RPF0314-Use_an_IRA_for_Early_Retirement_Even_with_the_Penalty
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00:00:29.800 | Many people in this audience are working very diligently to save enough money to retire
00:00:37.720 | early.
00:00:38.720 | Early, meaning before age 59 and a half.
00:00:43.120 | The challenge is what types of accounts do you use to save for this?
00:00:48.160 | After all, if you use an IRA and you take the money out before 59 and a half, you're
00:00:52.520 | going to pay a 10% penalty for the privilege of having access to your own money, right?
00:00:56.960 | Well, today I'm going to share with you why, even though that is the case, you might still
00:01:03.280 | be better off investing through an IRA or 401(k) or 403(b) for early retirement rather
00:01:11.880 | than using a non-tax qualified brokerage account.
00:01:18.240 | Early retirement community, here's a little bit of gift of knowledge that I pass along
00:01:22.060 | to you today.
00:01:39.920 | Welcome to the Radical Personal Finance Podcast.
00:01:41.800 | My name is Joshua Sheets and I am your host, your fellow adventurer.
00:01:45.320 | This is the show where we work every day on strategies and tools and techniques to live
00:01:49.940 | a rich life now while building a plan for financial freedom in 10 years or less.
00:01:55.060 | I hope that little gift of knowledge thing didn't sound arrogant because you know what?
00:01:58.900 | I was flat out wrong on this a week ago and today I'm going to tell you why and where
00:02:03.180 | I messed up.
00:02:12.140 | This is most definitely one of those things where I had to get my calculator out, but
00:02:17.420 | I realized that I was completely wrong.
00:02:19.580 | Now I won't keep you sitting around on pins and needles.
00:02:21.820 | I'll just tell it to you straight out.
00:02:23.620 | Did you know that if you are investing through a 401(k) or IRA and if you are taking the
00:02:30.180 | income from the account out at an early age, meaning before 59.5, so that you're still
00:02:39.280 | subject to the 10% penalty, did you know that even if you're paying the penalty by using
00:02:47.460 | a 401(k) or an IRA, you can still come out ahead than investing your money after taxes?
00:02:57.420 | Now there was one very important caveat in that statement.
00:03:00.260 | To the best that I can figure out, that statement is absolutely true and I'll share with you
00:03:04.100 | the math and I'll invite you to try to rebut it or try to prove it for yourself because
00:03:07.780 | this was totally new to me as of a week or two ago.
00:03:11.460 | But the statement was taking out the income from the account.
00:03:16.500 | Now let me tell you the back story and then we'll get into the math of how this came
00:03:20.140 | about.
00:03:21.140 | On some recent episodes, Q&A episodes of the show, there have been a number of different
00:03:24.140 | callers who've talked about how much money to save into taxable accounts as compared
00:03:29.220 | to tax qualified accounts.
00:03:31.660 | The idea is should I put more money in my 401(k) because I get the upfront tax savings
00:03:36.620 | of using that account or should I go ahead and invest more money into just a post-tax
00:03:42.440 | account so I have more flexibility?
00:03:44.780 | This is always a challenge for me to reconcile with.
00:03:47.780 | One of the regrets that I have from my younger investing life is that I feel as though I
00:03:52.140 | put too much money into tax qualified accounts.
00:03:55.460 | I put too much money into IRAs, Roth IRAs, 401(k)s, et cetera, and I've been frustrated
00:04:00.300 | by not having easy access to that money for my own business and investing purposes.
00:04:06.060 | I've gone from always saying to start with retirement accounts to swinging the pendulum
00:04:11.780 | to where at this point for me in my finances, I'm pretty bearish on the use of tax qualified
00:04:17.900 | accounts.
00:04:18.900 | Now, I cannot – I absolutely cannot contradict the reality of the tax savings.
00:04:26.960 | It is true.
00:04:28.360 | Those tax savings are important.
00:04:31.400 | I'm not trying to argue with the math of it.
00:04:33.420 | I'm just simply saying for me, probably for three primary factors, I no longer want
00:04:39.440 | to prioritize the use of tax qualified accounts in my own investment – in my own investing
00:04:45.020 | plans.
00:04:46.020 | I'm not excluding the use completely.
00:04:47.940 | I'm just saying that for me, I no longer want to prioritize these accounts.
00:04:53.180 | Now, you might be at a different stage.
00:04:54.960 | You might be in a different situation where these accounts work beautifully as for people
00:04:58.780 | who are employees, who have a high income, who can use these accounts to easily shelter
00:05:03.100 | a lot of money from taxes.
00:05:04.100 | There are a lot of strategies through which you can use Roth IRAs, 401(k)s, SEP IRAs,
00:05:09.660 | all of these things for your benefits.
00:05:11.820 | So hear me clearly.
00:05:12.820 | I'm just simply talking about for me.
00:05:14.900 | The three major reasons why is number one, a loss of flexibility.
00:05:19.460 | I've realized that for me, investing through a 401(k), trying to just simply buy mutual
00:05:25.900 | funds is probably the least effective, least flexible approach to building wealth.
00:05:30.180 | I much prefer to be involved in private business or in other types of investment that I can
00:05:36.140 | have more control over.
00:05:38.060 | So I don't like the loss of flexibility.
00:05:40.780 | I don't like the loss of privacy that you gain with 401(k)s and IRAs.
00:05:45.900 | I don't like the fact that every single year, my balance is reported and all that
00:05:49.380 | activity is reported to the IRS.
00:05:53.540 | I also don't love – third factor, I don't love the fact that the rules and the legislation
00:05:59.640 | I think will be changing in coming decades.
00:06:02.260 | Now what those changes will be, I don't know.
00:06:04.500 | The political pressures to keep things as they are are immense.
00:06:08.740 | But the US government is inexorably grinding over the coming decades toward what I perceive
00:06:15.740 | to be an inevitable default.
00:06:18.180 | And so all through that process, there will be a lot of political machinations of people
00:06:23.580 | trying to change this, change that, increase tax here, increase tax there, means test this,
00:06:28.820 | change this, other benefit, et cetera.
00:06:30.300 | It's going to be a long and difficult political process.
00:06:34.300 | If you can predict politics accurately, I will have you on the show to tell me how to
00:06:37.700 | do that.
