As I mentioned in my budgeting post, it’s important to remember that your budget is fluid as circumstances change. The same could be said for investment strategy. Here’s how I’m switching things up:
Max out my 401k, HSA, and Roth IRA. Set up automatic transfers to fund my car fund and fun money account. Any money leftover was then invested via my taxable brokerage account.
Continue to max out my HSA and Roth IRA. I’ve updated the automatic transfers to my savings accounts based on how much I’ll need for planned expenses and what the projected balances will be at the end of 2016. This will be higher in a couple savings accounts. To offset that, I’m reducing the amount of money that is transferred to my car fund. My car has less than 80k miles so I should be able to drive it for many more years. This account doesn’t need to be fully funded within the next year so the automatic transfer can be reduced.
I’ve reduced the amount I’m contributing to my 401k down to 10% (I’ll still get the company 4% match). I’m taking the extra money and investing that in my taxable brokerage account.
Why Change Course?
Earlier this year I read MadFIentist’s post about achieving financial independence sooner using tax deferred accounts. That money can then be converted to a Roth IRA tax-free if done in small increments. It sounded great at the time but I’m reconsidering if this is the best path for me.
After playing around with my early retirement calculation file, I determined just how expensive it would be for me to do those conversions. Here’s what I realized:
- I plan to stay single, which means that I get the standard deduction and an exemption ($10,300 for 2015). This is the amount that can be converted from a tax deferred account to a Roth and remain tax-free as long as there is no other earned income for the year. If I was married, we could transfer twice the amount. Because it’s so low, I’m hesitant to put too much into tax deferred accounts because it would take a lifetime to convert it all to a Roth.
- Which leads to my next point: At age 70 1/2, required minimum distributions kick in. This only applies to tax deferred accounts and not Roth IRAs or taxable brokerage accounts. That means that I may be able to avoid paying taxes at a rate of about 25% today (federal + state), but I’d likely have a much higher tax bill in my 70’s. This is a concern for two reasons: 1. The RMD may bump me up to a tax bracket higher than 25% and 2. There’s a possibility that federal taxes will be higher 30 years from now. I can’t accurately predict either, so I would rather pay the tax now than deal with the risk that comes with uncertainty. I also feel more secure in paying the taxes while I’m earning income and have the flexibility, rather than when I’m on a fixed income.
- Minnesota imposes an income tax on everything. I’m fully aware that I’ll need to pay state income taxes on capital gains from my taxable brokerage account, but that is on the gains only and not the entire distribution. I would guess that less than half of the amount I’d be withdrawing from that account at age 50 would come from capital gains and I’d likely be in the lowest (5.35%) bracket. If I were to do a Roth conversion of more than the standard deduction/exemption AND withdraw money from my brokerage account for living expenses, I’d be paying state income tax on both and would most likely get bumped up at least one bracket so the rate would be at least 7.05%. I’ll also have to pay state income tax on social security when I start drawing from that, which could bump me up yet another tax bracket.
- Medical coverage when I’m retired prior to age 65 is an unknown. I’m still looking into how the ACA coverage works (both Jeremy and Justin have written in length about this topic). If I go this route, I’ll need to be careful that my income isn’t so high that I become ineligible for subsidies, and Roth conversions would have an impact. My other option is to pay for coverage at full cost. While prices at age 39 aren’t too scary, I’m sure I’ll be in for sticker shock when I’m 50.
- My intention is that the taxable brokerage account will be used to fund my early retirement only. But even the best laid plans can fail. I would feel more comfortable if that money was invested in an account that I could withdraw from anytime, without penalties or limits. If something should happen (e.g. I need to take a year off from work in my 40’s for health or family reasons), I would like to be able to afford to do so. The same can’t be said for money tied up in traditional retirement accounts (at least without trying to locate a complicated loophole). Accessing the Roth is an option, but I could only withdraw the contributions I’ve made, not the capital gains. That may not be enough due to the low annual contribution limits ($5500 for 2015).
- I don’t know much about how traditional IRAs are transferred to heirs but I believe it’s pretty messy in that the beneficiary is required to take withdrawals (and pay taxes on them) each year. The same cannot be said for taxable brokerage accounts. It’s not that I’m intending to leave money to anyone, but, if I do, I would like the transfer to be as simple and tax-free as possible.
Risk and uncertainty are the enemy. Because of this, I’d rather pay taxes upfront while I have a paycheck and can earn more money or delay retirement if needed. I know that many personal finance bloggers would disagree with me on this point, and I understand their argument. It’s true that the calculations for early retirement boil down to simple math, but nowhere in these calculations do I see statistical analysis for risk and uncertainty. Therefore, they are incomplete and don’t show the entire picture.
These changes will translate into approximately half of my total investments being in tax deferred accounts (401k and IRA) and the other half in my Roth and brokerage accounts by the time I retire at 50. This is a much more balanced approach.
While I’ve decided that this is the best plan for me, it may not be best for you. That’s why it’s important to read and research as much as you can and find a plan that you feel comfortable with. Is it possible that I’ll change my mind later and max out my 401(k)? Most definitely, especially if I’m able to save enough in my taxable account a few years prior to my target retirement date. We do the best we can with the information that’s available and need to maintain some flexibility to make changes when needed.
Be sure to do your research and use the free tools available to you so you can find an approach that works best based on what you’re trying to achieve.