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That's FijiAirways.com. From here to happy. Flying direct with Fiji Airways. Many people in this audience are working very diligently to save enough money to retire early. Early, meaning before age 59 and a half. The challenge is what types of accounts do you use to save for this? After all, if you use an IRA and you take the money out before 59 and a half, you're going to pay a 10% penalty for the privilege of having access to your own money, right?

Well, today I'm going to share with you why, even though that is the case, you might still be better off investing through an IRA or 401(k) or 403(b) for early retirement rather than using a non-tax qualified brokerage account. Early retirement community, here's a little bit of gift of knowledge that I pass along to you today.

Welcome to the Radical Personal Finance Podcast. My name is Joshua Sheets and I am your host, your fellow adventurer. This is the show where we work every day on strategies and tools and techniques to live a rich life now while building a plan for financial freedom in 10 years or less.

I hope that little gift of knowledge thing didn't sound arrogant because you know what? I was flat out wrong on this a week ago and today I'm going to tell you why and where I messed up. This is most definitely one of those things where I had to get my calculator out, but I realized that I was completely wrong.

Now I won't keep you sitting around on pins and needles. I'll just tell it to you straight out. Did you know that if you are investing through a 401(k) or IRA and if you are taking the income from the account out at an early age, meaning before 59.5, so that you're still subject to the 10% penalty, did you know that even if you're paying the penalty by using a 401(k) or an IRA, you can still come out ahead than investing your money after taxes?

Now there was one very important caveat in that statement. To the best that I can figure out, that statement is absolutely true and I'll share with you the math and I'll invite you to try to rebut it or try to prove it for yourself because this was totally new to me as of a week or two ago.

But the statement was taking out the income from the account. Now let me tell you the back story and then we'll get into the math of how this came about. On some recent episodes, Q&A episodes of the show, there have been a number of different callers who've talked about how much money to save into taxable accounts as compared to tax qualified accounts.

The idea is should I put more money in my 401(k) because I get the upfront tax savings of using that account or should I go ahead and invest more money into just a post-tax account so I have more flexibility? This is always a challenge for me to reconcile with.

One of the regrets that I have from my younger investing life is that I feel as though I put too much money into tax qualified accounts. I put too much money into IRAs, Roth IRAs, 401(k)s, et cetera, and I've been frustrated by not having easy access to that money for my own business and investing purposes.

I've gone from always saying to start with retirement accounts to swinging the pendulum to where at this point for me in my finances, I'm pretty bearish on the use of tax qualified accounts. Now, I cannot – I absolutely cannot contradict the reality of the tax savings. It is true.

Those tax savings are important. I'm not trying to argue with the math of it. I'm just simply saying for me, probably for three primary factors, I no longer want to prioritize the use of tax qualified accounts in my own investment – in my own investing plans. I'm not excluding the use completely.

I'm just saying that for me, I no longer want to prioritize these accounts. Now, you might be at a different stage. You might be in a different situation where these accounts work beautifully as for people who are employees, who have a high income, who can use these accounts to easily shelter a lot of money from taxes.

There are a lot of strategies through which you can use Roth IRAs, 401(k)s, SEP IRAs, all of these things for your benefits. So hear me clearly. I'm just simply talking about for me. The three major reasons why is number one, a loss of flexibility. I've realized that for me, investing through a 401(k), trying to just simply buy mutual funds is probably the least effective, least flexible approach to building wealth.

I much prefer to be involved in private business or in other types of investment that I can have more control over. So I don't like the loss of flexibility. I don't like the loss of privacy that you gain with 401(k)s and IRAs. I don't like the fact that every single year, my balance is reported and all that activity is reported to the IRS.

I also don't love – third factor, I don't love the fact that the rules and the legislation I think will be changing in coming decades. Now what those changes will be, I don't know. The political pressures to keep things as they are are immense. But the US government is inexorably grinding over the coming decades toward what I perceive to be an inevitable default.

And so all through that process, there will be a lot of political machinations of people trying to change this, change that, increase tax here, increase tax there, means test this, change this, other benefit, et cetera. It's going to be a long and difficult political process. If you can predict politics accurately, I will have you on the show to tell me how to do that.

I don't know how to do it. So I don't really want to play that game. But those are the reasons why for me, I don't love investing through these qualified accounts. But I have to maintain professionally speaking that these are valuable and the tax savings are valuable. So I've done these Q&As in recent shows and I had a listener who had listened to some of those shows and who had emailed me and said to me, "Joshua, hey, I got a question for you and I'm wondering why people don't talk about it.