00:06:38.700 | I don't know how to do it.
00:06:39.700 | So I don't really want to play that game.
00:06:42.360 | But those are the reasons why for me, I don't love investing through these qualified accounts.
00:06:48.040 | But I have to maintain professionally speaking that these are valuable and the tax savings
00:06:53.140 | are valuable.
00:06:54.340 | So I've done these Q&As in recent shows and I had a listener who had listened to some
00:06:58.420 | of those shows and who had emailed me and said to me, "Joshua, hey, I got a question
00:07:02.580 | for you and I'm wondering why people don't talk about it.
00:07:05.860 | Listen, I think I'm better off investing through my 401(k) even if I have to pay the
00:07:10.820 | 10 percent penalty."
00:07:11.820 | Now, I work really hard to answer all the listener email and so this listener, when
00:07:18.820 | he sent the note, it sat in my inbox for a few days until I got around to it.
00:07:23.220 | Then I finally went ahead and wrote him a response and I carefully read his email and
00:07:27.820 | carefully wrote a response to disabuse him of the notion that somehow the IRA was superior
00:07:33.420 | to the Roth IRA and I suggested some past episodes of the show that might help him to
00:07:38.660 | establish some theory and so I'm feeling pretty confident.
00:07:43.100 | I hope I did it in a humble way but I'm supposed to be Mr. Hot Shot expert, right?
00:07:48.060 | I mean in theory, I'm supposed to know what I'm talking about.
00:07:51.020 | At least I've certainly spent enough time studying that this should be the case.
00:07:54.980 | So I wrote him back this note and I did the calculations for him and I was demonstrating
00:07:58.940 | to him how IRAs and Roth IRAs are exactly the same and if you have them, the penalty,
00:08:04.260 | it's a really bad thing, etc.
00:08:05.500 | I'm going to go through those calculations in a moment because you need to know them.
00:08:09.060 | But he wrote me back and said, "No, no, no.
00:08:10.380 | You don't understand."
00:08:11.380 | So I wrote him back.
00:08:12.940 | I went back and I read the article on his blog that he linked to.
00:08:15.660 | He has a blog called Smart Money Better Life and this listener, his name is Brian Rosner,
00:08:20.900 | smartmoneybetterlife.com.
00:08:21.900 | I'll link to the article where he talked about this in the show notes today.
00:08:26.240 | And so I wrote him again.
00:08:27.700 | He wrote me back and said, "No, no, no.
00:08:28.780 | You're still not understanding what I'm saying.
00:08:31.380 | If you only take the income from a 401(k) even if you pay the penalties, you're still
00:08:37.620 | better off."
00:08:39.300 | And so I realized that he was right.
00:08:42.100 | I hadn't been understanding what he had said.
00:08:44.780 | And so I sat down with a calculator and I just started working scenarios and I came
00:08:48.820 | to the conclusion that, you know what?
00:08:50.800 | He was right and I was wrong.
00:08:53.820 | I wrote him back and I said, "You were right.
00:08:55.860 | I got to stress test this and just see if I'm missing anything.
00:08:59.420 | But to the best that I can figure out, this listener is exactly right."
00:09:02.780 | And again, I will go through the math but I'm trying to set the stage here so you understand
00:09:07.820 | what I didn't understand initially.
00:09:10.060 | I sent this over to my buddy, Brandon at Mad Scientist.
00:09:13.820 | Brandon is – I've crowned him the unofficial guru of early retirement math because he writes
00:09:20.600 | these great in-depth articles for early retirees and all the specific things.
00:09:24.460 | So I sent this scenario over to him.
00:09:25.780 | I said, "Check this out.
00:09:26.980 | Have you ever considered this option?"
00:09:29.220 | And he took a couple – he thought about it.
00:09:31.260 | He took a couple of days, made a couple of spreadsheets and we talked about it.
00:09:33.500 | He said, "No, I never had.
00:09:34.660 | It was totally new to me."
00:09:36.100 | And it was totally new to – so it was new to Brandon.
00:09:38.180 | It was new to me as well.
00:09:39.780 | And I've not seen this discussed widely.
00:09:41.460 | I'm going to invite you to stress test this.
00:09:45.380 | To the best of my knowledge and ability, I believe this to be true.
00:09:48.660 | But I will post in the notes for the show today.
00:09:50.700 | I will post the – my calculations and I invite your commentary on this.
00:09:58.240 | If you can find a hole in this, if you can find a problem with it, then I invite you
00:10:03.300 | to demonstrate that to me so I can set the record straight.
00:10:07.600 | So in today's show, I'm going to start with the simple calculations, the way that
00:10:10.880 | we've done them in the past of comparing Roth contributions and traditional contributions
00:10:15.880 | and taxable contributions.
00:10:16.880 | I'm going to start with that to lay the ground floor and then I'm going to go through
00:10:20.320 | the specific calculations and demonstrate to you with numbers why some of you should
00:10:25.400 | consider using a 401(k) even if it involves you paying the penalty for your access to
00:10:32.040 | that early retirement.
00:10:33.040 | That's through the course of today's show.
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00:13:09.880 | As I go to the math, I want to begin with the math where I – what I had written Brian
00:13:14.880 | back and said to him, "Hey, listen.
00:13:16.760 | No, you're misunderstanding the math here."
00:13:19.880 | In fact, a few weeks ago, I did a show talking about how the Roth IRA and a traditional IRA
00:13:27.600 | actually come out with the absolute identical amounts of money if the assumptions are the
00:13:33.200 | same.
00:13:34.760 | That was episode 303 of the show titled Roth IRA versus traditional, which one pays less
00:13:40.680 | taxes?
00:13:41.680 | What I endeavored to prove in that show was that if you're in the same tax bracket during
00:13:47.940 | your working years as you are in retirement and if you're funding an account with the
00:13:52.840 | same amount of money during your working years, you will come out with the exact same amount
00:14:01.000 | of money whether you use a Roth IRA or a traditional IRA, that it does not matter which type of
00:14:09.400 | account you use if your tax rates, tax brackets are the same.
00:14:15.360 | I did that because there's this often held idea that somehow if you fund a Roth IRA,
00:14:20.160 | you're going to pay less money in tax simply because you're paying the tax up front.
00:14:24.780 | That is simply not true.
