Does Ultra-Frugality Mean That You Don’t Need A 401(k) Or A Roth IRA?

An ultra-frugal reader writes in with an interesting question – why even bother with a 401(k)?

My husband and I have been living on about half our income for many years. If our expenses and savings rate stay about the same, we’ll have enough savings to live off the interest in about 7-10 years (depending on your assumptions about interest), including the ability to pay off our mortgage. Let’s say 10 years — I’ll be 44 then.

Conventional wisdom is that we should be pouring money into IRAs & 401(k)s because of the tax benefits. “It’s free money!” people tell us. And we do have a pretty good nest egg in those accounts. But lately I am wondering: if we can get to the point where we could be living off the interest of our non-tax-preferred savings a full 15 years before we’re allowed to even touch the money in our tax-preferred savings, don’t the retirement savings become kind of moot? Shouldn’t we just build up our early-retirement savings instead? Or am I missing something? Are the tax benefits to retirement accounts so great that we really should keep putting more and more into them? Do expenses go up significantly in later life so much that we’ll need to have a big infusion of cash?

First of all, I’m going to assume that your savings are in a well-diversified portfolio; if not, then everything I say below is moot. If it’s all sitting in a savings account and your window for touching it is more than ten years out, you need to seriously diversify into other investments, but that’s another article.

Now, if your portfolio is diverse and you believe that you’ll be able to live off of the income from this portfolio in ten years, you need to remember two things. One, inflation is real, and your portfolio still needs to grow even after your withdrawals each year by about 4% or so (at least). Without that growth, everything will get progressively more expensive while your income level stays the same. Two, you need to remember the benefits of work as well; health insurance, in particular, will be an expense after making this move.

If you’ve got all of that covered and you can still walk at age 44, that’s fantastic, and a 401(k) probably is a waste for you because you will pay much lower taxes by putting that money directly into your investment accounts (assuming that you will follow through on your plans to retire at 44 with a relatively lower income from your investments than you have right now from your employments). For most people, a 401(k) is a very good thing – for your situation, though, I don’t believe that it benefits you.

However, a Roth IRA may still be worthwhile for you – at least, it is worth considering. Much like your investment portfolio, it is built with after-tax money. However, unlike your investment portfolio, you are not hit with capital gains tax when you go to withdraw it. Let’s say you’re in the 15% tax bracket and you put $4,000 a year into a Roth IRA for ten years and it grows at 10% a year, and you also put $4,000 a year into a mutual fund. At the end of that period, they’ll both have a value of $63,749.70. But, you’ll be due to pay capital gains tax on $23,749.70 of the mutual fund, but you won’t owe a dime on the money inside the Roth IRA. That’s going to be a difference of at least a few thousand dollars, and likely much more than that for your situation.

The only drawback of the Roth IRA is that you can’t tap it until you’re 59 1/2 without some serious penalties, but if you have your financial house in very good order, the tax advantage of a Roth IRA makes it worthwhile, even giving this reader’s exceptional situation.

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  1. chazzman2000 says:

    I would think that more would need to be known on the 401k before dismissing. In my case, if I put in 8%, the company throws in 6%. That’s a 6% bonus right there.

    I’m also in funds that are now closed to individuals and yet I can invest more within the 401k.

  2. David says:

    The real issue with the Roth IRA is taxes. With all the baby boomers retiring and our country’s cost structure changing, what is the likelihood that taxes will be higher in the long run? The likelihood is great. Why not have money that is tax free in a Roth IRA? That’s the issue. It’s protecting your money against future tax uncertainties. What if we have socialized medicine? Will taxes be higher? You bet. What if social security goes bust? You bet taxes will be higher.

  3. David Hunter says:

    As with any of these decisions the appropriate answer is always crunch the numbers! It always the depends. Trent’s advice is good, both in regards to diversification and in regards to accounting for inflation. Here is a possible alternative strategy (disclosure: I am a New Zealander who is now based in Northern Ireland so I don’t know much about the specifics of the 401k etc) You could do a fifty fifty, so in other words you could arrange to take care of yourself up until you can access your 401k then have that take care of you. This may give you a short stop to cover yourself if it turns out you have under budgeted the long term cost of living or inflation becomes rampant. Personally I would allow for inflation of 6% on a better safe than sorry principle.

    Cheers
    David

  4. Jim Lippard says:

    Everything they have invested in non-tax-deferred accounts is taking an annual tax hit on dividends and capital gains distributions, which reduces its return by comparison to tax-deferred accounts.