Listen, I think I'm better off investing through my 401(k) even if I have to pay the 10 percent penalty." Now, I work really hard to answer all the listener email and so this listener, when he sent the note, it sat in my inbox for a few days until I got around to it.

Then I finally went ahead and wrote him a response and I carefully read his email and carefully wrote a response to disabuse him of the notion that somehow the IRA was superior to the Roth IRA and I suggested some past episodes of the show that might help him to establish some theory and so I'm feeling pretty confident.

I hope I did it in a humble way but I'm supposed to be Mr. Hot Shot expert, right? I mean in theory, I'm supposed to know what I'm talking about. At least I've certainly spent enough time studying that this should be the case. So I wrote him back this note and I did the calculations for him and I was demonstrating to him how IRAs and Roth IRAs are exactly the same and if you have them, the penalty, it's a really bad thing, etc.

I'm going to go through those calculations in a moment because you need to know them. But he wrote me back and said, "No, no, no. You don't understand." So I wrote him back. I went back and I read the article on his blog that he linked to. He has a blog called Smart Money Better Life and this listener, his name is Brian Rosner, smartmoneybetterlife.com.

I'll link to the article where he talked about this in the show notes today. And so I wrote him again. He wrote me back and said, "No, no, no. You're still not understanding what I'm saying. If you only take the income from a 401(k) even if you pay the penalties, you're still better off." And so I realized that he was right.

I hadn't been understanding what he had said. And so I sat down with a calculator and I just started working scenarios and I came to the conclusion that, you know what? He was right and I was wrong. I wrote him back and I said, "You were right. I got to stress test this and just see if I'm missing anything.

But to the best that I can figure out, this listener is exactly right." And again, I will go through the math but I'm trying to set the stage here so you understand what I didn't understand initially. I sent this over to my buddy, Brandon at Mad Scientist. Brandon is – I've crowned him the unofficial guru of early retirement math because he writes these great in-depth articles for early retirees and all the specific things.

So I sent this scenario over to him. I said, "Check this out. Have you ever considered this option?" And he took a couple – he thought about it. He took a couple of days, made a couple of spreadsheets and we talked about it. He said, "No, I never had.

It was totally new to me." And it was totally new to – so it was new to Brandon. It was new to me as well. And I've not seen this discussed widely. I'm going to invite you to stress test this. To the best of my knowledge and ability, I believe this to be true.

But I will post in the notes for the show today. I will post the – my calculations and I invite your commentary on this. If you can find a hole in this, if you can find a problem with it, then I invite you to demonstrate that to me so I can set the record straight.

So in today's show, I'm going to start with the simple calculations, the way that we've done them in the past of comparing Roth contributions and traditional contributions and taxable contributions. I'm going to start with that to lay the ground floor and then I'm going to go through the specific calculations and demonstrate to you with numbers why some of you should consider using a 401(k) even if it involves you paying the penalty for your access to that early retirement.

That's through the course of today's show. The sponsor of today's show is Trade King. Trade King is – the reason I'm – Trade King for today, this is a perfect fit for the type of thing that you could do with Trade King. You can fund a 401(k) heavily at work.

You can fund – I mean you can fund an IRA or a Roth IRA, et cetera, with Trade King. But you can fund a 401(k) heavily at work and then you can – upon your exit, you can leave it – you can leave from there and you can transfer it to a brokerage company like Trade King and you can use that to create – to buy the portfolio that you create.

You can build that portfolio that you only take the income off of it just like we're going to discuss in today's show. You can set it up to provide you with a lifestyle and Trade King is one great way for you to do that. Many of you prefer to work with a financial advisor.

As a former financial advisor, I think that is a fine course of action and if you want – and many financial advisors will require you to custodian your assets with them and with their firm and there are a lot of advantages and – there are some disadvantages but a lot of advantages and benefits to doing that.

Many of you will be do-it-yourselfers but you'll work with a mutual fund company, you'll have all of your assets with Vanguard, you have everything with Fidelity, something like that and that works really, really well. Some of you prefer to DIY invest. That's a minority of the audience but some of you do like to do that.

You like to trade. You like to buy and sell ETFs. You like to set up options trades, etc. and that's where you should consider working with a brokerage company. Whether you do that with a large amount of your portfolio or whether you do that with just a small side account, you can check that out and you can do that and Trade King would be a great place for you to consider holding your accounts for that purpose.