00:14:26.920 | If tax brackets and tax rates are the same during your working years and in retirement,
00:14:31.920 | you're going to pay exactly the same amount of money whether you use a Roth IRA or a traditional
00:14:36.400 | IRA.
00:14:37.400 | Now, I intended that show and that show actually came out of this conversation with Brian in
00:14:41.360 | responding to him.
00:14:42.360 | I said, "This is a good show idea."
00:14:43.600 | I regret ever doing that show because all I wanted to do was just simply to demonstrate
00:14:48.960 | that one mathematical fact.
00:14:50.960 | I have received more feedback, more emails, more comments from people saying, "Joshua,
00:14:56.640 | yeah, but you forgot this.
00:14:58.000 | Yeah, but you forgot that.
00:14:59.000 | Yeah, but you forgot this other thing."
00:15:00.560 | All of those things are exactly true.
00:15:03.120 | It should teach me to ever do a 30-minute one-topic show when I actually need to do
00:15:08.120 | a four-hour marathon laying out for you all of the advantages and disadvantages and when
00:15:12.440 | you choose one account versus the other.
00:15:14.800 | I learned my lesson not to short-circuit it because there are many other factors and I
00:15:19.200 | had lumped those all in under this mysterious other factors point in the show that will
00:15:27.480 | affect your decision.
00:15:30.200 | One of the most valid and most important was simply that if you can pay the tax – let's
00:15:34.400 | say if you're going to contribute $5,000 to a traditional IRA or $5,000 to a Roth IRA,
00:15:39.880 | if you can afford to pay the income tax from other money, what that means is that you can
00:15:43.920 | actually contribute $5,000 to the Roth IRA, but in effect, you'd only wind up contributing
00:15:51.360 | – I'm getting myself all tied up.
00:15:55.000 | You're in effect contributing more to the Roth IRA if you're paying the tax with other
00:15:59.000 | money.
00:16:00.000 | So the analysis was putting $5,000 into a traditional IRA or earning $5,000, paying
00:16:05.920 | – if a 25 percent bracket, you contribute $3,750 to the Roth and you pay $1,250 of tax
00:16:13.240 | to the Roth.
00:16:14.240 | So you're actually contributing less to the Roth, which is why they're equal.
00:16:17.560 | So that's a valid criticism.
00:16:19.320 | If you can afford to pay the tax from other money such that you can actually invest the
00:16:22.180 | full $5,000, the Roth will come out.
00:16:24.640 | There are many other valid criticisms.
00:16:26.280 | For example, most people are simply not going to have the same level of income at retirement.
00:16:31.140 | This is one of the reasons why many financial advisors do prefer a traditional IRA for your
00:16:37.220 | investing purposes, simply because it's very difficult for you to build enough wealth
00:16:42.080 | to be at the same tax rate in retirement as it is during your working lifetime.
00:16:47.920 | If you just consider – I am at and going into one of the more expensive phases of life,
00:16:54.780 | young family, that involves expenses for – higher expenses for housing, expenses for education,
00:17:02.600 | expenses for food, all these just normal expenses for karate lessons.
00:17:07.500 | These are the types of things where generally young families spend a very high amount of
00:17:12.120 | their – higher amount of income.
00:17:14.580 | So these years are usually more expensive.
00:17:17.460 | When you take the need for a larger house to maintain children, you take the need for
00:17:22.320 | larger cars or more cars to maintain transportation, you go into retirement.
00:17:27.060 | Most retirees can get by and have a great lifestyle on less dollars simply because of
00:17:33.920 | their expenses are lower.
00:17:34.920 | So that's why it's unlikely that most people are going to be in a higher tax bracket
00:17:39.300 | or pay higher tax rates in retirement.
00:17:41.680 | Now, on the other hand, there are many compelling arguments for the Roth.
00:17:45.700 | For example, it's far more flexible.
00:17:47.900 | You can make the argument that when you have a position where your tax rates are low, for
00:17:53.080 | example, although my income might be high when I have a young family, I might also have
00:17:58.380 | useful extra deductions, nice mortgage interest deduction.
00:18:01.080 | I might have deductions for child tax credit deductions, etc.
00:18:06.280 | And so you can make corresponding arguments and that's where you have to sort through
00:18:10.440 | these things.
00:18:11.800 | But the intention of Show 303 was simply to disabuse you of the idea that somehow there's
00:18:17.040 | just one difference between these two.
00:18:20.260 | So when Brian first wrote to me, that was my initial response was to say to him – and
00:18:24.120 | I'm going to read just a quick moment.
00:18:26.320 | Let me read a paragraph from his website.
00:18:28.600 | He says, "I've been listening to your show and I think a lot about the 'how much
00:18:35.240 | to put in tax-advantaged accounts' question.
00:18:37.520 | But I discovered a neat math trick with traditional IRAs.
00:18:40.720 | Even if you want to prioritize for the now, you can still put money in the traditional
00:18:44.440 | IRA and even pull it out and pay the penalty on the earnings and still come out ahead compared
00:18:49.640 | to not putting it in at all.
00:18:51.640 | This is a breakthrough concept because it allows you to have your cake and eat it too."
00:18:55.960 | And he linked over to his blog post article about it where I could see it.
00:18:59.200 | Here's an example.
00:19:00.200 | He says, "Let's say you're in a marginal tax bracket of 25% federal and 9% state.
00:19:05.040 | I live in California.
00:19:06.480 | You have $10,000 at the end of the year.
00:19:08.160 | What should you do with it?
00:19:09.360 | If you invested at 10% – just an example – in an after-tax investment, first you
00:19:13.440 | have to pay 34% on it before you get to invest it so you have $6,600 left.
00:19:19.080 | You invest that at 10% and you get $660 a year.
00:19:22.160 | You pay tax on that and you get $435 a year to spend on roasting marshmallows on hot lava.
00:19:26.920 | Okay, let's say you put it in a traditional IRA, the 10K.
00:19:30.300 | You invest it at 10% and want to use the earnings now.
00:19:33.360 | You get $1,000 in income, pull it out, pay 34% tax plus 10% penalty and you're left
00:19:38.880 | with $560.
00:19:39.880 | So you come out with more income using the IRA income.