    Although, from their description, it sounds like they don’t even have it invested, that it’s just sitting in savings (they only mention interest, not dividends or capital gains), which means they’re probably losing more money every year to inflation than they’re preserving in interest.

    Chazzman also makes the very important point about company match on a 401K–if it’s available and you don’t take it, you’re just throwing away free money.

  5. beth says:

    I was under the impression that a person could withdraw the contributions to a Roth at any time, just not the earnings. Am I wrong about that?

  6. Ralthor says:

    As Chazzman says the free money issue has to do with employers matching contributions. Assuming your company matches some percentage of 401K contributions you are basically letting the company keep a portion of your salary.

  7. Chris says:

    David, there is also the risk of the tax structure changing entirely. What happens if we go to a VAT type tax structure? Will the tax adavantages in a Roth even matter at that point? Check out http://www.fairtax.org for an idea of what I’m talking about. Right now it’s sort of out there, but the current tax system is so complex and broken that it’s possible that in the next 38 years (the amount of time I have till I can withdraw from a Roth), that the tax system will significantly change.

    Remember, government is an aspect of risk. Don’t keep a narrow view of risk being just up or downs of stocks, there are hundreds of other factors that can just screw up retirement plans. Plan on and evaluate as many as you can. In the case of taxes, just diversify across pretax plans (Traditional IRA, 401k) and post tax plans (Roth).

  8. Rob in Madrid says:

    Well you can’t predict the future (beyond the fact that taxes will be higher in the future particularly with the Dems in charge) a visit to a for fee financial planner maybe in order. While it might go against the grain of low fee investing a good tax/financial planner can pick up on things that you might miss.

    The key to finding a good planner is to ask for recommendations and then ask how he’s paid commission or fee.

  9. MossySF says:

    Here’s the biggest reason for the ultra-frugal planning for early retirement to also contribute to 401Ks/Roth IRAs — what happens when 59.5 comes around? Surely you want to remain in retirement right? So think of it as a double portfolio. Taxable investments designed to last from age 45 to 59.5. And retirement assets to last from age 60 to 85.

    Why not designate a single taxable account to cover 45 to 85? Because tax-efficient vehicles (401Ks, IRAs, Roth IRAs, HSAs) just blow taxable accounts out of the water. Not having to pay taxes on yearly distributions or realized gains is a huge factor over the long term. Just run the numbers a few times and you will see what kind of impact it is. 3 years of 10% tax-deferred growth cancels out the 10% early withdrawal penalty when compared to an investment that gets fully taxed every year. For more tax efficient asset types, the target for passing the 10% penalty is 7 years (high yield stocks/reits) to 17 years (large cap growth).

  10. chazzman2000 says:

    I agree with Chris. Check out the site. Also think about how you get a yearly Social Security statement with what your proceeds should be for retirement. Yeah, right! How many k’s of my money are going down that drain.

    I have a few problems with Roth IRA’s. And maybe people can answer my concerns:

    1) Why do Roth IRA’s have income limits? I know its high 156-166k a year and I’m not near that by any means. But if the rich can’t play in the field it smells like a subsidy to me and something that the government can do something to in the future. Plus, the limit on Roth IRA’s isn’t really going to be a dent for an investment vehicle for a high income wage earner…I’m leery on this.

    2) Time value of money. Or, I’d rather have the dollar from you today than get it tomorrow. When I retire, I don’t plan on having an income…so what will be my tax then? I also plan not to have a mortgage, children expenses, car loan, etc.

    It’s probably in my best interest to start up a Roth this year to diversify. But I just don’t see all of the benefits that the industry talks about and it seems like 401k’s (and other investments) are kind of put on the back burner. I’m interested to hear what others think on this.

  11. chazzman2000 says:

    I just re-read my post and should note that I plan to have an income. Just not as high as it would be in pre-retirement and/or it would be income that would be non-taxable. :)

  12. Trent says:

    Yes, you can withdraw the contribution to a Roth IRA whenever you want, but you want to do that as a last resort because you can’t just put it back whenever you want – when it’s out, it’s out.

  13. Jason says:

    You can have 100% of your savings in your 401(k) and still retire early (such as age 45) without taking a penalty. See http://www.72t.net for the full details, but the long and short of it is that the IRS already has provisions in place for just this scenario. You have to follow some pretty strict guidelines to get at the money penalty-free, but it’s completely doable.

    It would be a horrible idea to intentionally avoid your 401(k) just because you plan to retire early.