If you use the special referral link at TradeKing.com/radical, that's a tracking link. It allows them to know how well their ad campaign here on my show is working but it also has some benefit for you. So try to bribe you to do it simply by giving you a $100 bonus when you open an account there.

You need to fund it with a thousand bucks I think and then you need to do I think it's two or three trades within 90 days and then you'll get a $100 bonus. So you can find that at TradeKing.com/radical. So while you're there, make sure you check out their – I hate the word but their RoboAdvisor platform meaning they've put together a portfolio that is carefully constructed and it's competitive with many of the other RoboAdvisor platforms that are out there.

Too detailed for me to get into at length in the verbal portion of this ad but you can read all that information there on the website. TradeKing is really proud of that offering and I think it's a good offering for some types of portfolios. So TradeKing.com/radical. As I go to the math, I want to begin with the math where I – what I had written Brian back and said to him, "Hey, listen.

No, you're misunderstanding the math here." In fact, a few weeks ago, I did a show talking about how the Roth IRA and a traditional IRA actually come out with the absolute identical amounts of money if the assumptions are the same. That was episode 303 of the show titled Roth IRA versus traditional, which one pays less taxes?

What I endeavored to prove in that show was that if you're in the same tax bracket during your working years as you are in retirement and if you're funding an account with the same amount of money during your working years, you will come out with the exact same amount of money whether you use a Roth IRA or a traditional IRA, that it does not matter which type of account you use if your tax rates, tax brackets are the same.

I did that because there's this often held idea that somehow if you fund a Roth IRA, you're going to pay less money in tax simply because you're paying the tax up front. That is simply not true. If tax brackets and tax rates are the same during your working years and in retirement, you're going to pay exactly the same amount of money whether you use a Roth IRA or a traditional IRA.

Now, I intended that show and that show actually came out of this conversation with Brian in responding to him. I said, "This is a good show idea." I regret ever doing that show because all I wanted to do was just simply to demonstrate that one mathematical fact. I have received more feedback, more emails, more comments from people saying, "Joshua, yeah, but you forgot this.

Yeah, but you forgot that. Yeah, but you forgot this other thing." All of those things are exactly true. It should teach me to ever do a 30-minute one-topic show when I actually need to do a four-hour marathon laying out for you all of the advantages and disadvantages and when you choose one account versus the other.

I learned my lesson not to short-circuit it because there are many other factors and I had lumped those all in under this mysterious other factors point in the show that will affect your decision. One of the most valid and most important was simply that if you can pay the tax – let's say if you're going to contribute $5,000 to a traditional IRA or $5,000 to a Roth IRA, if you can afford to pay the income tax from other money, what that means is that you can actually contribute $5,000 to the Roth IRA, but in effect, you'd only wind up contributing – I'm getting myself all tied up.

You're in effect contributing more to the Roth IRA if you're paying the tax with other money. So the analysis was putting $5,000 into a traditional IRA or earning $5,000, paying – if a 25 percent bracket, you contribute $3,750 to the Roth and you pay $1,250 of tax to the Roth.

So you're actually contributing less to the Roth, which is why they're equal. So that's a valid criticism. If you can afford to pay the tax from other money such that you can actually invest the full $5,000, the Roth will come out. There are many other valid criticisms. For example, most people are simply not going to have the same level of income at retirement.

This is one of the reasons why many financial advisors do prefer a traditional IRA for your investing purposes, simply because it's very difficult for you to build enough wealth to be at the same tax rate in retirement as it is during your working lifetime. If you just consider – I am at and going into one of the more expensive phases of life, young family, that involves expenses for – higher expenses for housing, expenses for education, expenses for food, all these just normal expenses for karate lessons.

These are the types of things where generally young families spend a very high amount of their – higher amount of income. So these years are usually more expensive. When you take the need for a larger house to maintain children, you take the need for larger cars or more cars to maintain transportation, you go into retirement.

Most retirees can get by and have a great lifestyle on less dollars simply because of their expenses are lower. So that's why it's unlikely that most people are going to be in a higher tax bracket or pay higher tax rates in retirement. Now, on the other hand, there are many compelling arguments for the Roth.

For example, it's far more flexible. You can make the argument that when you have a position where your tax rates are low, for example, although my income might be high when I have a young family, I might also have useful extra deductions, nice mortgage interest deduction. I might have deductions for child tax credit deductions, etc.