00:19:46.080 | So I responded and said, "Well, hey, it's good if you can leave California," which
00:19:50.200 | I want to touch on that at the end of the show, which is a very useful way to take these
00:19:53.920 | concepts and increase it.
00:19:56.160 | But the math still comes out exactly ahead and especially if you add in the math of the
00:20:04.480 | penalty you come out behind.
00:20:05.880 | So let me read you two paragraphs because it's important that you understand this distinction
00:20:09.840 | between the principle and the income or I should rather say your contribution and the
00:20:14.880 | growth because by income, I'm not specifically referring to dividends.
00:20:18.280 | I'm referring to the growth in the account.
00:20:20.580 | So I responded with this mathematical analysis form.
00:20:25.040 | I said, "A Roth IRA contribution and a traditional IRA contribution come out exactly the same
00:20:30.800 | if tax rates are equal."
00:20:32.640 | Here's the math for the Roth.
00:20:34.120 | If you earn $10,000 at a 25% effective tax bracket, you pay $2,500 in taxes and invest
00:20:41.760 | $7,500.
00:20:42.760 | $7,500 invested today in a lump sum at a 10% annual rate of return for 10 years comes out
00:20:50.280 | to be $19,453.07 at the end of the term.
00:20:55.340 | So you have $19,453.07 to spend.
00:20:59.760 | If you invest through a traditional IRA, you earn $10,000 but invest all of it pre-tax,
00:21:04.560 | you pay $0 in taxes, meaning you invest $10,000.
00:21:08.800 | Invest that today in a lump sum, 10% annual rate of return for 10 years and you wind up
00:21:12.600 | with $25,937.42 at the end of the term.
00:21:17.900 | You then pay 25% in taxes, leaving you with $19,453.07 to spend, which is exactly the
00:21:24.040 | same as the Roth.
00:21:25.600 | Now if you add the additional 10% penalty on top of that, you wind up with only $16,859.32.
00:21:30.240 | So you're poorer if you use the traditional IRA option.
00:21:36.280 | That's where I went in and talked about how even in that situation, you'd be better off
00:21:39.280 | with the Roth because you get your first 10% back – excuse me, you get your contribution
00:21:43.840 | back, the $10,000 back without paying the penalty.
00:21:50.480 | So he responded back and again, this is where he finally convinced me that I had missed
00:21:55.560 | understood him and he talked about the income.
00:21:58.040 | So let me walk you through the math.
00:21:59.200 | Again, I will post in the show notes for today's show on the blog and I also – if everything
00:22:03.920 | is working okay, I will post this – I believe I can post this as an attachment for those
00:22:08.240 | of you who use the Radical Personal Finance app.
00:22:10.240 | I haven't done this yet but one of the benefits of having the Radical Personal Finance app
00:22:15.160 | is I can deliver some additional materials, bonus materials with the episode.
00:22:19.360 | So if everything works okay, those of you who are using the Radical Personal Finance
00:22:23.440 | app, which anybody can use, it's free in all the app stores, just search the app store
00:22:27.080 | on your phone for Radical Personal Finance, you can see these immediately.
00:22:30.120 | Otherwise, this will go onto the website in a few days once it gets posted there.
00:22:34.280 | If you haven't noticed, by subscribing to the feed of the show, you will always get
00:22:39.120 | the show immediately but it takes about three or four days for it to migrate over to RadicalPersonalFinance.com.
00:22:45.360 | So I recommend that you subscribe and I recommend you subscribe using the app.
00:22:48.040 | I'm going to walk through the numbers because it's important and I'm going to try to
00:22:52.840 | do it in a clear way.
00:22:54.040 | I recognize it's hard to do math in an audible format.
00:22:57.740 | So let me just tell you the conclusion.
00:22:59.200 | The conclusion is that the traditional IRA wins, that investing through a traditional
00:23:05.920 | IRA, if you're just spending the income and growth from the account, you're going
00:23:10.000 | to wind up with more money to spend even if you have to pay the 10% penalty tax.
00:23:14.040 | I'll demonstrate that to you.
00:23:15.520 | I'll link notes and things in the blog post and I invite you to follow the math and the
00:23:19.680 | logic there and to see if you can find any error in my thinking.
00:23:24.360 | But let's go through the scenario.
00:23:25.840 | So to demonstrate, to try to prove this, I'm going to keep something very simple.
00:23:30.200 | I'm going to say that there are three aspects to this scenario.
00:23:34.400 | We're going to assume that we're going to earn and invest $5,000 starting at the
00:23:39.280 | age of 30.
00:23:41.360 | Then that money is going to grow for 10 years.
00:23:43.800 | So step two is we're going to spend the income from the portfolio at age 40.
00:23:49.440 | Then we're going to leave the principal, leave the original contribution in the account
00:23:55.640 | until the age of 60.
00:23:57.040 | That's step three.
00:23:58.040 | At step three, we're going to spend the balance of all of the income and the principal
00:24:03.000 | at the age of 60.
00:24:05.160 | So these numbers are totally arbitrary.
00:24:07.040 | I'm trying to use round numbers.
00:24:08.360 | But the idea is at one stage, you're working.
00:24:11.480 | Some stage a few years later before you can take the money out without penalty, meaning
00:24:16.320 | before 59.5, you're going to start spending some of the income and growth from the account.
00:24:21.600 | Then finally after you've reached 59.5, then you're going to go ahead and spend all of
00:24:26.600 | the money.
00:24:27.600 | The question is do you come out better using a traditional IRA, a taxable brokerage account
00:24:35.480 | or a Roth IRA given this scenario?
00:24:39.320 | That's the major question.
00:24:41.680 | I want to clarify when I'm using traditional IRA.
00:24:44.640 | The reason this is powerful is because many of you have access to a 401(k) program or
00:24:51.600 | a 403(b) program or a SEP IRA that you've established or something in your – a solo
00:24:57.480 | 401(k), something like that.
00:24:59.140 | Many of you have access to those types of accounts where you can put much more money
00:25:03.240 | in.
00:25:04.240 | So for example, if I'm in a business with my wife and we set up in our – a 401(k)
00:25:10.000 | program, a solo 401(k) program in our company, I can defer – I can set it up such that
00:25:15.840 | I can defer up to about $50,000 into this account through the different employee contribution,
00:25:21.840 | employer contributions and depending on how I do that.
