The Best Tax-Advantaged Account for Early Retirement
In recent years, the idea of early retirement has gained traction among a growing subset of people who want to cut back on working before the "traditional" retirement age. This traditional age of retirement hit around 62 to 65, about the time that Social Security payments kick in for most people.
For those who want to gain FIRE status, 9-to-5 'til 65 just won't cut it. FIRE in this instance stands for Financial Independence, Retire Early. The concept of financial independence first became popular with the publication of Vicki Robin and Joe Dominguez's classic work Your Money or Your Life.
The basic concept of this book revolves around the idea that any money that you have left over after paying for expenses each month is capital that you can put toward achieving financial independence.
Rather than working for themselves and their own benefit, most people spend up their life's energy, defined as the finite number of hours they have left revolving around the sun, working to buy stuff and to pay other people. Cutting expenses and investing the rest is the way to build up enough capital to escape the normal rat race.
The concept of retiring really early has become more popular with the growth of popular blogs and podcasts like Early Retirement Extreme, Mr. Money Mustache, and the Mad Fientist.
Use Tax-Advantaged Accounts for Early Retirement
A dollar earned is not really a dollar earned. This might seem like a strange concept. However, any employee will testify to the fact that a dollar earned is not really a dollar earned.
I remember my first job a few years ago. Minimum wage at the time was a whopping $4.25 per hour. My first check included 5 hours, and should have equaled out to $21.25 based upon my hourly rate. However, there were Social Security taxes, Medicare taxes, and state income taxes withdrawn, and I drew about $19. As I started to make more money on each biweekly check, Federal income taxes also started to come out.
My coworkers used to complain, "The more you make, the more they (meaning the government) take." They used this justification not to take extra shifts. I took just about any hours that I could get at the time.
There are ways, however, to cut down on the amount that "they" take in any given year. The government has provided several different tax-deferred and tax-advantaged accounts that can allow hard-working, or even not-so-hard-working Americans, to cut their tax liability legally. These are common retirement accounts that most people have heard of.
The traditional retirement accounts provide a tax benefit in the present. They allow workers to come closer to making a dollar earned actually equal a dollar earned.
How? By allowing taxpayers to deduct every dollar they're able to save from their taxable income.
Traditional or Roth?
For early retirement, it is possible to save more money in the present by using tax-deferred traditional accounts. The most common are the 401(k), the 403(b), and the Individual Retirement Account (IRA).
There are savings limits for each of these. For 2018, account holders can save $18,500 in 401(k) or 403(b) accounts. If they happen to have reached 50 years of age, the limit goes up by an additional $6,000 to $24,500.
People who save in IRA accounts can save $5,500 in 2018. Those who are 50 or older can save an additional $1,000 in these accounts as a "catch-up" contribution.
What's the benefit of saving in a traditional account as opposed to a Roth account that allows for tax-free withdrawals in the future? It's likely that most people will make less money in retirement and have a lower tax bracket. If you think you'll be in this boat, a traditional account could work better.
The average American household made a little more than $61,000 in 2017. In 2018, the standard deduction goes up to $12,000 for single filers, and $24,000 for married folks who file jointly. This will drop the "average" family's taxable income to about $37,000. Taxes are due on this income.
Tax-deferred accounts allow retirement savers to cut the amount of taxable income even further, and they might also allow them to take advantage of a special saver's credit as well.
A person who could save the maximum of $18,500 in 2018 could cut their taxable income from $37,000 to about $18,500. For a married couple, this would cut their tax to about $1,850, and this amount of earnings would fall in the 10-percent bracket. The effective tax rate would be about 3 percent of the $61,000 income. Without the deduction for saving in a 401(k) or a 403(b), this family would hit the 12-percent bracket.
Dollars Compound Over Time
Negatives With Traditional Retirement Accounts: Early Withdrawal Penalties
Cutting your taxable income with traditional retirement accounts means that the government gets less of your money. This is the positive. For those looking to retire early, however, there is a negative that will hit in most instances: early withdrawal penalties.