And so you can make corresponding arguments and that's where you have to sort through these things. But the intention of Show 303 was simply to disabuse you of the idea that somehow there's just one difference between these two. So when Brian first wrote to me, that was my initial response was to say to him – and I'm going to read just a quick moment.

Let me read a paragraph from his website. He says, "I've been listening to your show and I think a lot about the 'how much to put in tax-advantaged accounts' question. But I discovered a neat math trick with traditional IRAs. Even if you want to prioritize for the now, you can still put money in the traditional IRA and even pull it out and pay the penalty on the earnings and still come out ahead compared to not putting it in at all.

This is a breakthrough concept because it allows you to have your cake and eat it too." And he linked over to his blog post article about it where I could see it. Here's an example. He says, "Let's say you're in a marginal tax bracket of 25% federal and 9% state.

I live in California. You have $10,000 at the end of the year. What should you do with it? If you invested at 10% – just an example – in an after-tax investment, first you have to pay 34% on it before you get to invest it so you have $6,600 left.

You invest that at 10% and you get $660 a year. You pay tax on that and you get $435 a year to spend on roasting marshmallows on hot lava. Okay, let's say you put it in a traditional IRA, the 10K. You invest it at 10% and want to use the earnings now.

You get $1,000 in income, pull it out, pay 34% tax plus 10% penalty and you're left with $560. So you come out with more income using the IRA income. So I responded and said, "Well, hey, it's good if you can leave California," which I want to touch on that at the end of the show, which is a very useful way to take these concepts and increase it.

But the math still comes out exactly ahead and especially if you add in the math of the penalty you come out behind. So let me read you two paragraphs because it's important that you understand this distinction between the principle and the income or I should rather say your contribution and the growth because by income, I'm not specifically referring to dividends.

I'm referring to the growth in the account. So I responded with this mathematical analysis form. I said, "A Roth IRA contribution and a traditional IRA contribution come out exactly the same if tax rates are equal." Here's the math for the Roth. If you earn $10,000 at a 25% effective tax bracket, you pay $2,500 in taxes and invest $7,500.

$7,500 invested today in a lump sum at a 10% annual rate of return for 10 years comes out to be $19,453.07 at the end of the term. So you have $19,453.07 to spend. If you invest through a traditional IRA, you earn $10,000 but invest all of it pre-tax, you pay $0 in taxes, meaning you invest $10,000.

Invest that today in a lump sum, 10% annual rate of return for 10 years and you wind up with $25,937.42 at the end of the term. You then pay 25% in taxes, leaving you with $19,453.07 to spend, which is exactly the same as the Roth. Now if you add the additional 10% penalty on top of that, you wind up with only $16,859.32.

So you're poorer if you use the traditional IRA option. That's where I went in and talked about how even in that situation, you'd be better off with the Roth because you get your first 10% back – excuse me, you get your contribution back, the $10,000 back without paying the penalty.

So he responded back and again, this is where he finally convinced me that I had missed understood him and he talked about the income. So let me walk you through the math. Again, I will post in the show notes for today's show on the blog and I also – if everything is working okay, I will post this – I believe I can post this as an attachment for those of you who use the Radical Personal Finance app.

I haven't done this yet but one of the benefits of having the Radical Personal Finance app is I can deliver some additional materials, bonus materials with the episode. So if everything works okay, those of you who are using the Radical Personal Finance app, which anybody can use, it's free in all the app stores, just search the app store on your phone for Radical Personal Finance, you can see these immediately.

Otherwise, this will go onto the website in a few days once it gets posted there. If you haven't noticed, by subscribing to the feed of the show, you will always get the show immediately but it takes about three or four days for it to migrate over to RadicalPersonalFinance.com. So I recommend that you subscribe and I recommend you subscribe using the app.

I'm going to walk through the numbers because it's important and I'm going to try to do it in a clear way. I recognize it's hard to do math in an audible format. So let me just tell you the conclusion. The conclusion is that the traditional IRA wins, that investing through a traditional IRA, if you're just spending the income and growth from the account, you're going to wind up with more money to spend even if you have to pay the 10% penalty tax.

I'll demonstrate that to you. I'll link notes and things in the blog post and I invite you to follow the math and the logic there and to see if you can find any error in my thinking. But let's go through the scenario. So to demonstrate, to try to prove this, I'm going to keep something very simple.