00:25:25.000 | I can set the – I can arrange the documents to put $50,000 into that.
00:25:28.440 | I can do that for me and I can do it for her.
00:25:30.800 | So some of these traditional accounts, SEP IRA, it's the same thing.
00:25:34.600 | You can put a lot of money into these accounts up front.
00:25:39.400 | It's much more useful to many of you who are high-income earners than just being able
00:25:44.000 | to put a few thousand dollars into a Roth IRA.
00:25:47.160 | So that's what – why – when I'm using traditional IRA, you should see the power
00:25:51.040 | of this of being able to apply it to your 401(k) or other account where you have a much
00:25:55.840 | higher ability to contribute to those accounts than just a few thousand dollars.
00:26:01.220 | So step one, let's start with scenario A, the traditional IRA.
00:26:04.520 | This is the base scenario that we want to measure against.
00:26:08.040 | So step one, we're going to earn $5,000 and invest it before we pay income tax into
00:26:16.200 | the account.
00:26:17.200 | We're investing the money at age 30.
00:26:19.600 | So we take $5,000.
00:26:21.160 | We invest the money pre-tax.
00:26:22.160 | We now pay no current income tax when we earn the money and we invest it for 10 years.
00:26:27.180 | So we put – and I'm assuming throughout, I'm assuming just a 10% annualized rate
00:26:31.440 | of return simply for the sake of round numbers.
00:26:34.580 | You can use five.
00:26:35.580 | You can use 15.
00:26:36.580 | It does not matter.
00:26:37.580 | I like round numbers.
00:26:39.480 | So N is 10.
00:26:40.840 | The interest rate is 10.
00:26:42.220 | We start with the present value of minus $5,000 because if you're running your calculator,
00:26:46.740 | it's a cash outflow.
00:26:47.740 | So we use a negative number.
00:26:49.220 | Put in zero contribution, zero payments.
00:26:51.280 | We solve for the future value.
00:26:52.500 | What we find is that if we invest $5,000 pre-tax for 10 years, at the end of the 10-year term,
00:26:59.200 | we have a total account value of $12,968.71.
00:27:11.000 | Now step two, the goal is at age 40, we're going to spend the income from that account.
00:27:17.360 | So meaning we're going to spend the growth.
00:27:19.020 | We're going to leave the original contribution in the account, leave the five grand there,
00:27:22.880 | but we're going to spend all the income.
00:27:25.380 | So we spend the income.
00:27:26.380 | Let's calculate how much we have to spend.
00:27:27.880 | Well, if we pull $5,000, our original contribution out of $12,968.71, that leaves us with $7,968.71
00:27:38.000 | to spend.
00:27:39.000 | Now, I'm going to assume that we're in the same tax bracket at that time.
00:27:43.320 | So we're paying a 25% effective tax rate on our money.
00:27:48.000 | That means that we're going to pay $1,992.18 of current income tax at a 25% rate.
00:27:56.160 | I'm also going to assume that we're going to pay a 10% penalty because we're taking
00:28:00.160 | the money out at age 40.
00:28:02.360 | So we're not trying to employ any other strategy that's avoiding the penalty.
00:28:05.700 | We're just paying the penalty.
00:28:07.260 | That would incur a $796.87 penalty, which means that if you took $7,968.71 out of the
00:28:17.440 | account, paid a 25% tax and a 10% penalty tax, you now have $5,179.66 to spend.
00:28:27.760 | Now you leave that pot of money alone and here's where we move into step three.
00:28:31.920 | You leave the $5,000 in the account and you let it grow now for 20 years from age 40 to
00:28:39.200 | 60.
00:28:40.200 | You have the same constraints, 20 years of time, 10% annual growth rate, present value
00:28:47.720 | starts at $5,000, no further contributions to the account.
00:28:50.880 | That means that at the end of 20 years, you now have $33,637.50 in the account that you
00:28:58.320 | can now spend.
00:28:59.320 | Now of course, this is a traditional IRA or a 401(k) or a 403(b), et cetera.
00:29:05.680 | So meaning that when you take out the $33,637.50, you're going to pay a 25% effective tax rate,
00:29:13.000 | ordinary income tax.
00:29:15.100 | That means you pay a tax of $8,409.37 of tax, leaving you with $25,228.13 that you can spend
00:29:25.960 | on cruises and cocktails on the beach.
00:29:28.740 | So how much money do we get from this scenario to spend and how much tax do we pay?
00:29:34.920 | Well, if you add the two amounts of money together to spend, you will wind up with a
00:29:40.360 | total of $30,407.79 to spend.
00:29:46.320 | That included the $5,179 you were able to spend at the age of 40 plus the $25,228 that
00:29:56.360 | you could spend at the age of 60.
00:29:58.240 | So your total amount of money is $30,407.
00:30:01.340 | Your total tax paid is $11,198, which included the $19,092 of tax at age 40 plus the $796
00:30:08.920 | penalty plus the $8,409 of tax at the age of 60.
00:30:13.580 | So that's our baseline scenario, the traditional IRA.
00:30:17.460 | Now let's compare that to an all-taxable account.
00:30:20.760 | And so here is where the tax rates possibly could change.
00:30:24.760 | We'll pay and assume the same 25% income tax rate in the beginning, but we could play a
00:30:32.100 | little bit with scenarios regarding how much money at a 15% long-term capital gains rate
00:30:39.000 | if we're paying long-term capital gains taxes, how much money if we're paying ordinary income
00:30:42.640 | taxes, or perhaps some of you might even be able to get to a 0% long-term capital gains
00:30:47.140 | rate if your earned income is low enough.
00:30:49.580 | And that's where you got to play with these scenarios a little bit.
00:30:51.860 | But let's just walk through the simple math.
00:30:53.860 | So scenario B is what if we just take the money out, pay the tax, and we invested ourselves
00:30:59.580 | outside of any IRAs or Roth IRAs of any kind?
00:31:03.080 | So step one, we're going to earn $5,000 and we're going to invest it.
00:31:07.820 | We earn it at age 30 and we're going to invest it after paying the tax.
00:31:11.440 | You earn $5,000, pay a 25% income tax, meaning that you're going to pay $1,250 of tax currently,
00:31:19.380 | leaving you with $3,750 to invest.
