away free money. Add in the tax savings, and you have a win-win-win. Of course, savings alone will not help one reach financial independence - an investment plan is a must.

      Thanks for stopping by and sharing your story!

      DGI

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  10. "There are required minimum distributions at age 70 ½ for money in a pre-tax 401 (k) or Roth 401 (k)."...
    Roth 401K has RMD?

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    1. Yep, Roth 401 (k) does have RMD

      The Roth IRA doesn't have RMD

      There is a slight difference between the two - the first is provided by an employer, the second is for the individual saver/investor

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  11. Great article and good advice DGI.

    I remember when you woke-up with that "aha moment" in 2013 concerning tax deferred accounts and wrote about it.

    Just turned 55 and plan to retire next year. Been maxing out my 401(k) for years and when my company offered a Self Directed Brokerage account option 4 years ago I was in heaven piling money into dividend paying stocks.

    But as my retirement date grows closer I became more and more concerned about the required minimum distribution (RMD). As you know, RMD says that at 70 1/2 you must start withdrawing cash from your 401(K) based on the total numbers of years you are expected to live and the dollar worth/value of your 401(k). So a hypothetical here:

    As a woman my life expectancy is 87. If I have $800,000 in a 401(k) I'm would be required to withdraw $47,058 that first year (800,000/17). But what if my dividends are paying me $30,000 that year? Too bad, I would have to cash out an additional $17,058 of my dividend stocks to make up for the RMD requirement. Ouch! Not only do I have to cash out some of my stocks but I loose the dividends they provided as well. Double ouch!! And whose to say I only live to 87? Folks in my family have lived into their mid/late 90s.

    So I realized I needed to do exactly what you are advocating in this article (though mine is a variation due to age/retirement timeline differences). I'm in a low tax bracket now and intend to stay that way once I retire. Effectively, when I turn 60 I will begin taking a set monthly amount from my 401(k) (literally selling some of my dividend stocks) and rolling that money (minus taxes, if any, owed) into a Roth IRA. Once in the Roth IRA I will be buying new shares in dividend paying stocks. And because I am allocating my 404(K) distributions on a monthly basis I can DCA into the stocks. By the time I turn 70 1/2 there will be no monies left in my 401(k) that will require an RMD...it will all be in a Roth IRA, producing non-taxable dividend income.

    That's a winning strategy in my book and for DGIers, my age and close to retirement, it's a great way to do tax planning that takes into account the RMD coming down the pike.

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    1. Thanks for stopping by and sharing your story. You are one of the lucky few who have access to a self-directed brokerage window within their 401K plan.

      The nice thing is that you managed to accumulate a nest egg for years in tax-deferred account, and avoid paying taxes on dividends and capital gains all those years. If you had been investing in a taxable account, you would have likely had less money. And since the money is in a 401K, you have some flexibility as to the timing of conversions into Roth or just withdrawals.

      It does seem like the best way to go is to rollover money into a Roth IRA prior to the start of RMD at age 70 ½ years. If you sell say 500 shares of KO at $40 in the 401 (k), you can roll that money over into a Roth Ira and buy 500 shares of KO ( minus cost of commissions and any taxes on rollover). As long as you end up paying a lower marginal tax rate on the rollover into Roth IRA than the tax rate when you were working, you will come out ahead.

      In my case I am hoping to have all my 401K converted into Roth with a minimal tax bite in the process, by the time I am in my 60s. After that I will have income from Social Security and dividends. I am hoping to not have to touch the Roth Ira much, though you never know. I am also hoping to have this conversion to Roth Ira completed by the time I start collecting Social Security. That way, I will have the maximum amount of Social Security to be tax-free.

      Please stop by along the way and let me know how your journey progresses!

      DGI

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    2. Anon-

      There is something important you should know about RMDs. They do not have to be in cash. You do not have to sell any shares if you don't want to, especially if you have another source of cash to pay the taxes owed. All you have to do is transfer the value of shares needed to reach the RMD amount. This is called an "in kind" transfer. For example, if your RMD was 42k, then you would need to transfer approx. 1000 shares of KO from your tax deferred account to a taxable account. Your broker will set this up for you (it's basically no different than rolling a 401k to an IRA). The value of the shares counts towards your RMD requirement. You still have to pay the taxes, but the number of shares you have and what you receive in dividends doesn't have to change at all.

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  12. Phenomenal article. Coming from the accounting and tax industry myself there are far to many people who do not understand the intricacies of the tax code and options available. Many people even in the industry do not fully understand the options available. Heck even I have to put in a lot of work to get it right. You summed it up very nicely for everyone to understand the basics regarding the topics.

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    1. The Long Haul Investor

      Thanks for stopping by. I am ashamed to admit that I invested for five years through 2012/2013, and I completely ignored/avoided learning much about the basic rules regarding tax deferred retirement accounts. I costed my future self a lot of money in the process.

      I am trying to learn now. I am glad you have gotten around to learning how to apply the tax code to your advantage!

      DGI

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  13. @ Dividend Growth Investor - After maxing out a ROTH IRA and receiving the maximum employer match from a pre tax 401k, where is the best place to max out next? I have access to continue to max out the pre tax 401k, my employer offers a ROTH 401k, or I could add to a taxable account.

    I am in the 15% tax bracket and anticipate having more income in the future and also in retirement. The ROTH 401k looks like my next best bet, although the taxable account may provide flexibility. Would you give your quick thoughts?

    Thank you, I really enjoy the blog.

