Ultra-Frugal? Still 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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