00:31:23.600 | We invest $3,750 from age 30 to 40, totaling 10 years, at a 10% annual rate of return,
00:31:31.420 | leaving us with no more contributions to this account, leaving us with a future value at
00:31:36.540 | the age of 40 of $9,726.53.
00:31:40.660 | $9,726.53, let's keep our original $3,750 in the account and pull everything out.
00:31:49.500 | If we keep our original $3,750 in the account, we're left with $5,976.53 to spend.
00:31:57.960 | Now here would be the question of what is the appropriate tax rate for us to apply?
00:32:04.680 | Do we use a 25% long-term capital gains rate?
00:32:07.640 | Do we use a 25% ordinary income rate?
00:32:10.760 | Or do we use a 0% long-term capital gains rate?
00:32:13.380 | By the way, excuse me, I misspoke.
00:32:14.380 | I meant to say 20% long-term capital gains rate.
00:32:17.160 | That's the current brackets, 0, 15, and 20.
00:32:21.760 | I was looking at my ordinary income rate number.
00:32:24.140 | So what's the rate that we use?
00:32:26.120 | For the sake of my example, I'm going to start just simply by using a 15% long-term
00:32:31.520 | capital gains rate.
00:32:33.000 | So we had – we spent our – so we invested the money.
00:32:39.960 | We took out our $3,750 original capital, which left us with a $5,976.53.
00:32:45.040 | We're going to pull off a 15% long-term capital gains rate.
00:32:48.500 | We assumed no taxes year by year over that 10-year period and we're just spending this
00:32:53.800 | at the end of 10 years, $896.48 of total tax due at a 15% long-term capital gains rate.
00:33:02.840 | That leaves us with $5,080.05 to actually spend on lifestyle.
00:33:09.180 | Now we keep that $3,750 of original capital invested for 20 years, 10% return, etc.
00:33:16.460 | That leaves us with at the end of 20 years, we have $25,228.12 to spend.
00:33:22.660 | And here again, I'm going to assume that we incurred no taxes during that 20-year period.
00:33:27.020 | We just simply pay the taxes at the end of 20 years, leaving us with a 15% tax bill of
00:33:34.260 | $3,784.22.
00:33:35.260 | So we pull that $3,784 from the $25,228, leaving us with $21,443.90 to spend on cruises and
00:33:48.220 | cocktails.
00:33:49.220 | I know the numbers are overwhelming when it's just audio.
00:33:51.420 | Forgive me.
00:33:53.060 | Total in this scenario that I've done using a 15% long-term capital gains rate leaves
00:34:00.440 | us with a total of $26,523.95 to spend.
00:34:11.420 | We had $5,080 to spend at the age of 40, and we had $21,443 to spend at the age of 60.
00:34:17.340 | Now to compare that, our scenario A, the traditional IRA, we wound up with $30,407.79 to spend.
00:34:29.980 | Versus here, using a taxable account where we got to pay the tax up front, where we wind
00:34:37.020 | up with $26,523.95 to spend.
00:34:43.160 | So the traditional IRA was superior to this approach where we had to pay the 25% ordinary
00:34:50.120 | income tax rate up front and a 15% long-term capital gains tax rate at the end of the term.
00:34:56.800 | The total taxes paid are very different.
00:34:59.160 | Under this scenario, all taxable, you wind up paying a total of $5,930 of tax, which
00:35:05.440 | is less than half or about half of the $11,198 of total tax that you paid with the traditional
00:35:11.280 | IRA.
00:35:12.320 | But you had more money to spend with the traditional IRA.
00:35:16.680 | Interesting, huh?
00:35:18.680 | So what would be the variations?
00:35:20.280 | Well, first, is that 15% long-term capital gains tax rate going to continue or would
00:35:26.720 | that go to a higher rate?
00:35:28.080 | I don't know.
00:35:29.080 | That's where these things get to the point of being unknowable.
00:35:32.620 | You will have to understand the concept and apply it yourself.
00:35:36.720 | Obviously, if you were paying a higher tax rate, whether you went up to the 20% long-term
00:35:42.240 | capital gains tax bracket, which is unusual because that's the highest ordinary income
00:35:47.600 | tax rate bracket, or if you incurred more long-term capital gains taxes along the way,
00:35:55.400 | or if you paid short-term capital gains taxes, or if you incurred ordinary income, all of
00:36:00.600 | those things would mean that you would pay more taxes.
00:36:03.840 | So still, the traditional IRA would come out to be superior.
00:36:07.200 | Now what I wanted to test was I wanted to see what would be the difference if you paid
00:36:11.040 | a 0% long-term capital gains tax rate.
00:36:14.760 | What would the amount be?
00:36:16.640 | That one I think is interesting.
00:36:18.200 | So same assumptions as I've just gone through.
00:36:21.180 | We earned the $5,000.
00:36:22.840 | We pay the taxes up front one time, but then from then on, pretend we never paid taxes
00:36:28.880 | on the growth of the portfolio.
00:36:32.440 | Well, under that scenario, you would wind up with a total of $31,204.65 to spend and
00:36:43.840 | you pay $1,250 a tax.
00:36:45.400 | So this would incur the lowest amount of tax, but still, you would have a very comparable
00:36:49.880 | amount, $31,204.65 to spend under scenario B, all taxable but a 0% long-term capital
00:36:57.760 | gains rate after you paid that initial amount versus $30,407.79 under scenario A. So the
00:37:07.560 | difference between those two would be $30,407.79.
00:37:14.760 | The difference between those two is $796.86.
00:37:19.280 | So those are very, very comparable.
00:37:22.520 | Now, that was what really surprised me.
00:37:27.520 | Scenario A was a traditional IRA and that involved you spending the income from the
00:37:34.360 | portfolio and paying the 10% penalty tax.
00:37:39.600 | Scenario B doesn't incorporate any penalty tax or any tax after that initial payment
00:37:45.940 | on income and still, they're very comparable.
00:37:50.960 | Really, really surprised me.
00:37:52.160 | I just share it with you as something that you might be interested in.
00:37:56.240 | There are other permutations.
00:37:57.240 | As with everything, I'm going to go through the Roth IRA in just a moment and illustrate
00:38:01.400 | that one to you as well.