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    1. Thanks for stopping by and reading. Unfortunately, I cannot provide you with any individualized investment advice, since I know absolutely nothing about you. I don’t know your level of knowledge, goals and objectives, income etc

      I personally max the 401K ( only options include low cost mutual funds), and then use the savings to max out the Roth IRA ( I buy individual dividend stocks). The rest goes to taxable accounts ( though I did max out taxable accounts for years before starting to max out tax-deferred accounts, so I have a decent dividend income coming out from taxable accounts). Taxable accounts offer flexibility, but this comes at a cost - you have to pay taxes on dividneds and realized capital gains. Assuming you can make money investing, a Roth IRA is superior than a taxable account.

      Technically, money in a 401K provides more safety to you in case you are sued or in case of bankruptcy.

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  14. Great article! I've been looking into the SEPP recently (just turned 52) as a way to tap into the fruits of years past a bit sooner in case my aversion to work turns takes a turn for the worse (better?).

    For those of you in an HSA--are you happy with it?

    [For me, the HSA tax benefits aren't quite as good as written above, though they can still be pretty good:
    If I haven't maxed out my SEP-IRA, adding $3500 to the HSA instead of the SEP-IRA defers only an additional $80 in taxes. Definitely not worth setting up an HSA account for...

    If I have maxed out my SEP-IRA, then it's much better--an additional $3500 saves $879 in taxes (~25% tax savings). Much better!

    (assuming my spreadsheet works as it should:)

    The interactions between self-employment tax, agi, SEP-IRA contribution and HSA contribution are a great example of the wasted complexity in the US tax code...]

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    1. Hi,

      In my situation, I want to max out anything I can get my hands on – both 401K, IRA, H S A etc. So I have not thought about H S A versus SEP IRA. I would be curious to see your spreadsheet ( if you could please share it with us that would be much appreciated)

      I am not sure about tax implications for H S A when self-employed. My H S A comes out of a paycheck ( reduces W2 income automatically along with SS, Fed, State etc).

      I know that a SEP IRA reduces taxes as well, and there is a deduction for ½ of self employment taxes. I would have thought that an H S A would be better because you won’t have to pay your own FICA ( though the employer will have to pay it I think)

      The one positive of SEP IRA over H S A is that H S A accounts have more fees, and are usually limited in their investment options. Of course, the question is why not use both ;-)

      You might like my review of HSA here: http://www.dividendgrowthinvestor.com/2015/02/health-savings-account-hsa-for-dividend.html

      Best Regards,

      DGI

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    2. I wish I'd seen your HSA article sooner! Thanks! I started mine in 2009 or 10, and saw only a few bad options back then. I'm going to switch to Fidelity before the year is out (hopefully that'll mean one fewer username/password to write down :)

      --

      I started trying to get a clean copy of the spreadsheet to ship out but made the mistake of looking at the 2015 1040 ES instructions and worksheet. It's changed structure considerably since I started my spreadsheet, and I'm not sure I can make a clean copy that works within a reasonable time : (. The numbers seem to work the same, but the lines are too different for anyone (including me) to track to the current incarnation.

      I guess you could just use last year's turbo tax instead and run it twice: once with a $0 HSA and $3500 more to your IRA, and once with $3500 to the HSA and no more to the IRA...

      I think where you live, how much you make, what you do to make it, and how you're employed all play into the answer of how much benefit you see from an HSA contribution versus an IRA contribution...crazy complicated tax code :(
      ---

      I'm kinda surprised your blog income doesn't count as self-employment income for which you can then set up a SEP-IRA separate from your other IRAs and 401(k)s--but that's not something you need to respond to SEP-IRAs are much better than the regular IRA or 401(k) for heavy savers since you can put so much more into them. SEP-IRAs are pretty easy and cheap to set up (free at Fidelity, for example). And once you've put a lot into them, the SEPP is how you get it back out (without penalty:).

      Thanks again for this article and all the others--they're both practical and inspiring!

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  15. Great article. Not gonna lie, it did make my head spin a little. I am still several years (10-15) from my early retirement, but I have often wondered how to access all this money I am socking away in my 401K. This year my employeer started offering a roth 401K option, so I split my contributions 50-50 roth vs traditional, that way I still get some tax savings now but will have access to withdrawal money without penalty down the road.

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  16. Hey DGI (and anyone who as insight here),

    Thanks for this article! This definitely opened my eyes to tax-deferred accounts. I have a couple questions. I am not asking for tax advice but insight into if you were in my situation, what approach would you take or how would you be thinking about strategy regarding all of the options.

    I am 27 and plan to have enough in dividend income to retire in my 40s. My employer currently offers a 401k with 6% match through Fidelity where we can make either a traditional or Roth contribution. I currently contribute 6% of my salary (which is a Roth contribution) to get the matching contribution from my employer (which goes in as traditional). Everything else I save goes into a taxable brokerage account where I invest in dividend growth stocks. The reason I chose the Roth 401k contribution option is so that I can withdraw my contributions each year (I only wanted the match) and invest them into dividend stock (fidelity and my company only have mutual funds to select from).

    If you were in my shoes, would you be contributing more to the 401k? Would it all be Roth or Traditional? I want your thoughts and experience on strategy so I can form a more structured plan for myself.

    Once that has been established, would you convert the taxable account into a Roth? And then each year convert the 401k contributions into the Roth so you can buy individual stocks? I am sure there are others who have this dilemma as well. Would love to hear your thoughts! I am a rookie willing to learn :)

    ReplyDelete

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