Recently I have seen an unprecedented amount of conversation advocating for ignoring tax-advantaged retirement accounts. Most of these conversations seem to be well intended. After all, these accounts are designed to not be accessed until you hit the legislated age of retirement. I am not saying there isn’t solid advice in what is being said, just that I think it is a little unbalanced. Both retirement accounts and traditional brokerage accounts serve a purpose. You shouldn’t just pick one, but blend them together for a long term plan.
Retirement Accounts : A Primer
In the United States there are several different types of retirement accounts. The two most common types of retirement accounts would be IRAs and 401(k)s. Now there are several varieties of these which we will get into in a bit. There are also TSPs, 403(b)s, ESOPs and 457(b)s. All of these retirement accounts are a little bit more restrictive than an IRA or 401(k)s.
Traditional or Roth
Both 401(k)s and IRAs come in several varieties. The two most common are Traditional and Roth. There is a major difference between these two varieties. Traditional IRAs or 401(k)s are funded with pretax dollars and you have to pay tax on distributions in retirement. Roths are the exact opposite, they are funded with post-tax dollars and grow tax free. There some different income requirements for both of these which you will have to talk to your tax professional about.
Why would you want a traditional over a Roth or vice versus? The major consideration is whether you believe you will be in a higher tax bracket in the future or not. If you believe that you are in a higher tax bracket now, then you may consider putting money into a Traditional retirement account to get the immediate tax benefit. If you believe you will be in a higher tax bracket in the future, then you should fund a Roth account if you are eligible so you get the long term tax benefit.
I will add another personal caveat, which is time. I strongly believe that Roth products become more advantageous the further you are from retirement account. This is due to the time value of our investment. I ran a few simulations to demonstrate this. The first chart is a Monte Carlo simulation of 30 years of growth with an initial investment of $10,000 with $500 per month after that. The entire portfolio is invested into SPY.
Beginning our Retirement
Using this chart we can see that the median amount of money we will have in our retirement account is $1,500,000. Using the 4% safe withdrawal rate this gives us an income of $60,000 in retirement. Which would put you on par with the average household in America.The difference comes from whether this is pretax or post-tax. If it was a Roth account then we do not have to account for paying income taxes on this money. If we used a Traditional retirement account then we would have to pay income taxes, which using current federal tax guidelines would be 22% for single filers and 12% for married filing jointly. For single filers that means we only have $46,800 for our expenses. For the married couple they would have slightly more at $52,800. Using our Monte Carlo simulator and a 50/50 Total US Equity and Total US Bond asset allocation we can see how this will be successful 99.54% of the time over 25 years.
We can also see that in at least 25% of our portfolios we end up with more money then we started with. This allows us to create a legacy plan to pass down money to the next generation.
Betting on Early Retirement
What if we think we are going to retire before we turn 59 and a half. We won’t be able to access our retirement accounts just yet, so we will need some form of a taxable brokerage to sustain us until then. Then we can have our retirement account kick in and take over our expenses. Our goal here is to have $60,000 in income through both stages of our retirement. Now we could just buy 28,847 share of AT&T and let the dividend fuel our retirement, but I believe in diversification. I also believe early retirement portfolios can have a much higher chance of failure, because we can always do some BaristaFI and make some income during our early retirement.
Let’s create a scenario. We are 23, fresh out of college and planning our early retirement already. Our goal is to combine our retirement account and taxable brokerage to create $60,000 in income for both stages. We are able to save $750 per month based off of our current salary. Our employer offers a modest 3% match or $125 per month. Our goal is to retire at 43 and enjoy a nice early retirement. Let’s see how the numbers break down.
We decide the best chance of being able to retire early, is to invest heavy into our taxable brokerage account. We invest enough in our Roth 401(k) at work to get the match with the remaining money going to our brokerage. This means we are investing $625 a month into our brokerage and $125 into our Roth 401(k) to get the $125 match. After 20 years this gives an average portfolio of $665,868.
Taxable Account Success
We need our taxable brokerage to sustain us for 17 years until we are able to tap into our Roth 401(k) to sustain the rest of our retirement. The Monte Carlo simulation uses historical returns and standard deviations to determine the viability of our portfolio over the long term. We can see using the above chart that 50% of the portfolios have $160,144 left in them after 17 years while 25% of them have $1,292,728 or more left over. Using the below chart we can see that our portfolio fails 44.75% of the time. To me this is acceptable. The first few years of investment income are the most vital for a portfolio. If you retire in huge bear markets, you won’t have compounding interest helping you early on. The exact opposite is true if your retire during a roaring bull market. If we have unfavorable market conditions we can always continue working or even work part time to sustain our lifestyle in the short term.
Retirement Accounts Time
Now we get to our retirement account. When we turn 43 and retire we will contributed an average of $266,289 to our portfolio. We will not be contributing any more since we want our income to focus on sustaining our lifestyle not sustaining our retirement contributions.
Then once we are ready to start tapping our retirement accounts we can see that on average we have $1,490,111 in our account. Using the 4% rule we have a safe withdrawal of $59,604.44 with this portfolio. That means given the right market conditions we can keep withdrawing our $60,000 a year without any real fears. Not too shabby for only contributing $250 a month for 20 years to our retirement accounts.
The Merging of Two Worlds
Retirement accounts serve a purpose. So do taxable brokerage accounts. In the world of financial Independence and early retirement, they are two tools in the shed that need to be utilized. When we take advantage of the benefits of retirement accounts, it can often reduce the amount we need to save and help us achieve our goals even sooner.
Do you use retirement accounts along your journey? Let me know in the comments below!