00:38:02.800 | But I just want to point out to you, there are other scenarios between – let me do
00:38:07.960 | the Roth first and I'll come back to the other considerations.
00:38:11.060 | So the Roth, now that you've got the flow of these steps, one, two, three, you earn
00:38:14.480 | $5,000.
00:38:15.480 | You pay 25% of income tax, meaning leaving you with $3,750 to invest.
00:38:20.760 | You invest it for 10 years.
00:38:22.040 | You wind up with $9,726.53 at the end of 10 years.
00:38:27.520 | At the age of 40, you want to spend the income from the portfolio.
00:38:30.680 | Now, here is where you would have some choices with the Roth and I originally worked several
00:38:36.260 | variations of how much income to spend.
00:38:38.560 | Do we spend the same amount of income as the traditional IRA?
00:38:41.680 | Do we spend the same amount as the alt-taxable account?
00:38:44.800 | What do we do?
00:38:46.040 | For the sake of the three illustrations I want to go on the show, I simply assumed that
00:38:50.460 | you spend the income from it.
00:38:52.460 | So you take your total account balance at age 40 of $9,726.53.
00:38:57.420 | You keep your original $3,750 in the account, leaving you with a total of $5,976.53 to spend.
00:39:04.360 | Now, of course, you could take out $3,750 of that money as your return of contribution.
00:39:13.320 | So that money comes to you tax-free and penalty-free.
00:39:16.200 | So you take out $3,750.
00:39:17.840 | That leaves you with $2,226 of your distributions that's taxable as ordinary income plus a 10%
00:39:24.040 | penalty tax.
00:39:25.040 | You pay $5,056 of ordinary income plus $2,222 of 10% penalty tax.
00:39:30.120 | Leaves you with, if you run the math, $5,197 to spend from the Roth at the age of 40.
00:39:37.120 | You then leave that original $3,750 alone for another 20 years.
00:39:41.180 | That grows at 10%.
00:39:42.980 | That leaves you with $25,228 to spend at the age of 60.
00:39:49.000 | And remember, at that point, you could take it out with no income tax due, which is really
00:39:53.440 | nice.
00:39:54.640 | At the age of 60, if you total the amount of income that you have together, you've
00:40:01.200 | had $30,425.37 to spend and you have $2,029 of total tax.
00:40:10.560 | Now let's compare that $30,425.37 first against the traditional IRA.
00:40:16.280 | Comes out to be slightly better than the traditional IRA, better to the tune of – what is this?
00:40:22.480 | Less than $20.
00:40:23.720 | In the Roth IRA, you have $30,425.37 to spend.
00:40:29.880 | In the traditional IRA model that we started from as our baseline, you have $30,407.79.
00:40:37.680 | So you have $17.58 more total income to spend in the Roth IRA.
00:40:47.040 | One important similarity is you have a very similar number to spend at the age of 40 under
00:40:51.440 | those scenarios.
00:40:52.700 | So you have $5,197 to spend at 40 with a Roth and you have $5,179 to spend with a traditional
00:41:00.880 | IRA.
00:41:01.880 | So you still have a very comparable amount of money to spend.
00:41:04.880 | Now the Roth IRA pays much less of total tax, only $2,029.28 of tax as compared to $11,198
00:41:12.560 | of tax in the traditional IRA, but very comparable.
00:41:15.760 | So the Roth comes out slightly ahead, but very comparable numbers.
00:41:21.440 | Then if you were to compare the Roth to scenario B, all taxable, the Roth here under those
00:41:26.940 | constraints is superior.
00:41:30.520 | So when comparing the Roth IRA to scenario B under that 15% long-term capital gains tax
00:41:36.160 | rate, you had $30,425 to spend from the Roth or you had $26,523 to spend from all taxable.
00:41:45.000 | So the Roth is superior to the tune of about $3,500, $4,000-ish.
00:41:49.940 | So what would be the scenarios that would cause you to – let's get out of the weeds
00:41:55.220 | of the numbers and what would be the scenarios that would cause you to choose one over another?
00:41:59.260 | As with most things, I've not solved anything perfect here because there are a number of
00:42:05.900 | things you could do.
00:42:06.900 | First, with this Roth, remember, I kept this under the constraint of earning and investing
00:42:12.060 | the $5,000 and paying the tax from those earnings.
00:42:18.700 | But if you were deciding between the Roth and the traditional, if you had the money
00:42:22.900 | to pay the tax from another source of funds, then you would be able to get more money in
00:42:28.140 | the Roth than the $3,750.
00:42:30.060 | But remember, you're actually contributing more.
00:42:32.140 | So now we've lost our sense of equilibrium and you can run the math on that.
00:42:37.020 | It just gets too complicated that I could do on audio.
00:42:40.140 | Point is there are other scenarios.
00:42:42.240 | What about the scenario of when you need the money or what about some of the scenarios
00:42:45.800 | of when you're going to move?
00:42:48.300 | That was – those are one of the things that I wanted to demonstrate to Brian is even in
00:42:54.260 | my original response.
00:42:55.580 | There are three major tax planning scenarios that I talk about and I've covered them
00:43:03.740 | in episode 36 and episode 41.
00:43:07.420 | So they are timing, income timing, income shifting and income conversion.
00:43:12.060 | So you could use an IRA.
00:43:14.020 | The great thing about using an IRA or a 401(k) is that you can use this very effectively
00:43:19.260 | if you're going to implement it as a timing strategy and as a shifting strategy.
00:43:24.280 | So here's the idea.
00:43:25.280 | Let's say Brian is working in California.
00:43:28.300 | Putting contributions into his 401(k) allows him to avoid the California – the 9% state
00:43:34.580 | income tax that he says that he's paying.
00:43:36.780 | That's really valuable.
00:43:38.300 | Now let's say that he works for a decade or two.
00:43:40.580 | He's avoided paying income tax when he's working really hard, paying at the highest
00:43:45.460 | marginal tax bracket, having a professional job and he's avoided the California state
00:43:49.720 | income tax.
00:43:50.720 | Now, he takes this traditional IRA concept.
00:43:53.360 | He funds his 401(k)s with as much money as possible.
00:43:56.420 | Let's say he's able to structure one of these things where he can put – with total
00:44:00.840 | of his contributions and his deferrals, he can put in $50,000 into that.