The tax that you have to pay on these earnings is deferred. That means that it will need to be paid when you take the money out of the account. If your taxable income is below the standard deduction or any itemized deductions you might be able to deduct, you'll owe nothing for the year to start to take it out.
On the other hand, if your income exceeds these levels, you'll pay at the marginal rate of your accumulated income for the year. If you start taking out this money before you're 59.5 years old, you'll likely have to pay the marginal tax rate along with a 10-percent penalty in addition. That means that if you're in the 10-percent bracket, you'll pay 20 percent to the tax man, rather than 10 percent.
There are exceptions for a few hardships and for Substantially Equal Periodic Payments. There is, however, an account that avoids this. Find out about it below.
2018 Tax Brackets
Married, Filing Jointly
Standard Deduction: 0% Tax Bracket
Taxable Income of $0 – $9,525
Taxable income of $0 – $19,050
$9,526 – $38,700
$19,051 – $77,400
$38,701 – $82,500
$77,401 – $165,000
$82,501 – $157,500
$165,001 – $315,000
$157,501 – $200,000
$315,001 – $400,000
$200,001 – $500,000
$400,001 – $600,000
$500,001 or more
$600,001 or more
The Best Option: 457(b) Accounts
The best option for early retirees is available to only a portion of the American population. Many government employees and a few nonprofit employees have the option for deferring some of their income each year in a 457(b) plan.
The contribution limit for a 457 account is the same as it is for a 401(k) or 403(b) plan. For 2018, it's $18,500. This limit goes up to $19,000 for 2019, and savers who are older than 50 get the same $6,000 catch-up contribution limit.
This is a large amount of money, but saving anything helps. Why is this the best tax-deferred option for those who have access? It's the best option because you can take out the funds whenever you separate from your employer. These withdrawals are penalty-free, even if you're younger than 59.5.
Therefore, the example given above that indicated a 20-percent tax rate would drop to a 10-percent tax rate. Those who take out an amount that keeps them below the standard deduction would have a tax rate of 0 percent, which is $0.
Watch out for Fees
When investing in a 457 deferred-compensation plan, it's a good idea to look at the fees that you're getting charged. Sometimes, these accounts can come up with huge fees. Anything over 1 percent is excessive. I've seen some that are as low as 0.25 percent.
If your fund is charging 2 percent, saving in a Roth IRA might be a better option for early retirement. You'll get no tax deduction up front, but you can withdraw contributions (but not gains) without penalty.
When to Start Saving in a 457 Plan
The time to start saving in a 457 plan is yesterday. The second best time would be a visit to your HR department ASAP. The earlier you start saving, the sooner your dollars will start to compound through interest and dividends.
Even if you're 21 and your budget is tight, saving even $25 a month is something. It will add up over time. A better option is starting with a percentage of your pay. If you start with 1 percent at $25,000, you'll save $250 in the first year.
A 4-percent raise would add $1,000 to your salary, and your savings would automatically go up to $260 in year two. An even better option would be upping your savings to 2 percent in the second year and working up from there as your income starts to grow over time. Regardless, the amount that you save should go up over time, and the dollars you've saved should start to grow over time to a nice nest egg by the time you're 45 or 50.
What Type of Employer Retirement Account Is Available to You?
What if Your Employer Doesn't Offer a 457 Plan?
Most employers will not offer a 457(b) plan for retirement savings. Most of those who qualify will be government or educational employees.
If you find yourself working for an employer who does not offer one of these great retirement options, it's a good idea to take advantage of what they do offer. Save as much as you can in a 401(k) or a 403(b), especially if there is an employer match, as it will supercharge your savings.
If your employer offers no work-based retirement accounts, you'll still have the option of saving within an traditional IRA or a Roth IRA. Setting up an IRA with a discount online brokerage is a pretty painless process that should take just a few minutes. Options like Fidelity and Vanguard have funds and ETFs with very low fees, as well.
Whatever you decide to do, just start saving. The you of 20 or 30 years down the road will thank the present you for the present that you give them.