Are 401Ks & IRAs WORTH IT? (Financial Independence & Early Retirement) | Investing For Retirement

Updated : Sep 02, 2019 in Articles

Are 401Ks & IRAs WORTH IT? (Financial Independence & Early Retirement) | Investing For Retirement

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


  • I used to be a believer in traditional IRA usage with tax write offs, but, I feel that managing income and paying tax NOW and then investing money into a regular brokerage account is the way to go because of mandatory withdraws on IRAs at 70 1/2. I think no one plans to live on less than their current income level in retirement. Essentially maintaining their current tax burden in retirement. Unless you are able to draw down your account(s) before 70 1/2 mandatory limits kick in…while still managing taxes of course, you will start to be forced to withdraw. This could make you suffer huge tax burdens. Roth IRA ladder conversion work don't get me wrong good idea, but, if contributions are taxed at conversion time is that less than 15 percent (capital gains) which is what you would pay if already taxed and then invested in brokerage account….with no limits. Can you maybe make a video about this…. please prove me wrong…I will change my plans😀

  • I've been waiting for this one, thank you for all the time/effort you put into making this. Awesome job! A bit longer than normal, which is understandable, given the complexity of this topic. I'm guessing this one will need multiple views for some people to really get a good grasp on it… Btw good luck when you decide to do a 72t video; the calcs on that are just weird to me and simply not worth it for a really early retiree, due to the lack of flexibility.

    One thing I noticed you didn't touch on is the big benefit that can come from an employer match on the 401k. I get why you didn't put it in the calcs, because not everyone has access to a company match, however I do think it would have been worth mentioning. Looking forward to your future videos. I'm working on starting my own YouTube side hustle pretty soon, hopefully I can stick with it and it pays off.

  • I just used an online retirement calculator from NerdWallet. It says that I'm not going to make it if I keep on my current path. I am not sure if the NerdWallet calculator is considering SS or Medicare.
    My question is, are you considering SS and Medicare? Or is this video only for early retirees, and only talking about how to get from your retirement age, to 65-70?

  • Thank you very much for this video, this answered a lot of questions for me, you rock! Really love the financial independent videos

  • I currently have Roth IRA which I contribute 6K a year. And my employers 401K. For the 401K with my employer would you recommend Roth or before tax contribution? If so why?

  • Roth IRA for those that think because of job security/low income who think they may need to tap that cash should avoid the 401k and just put money in a Roth IRA which allows you to withdraw your contributions but not the capital gains at any time and for any reason. BEEN THERE DONE THAT!

  • I’m clear on the accounts until (at the 11:45 mark), the $226,500 is introduced. Where precisely is that $ coming from?

  • I'd love to see this strategy played out in a part 2 video, using real market data to see how the ups and downs in the market along with taxes and inflation effect the portfolio. I wonder how well the standard 4% rule (although I'm more conservative at 3.5%) pans out during a downturn, since you have to sort of plan your expenses 5 years in advance.

    Edit: For anyone else who would like to see that, like this post to see how many people are interested. Or of it's just me. Sorry Daniel, for trying to add more to your already full plate 🙂

  • My 457 is giving me the option to put money towards both the salary reduction and Roth could explain this

  • Daniel, quick question. If I have both an IRA and 401k, can I retire at 58, have money saved to live on until 62 when I start withdrawing from my 401k, and not touch my IRA and just let it keep growing?

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