00:44:05.940 | Whether that's between just him or whether it's him and his wife or anything like that,
00:44:08.980 | he's put $50,000 into that.
00:44:11.220 | Assume that he does it over a 10-year period of time, that's half a million dollars of
00:44:14.700 | contributions, all of which have avoided the high marginal tax bracket and have also avoided
00:44:22.100 | the high California state income tax.
00:44:25.780 | Now after that point in time, he moves to another state.
00:44:28.300 | He decides he wants to retire.
00:44:29.520 | He moves to a low state tax – state income tax state or to a no state income tax state,
00:44:35.260 | refers his place of residence to a low state income tax state and also now he's able
00:44:39.720 | to cut his expenses because he doesn't have to live in high cost of living California.
00:44:43.640 | He can move to a low cost of living state.
00:44:45.500 | So now he doesn't need to spend as much money.
00:44:48.900 | With that point in time, he starts taking income from his IRA and pretend that IRA through
00:44:55.740 | investment prowess has grown to become worth a million dollars and he starts taking $30,000
00:45:01.220 | a year off of that IRA as income.
00:45:04.420 | Even if he incurs the 10% penalty, well, it's the same as what he would have had to pay
00:45:09.180 | under the California state income tax rules.
00:45:13.020 | Now he's at a lower marginal bracket because he's only taking $30,000 of income off.
00:45:17.220 | So essentially in that scenario, essentially he would only be paying the penalty depending
00:45:24.520 | on his deductions, etc.
00:45:27.900 | So that would be a good way of understanding how even this penalty, when you calculate
00:45:33.500 | it in, this could be very compelling.
00:45:37.660 | So I wanted to share this with you because I believe this can be a valuable tool in your
00:45:41.340 | tool chest.
00:45:42.340 | First, I invite you to see if there's any flaw in my math or in my illustrations and
00:45:48.300 | I mean that sincerely.
00:45:49.700 | I love – so I'm a huge fan of the concept of the open source community.
00:45:55.660 | That's why I try to share this.
00:45:57.420 | The first thing I did was I said, "Let me do this to Brandon.
00:45:59.340 | Brandon has got a massive platform on the early retirement community and I want to share
00:46:02.780 | this with the early retirement community."
00:46:04.340 | So I expect him to publish an article on this in written form soon and hopefully this show
00:46:10.900 | will be a good verbal form to help some other people as well.
00:46:16.180 | So we're going to get this out there and look to see if we can find any flaws in it.
00:46:20.180 | I can't find any flaws in it.
00:46:22.020 | But the real power of it is going to be when combined in conjunction with some of these
00:46:27.160 | other strategies.
00:46:29.860 | This will help many of you who are prioritizing the use of 401(k)s and 403(b)s, et cetera,
00:46:37.000 | as a primary source of your investment dollars.
00:46:39.780 | I think this is a really great option.
00:46:42.240 | If you are a highly paid employee and you have a good, well-run 401(k) and if you're
00:46:48.860 | working hard at your job such that you're not going to have time, you're not going
00:46:51.580 | to go start a business on the side necessarily, this can be a really great option for you.
00:46:56.700 | Under the constraint of only spending income, you can feel confident that you don't have
00:47:02.340 | to necessarily decrease those contributions in order to prioritize a taxable account versus
00:47:09.540 | this 401(k) account.
00:47:11.260 | That helps a lot.
00:47:12.260 | I think that will help a lot of you.
00:47:14.100 | Now of course remember there are other things.
00:47:16.700 | So in this scenario, I've isolated only the example of which account to use.
00:47:23.100 | But the reality is there are many other factors.
00:47:25.240 | If you're going to earn a 6% rate of return net of taxes and fees in a 401(k), but if
00:47:31.660 | you have an opportunity with a side business that you see or some investment that you're
00:47:36.140 | going to manage much more actively to earn a 20% rate of return, but you can't invest
00:47:41.460 | in that type of thing through your 401(k), well, now you're in a much better situation.
00:47:45.880 | So this is only one variable and I'm repeating this again and again because often people
00:47:50.060 | I think take one variable too far.
00:47:51.940 | You need to look at this in a comprehensive way.
00:47:54.100 | But I think it's a very useful variable for many of you.
00:47:58.100 | When you start to put these things together, again, think of Brian, earning income in California,
00:48:05.660 | high cost of living, high taxes, anything you can do to avoid some of those taxes and
00:48:11.260 | later be able to move to another place if that's the goal or just to be able to adjust
00:48:16.700 | the lifestyle in a way, this can be very valuable – a very valuable tool.
00:48:22.420 | So I hope it's useful to you.
00:48:23.420 | I invite you to check it out.
00:48:25.460 | I invite you to see if you can find any flaws.
00:48:29.020 | And for the retirement community, there's a little gift.
00:48:32.580 | I will link to Brian's original article.
00:48:34.900 | Go buy his blog and give him some love, give him some comments and whatnot.
00:48:38.020 | His blog again is smartmoneybetterlife.com.
00:48:40.740 | I did not come up with this idea.
00:48:42.860 | None of us come up with any ideas.
00:48:44.380 | Maybe Brian.
00:48:45.380 | I don't know.
00:48:46.380 | Maybe Brian came up with this.
00:48:47.380 | But I did not come up with this idea.
00:48:48.380 | I'm just simply helping to give a little bit of publicity here since I have that opportunity
00:48:52.660 | and that privilege now to have a platform where I can give good ideas a little bit of
00:48:56.100 | publicity.
00:48:57.100 | So smartmoneybetterlife.com is Brian's blog.
00:49:01.100 | I think that's basically it.
00:49:04.660 | Thank you so much for being here for today's show.
00:49:06.820 | If this is your first time over here to the Radical Personal Finance podcast, on Wednesdays
00:49:10.740 | I usually try to do a technical financial planning show like this.
00:49:13.940 | Check out the show.
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00:49:21.740 | That free mobile app gets every back episode of the show.
00:49:25.540 | It also gets little goodies and bonuses like you can get these notes or come by RadicalPersonalFinance.com.
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00:49:36.740 | Patrons of the show are the primary income that I earn for doing this as frequently as
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00:49:49.100 | Thank you all so much for listening and I will be back with you soon.
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