  14. Trent says:

    Jason, starting a 72(t) that early is a very risky proposition, because if we go through another market downturn after that’s set up and you run out of money in the 401(k), you have to pay the 10% penalty with nothing left in your 401(k). With more than ten years in there, I would never, ever trust that the market wouldn’t see a downward slide in there, which means in order to execute it with little risk, you have to turn everything into bonds, which means you lose out on a ton of gains. 72(t)s are okay if they’re very conservative and are just for five years, but running one for ten or more scares the pants off of me.

  15. Lisa says:

    I am at the tail end of the baby boomers. For years, financial planners have included Social Security into projections for my “retirement planning”. They had good intentions but were probably wrong. By the time I qualify to collect at 62 the money won’t be there and they will have changed the rules, just like Reagan did in 1983 changing my age to collect from 65 to 67. All these plans are just social contracts that can change and leave you high and dry. Now, I am a realist not a pessimist. I have every hope for the future and so I decided to diversify. I use a 403B, a 457, a roth, individual taxable accounts, a tiny state pension and social security(ha-ha). Some years its 60/40 split between taxable vs sheltered and others its 40/60. I keep my options open and try to maximize today’s money returns. I can only be sure of this year and maybe the next 2 or 3. For example, in 2008 if I make less than 30,000 I can pay 0% tax on my capital gains so I will maximize my 403B and sell some stocks I was going to sell in 2007 in 2008. I include in my plans tax consequences based on the laws today and projections of how tax/market changes could effect my plans. I try to keep it fluid and diversified. I need the larger taxable account because I will reach FI at age 48.

    Another reason to have sheltered accounts is because many are protected from law suits and creditors. Not a bad idea in a sue happy society.

  16. Jason says:

    Trent, if you’re retiring at 45, but are afraid that your nest egg won’t even last you for 15 years, you obviously have no business retiring at 45. Fear of a market crash is also a bad reason to avoid your 401(k), providing that you have a reasonably sized 401(k) for your retirement plans.

  17. EA says:

    I second (third? fifth?) the Rorth suggestion, if they’re below the income limits. And don’t forget 401k matching. It’s worth funding the 401k up to the point where they get full matching, and no further.

    A 401k is great for most people because it comes out of their paycheck before they see the money. For people who are capable of saving on their own (and who may have the same or higher taxes at retirement) it might be better to save outside the 401k because then you’ll be paying the (currently lower) long term capital gains rate, rather than the income rate on the proceeds.

  18. pf101 says:

    2 comments:

    Trent/Beth – you are both correct but it’s good to know that you CAN put money back into the Roth if you take it out…IF you do it within 60 days. After 60 days it’s gone for good.

    With regards to getting at your 401k money before 59.5, you can do so, without penalty, if you set up a SEPP plan. This stands for Substantially Equal Periodic Payment and it means that if you try to tap your money before 59.5 they will figure out what your life expectancy is and set up a plan that pays you an equal amount each year depending on what that expectancy is. You get that money just as you would with an of-age distribution and there are no early-withdrawal penalties but you have to do it for at least 5 years. Just something to keep in mind.

  19. pf101 says:

    Guess I should have refreshed before I commented. :-) I see Jason mentioned the SEPP and I have to agree with his comment about worrying about the nest egg being depleted. At 45 you should still be pretty agressive with +/-80% of your money in stock funds. If you’re going to start a SEPP you may want to be a *bit* more conservative, but not much or it will impact your long-term returns.

    It sounds like they already have a lot outside of retirement accounts so I don’t see why they couldn’t use that money until 59.5 if they had to…or the Roth money if they decide to do it.

  20. lorax says:

    [quote]just like Reagan did in 1983 changing my age to collect from 65 to 67[/quote]

    Yeah, this one annoys me too. I suspect it will go to 70 for the later Gen Xers and Gen Yers. But we do get to live longer. :) At least in theory.

    I also agree with 1) that you should at least get the employer’s 401k match, 2) that a SEPP plan is decent concept for early retirees, and that 3) you should be as sure as you can that you actually have the funds to retire, even though market declines.

    Another point to consider in a 401k is that some companies provide very low cost index funds. Some carry the institutional funds, which expense ratios below those of ETFs. Nice, if you can get it.

  21. Quinton says:

    Umm..Let this woman know the tax code!

    See
    http://www.irs.gov/pub/irs-irbs/irb02-42.pdf

    and http://taxes.about.com/od/preparingyourtaxes/a/1040line59.htm

    http://www.jennisondryden.com/view/page/jd/11654

    ANYONE can take out money from their retirement accounts BEFORE 59.5 years and not have a penalty, IF they take it out according to the IRS actuarial tables for life expectancy.

    So GO AHEAD and put it into the IRA or 401 (k), then withdraw it like an annuity, equal payments to you for your calculated life.

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