I'm going to say that there are three aspects to this scenario. We're going to assume that we're going to earn and invest $5,000 starting at the age of 30. Then that money is going to grow for 10 years. So step two is we're going to spend the income from the portfolio at age 40.

Then we're going to leave the principal, leave the original contribution in the account until the age of 60. That's step three. At step three, we're going to spend the balance of all of the income and the principal at the age of 60. So these numbers are totally arbitrary. I'm trying to use round numbers.

But the idea is at one stage, you're working. Some stage a few years later before you can take the money out without penalty, meaning before 59.5, you're going to start spending some of the income and growth from the account. Then finally after you've reached 59.5, then you're going to go ahead and spend all of the money.

The question is do you come out better using a traditional IRA, a taxable brokerage account or a Roth IRA given this scenario? That's the major question. I want to clarify when I'm using traditional IRA. The reason this is powerful is because many of you have access to a 401(k) program or a 403(b) program or a SEP IRA that you've established or something in your – a solo 401(k), something like that.

Many of you have access to those types of accounts where you can put much more money in. So for example, if I'm in a business with my wife and we set up in our – a 401(k) program, a solo 401(k) program in our company, I can defer – I can set it up such that I can defer up to about $50,000 into this account through the different employee contribution, employer contributions and depending on how I do that.

I can set the – I can arrange the documents to put $50,000 into that. I can do that for me and I can do it for her. So some of these traditional accounts, SEP IRA, it's the same thing. You can put a lot of money into these accounts up front.

It's much more useful to many of you who are high-income earners than just being able to put a few thousand dollars into a Roth IRA. So that's what – why – when I'm using traditional IRA, you should see the power of this of being able to apply it to your 401(k) or other account where you have a much higher ability to contribute to those accounts than just a few thousand dollars.

So step one, let's start with scenario A, the traditional IRA. This is the base scenario that we want to measure against. So step one, we're going to earn $5,000 and invest it before we pay income tax into the account. We're investing the money at age 30. So we take $5,000.

We invest the money pre-tax. We now pay no current income tax when we earn the money and we invest it for 10 years. So we put – and I'm assuming throughout, I'm assuming just a 10% annualized rate of return simply for the sake of round numbers. You can use five.

You can use 15. It does not matter. I like round numbers. So N is 10. The interest rate is 10. We start with the present value of minus $5,000 because if you're running your calculator, it's a cash outflow. So we use a negative number. Put in zero contribution, zero payments.

We solve for the future value. What we find is that if we invest $5,000 pre-tax for 10 years, at the end of the 10-year term, we have a total account value of $12,968.71. Now step two, the goal is at age 40, we're going to spend the income from that account.

So meaning we're going to spend the growth. We're going to leave the original contribution in the account, leave the five grand there, but we're going to spend all the income. So we spend the income. Let's calculate how much we have to spend. Well, if we pull $5,000, our original contribution out of $12,968.71, that leaves us with $7,968.71 to spend.

Now, I'm going to assume that we're in the same tax bracket at that time. So we're paying a 25% effective tax rate on our money. That means that we're going to pay $1,992.18 of current income tax at a 25% rate. I'm also going to assume that we're going to pay a 10% penalty because we're taking the money out at age 40.

So we're not trying to employ any other strategy that's avoiding the penalty. We're just paying the penalty. That would incur a $796.87 penalty, which means that if you took $7,968.71 out of the account, paid a 25% tax and a 10% penalty tax, you now have $5,179.66 to spend. Now you leave that pot of money alone and here's where we move into step three.

You leave the $5,000 in the account and you let it grow now for 20 years from age 40 to 60. You have the same constraints, 20 years of time, 10% annual growth rate, present value starts at $5,000, no further contributions to the account. That means that at the end of 20 years, you now have $33,637.50 in the account that you can now spend.

Now of course, this is a traditional IRA or a 401(k) or a 403(b), et cetera. So meaning that when you take out the $33,637.50, you're going to pay a 25% effective tax rate, ordinary income tax. That means you pay a tax of $8,409.37 of tax, leaving you with $25,228.13 that you can spend on cruises and cocktails on the beach.

So how much money do we get from this scenario to spend and how much tax do we pay? Well, if you add the two amounts of money together to spend, you will wind up with a total of $30,407.79 to spend. That included the $5,179 you were able to spend at the age of 40 plus the $25,228 that you could spend at the age of 60.

So your total amount of money is $30,407. Your total tax paid is $11,198, which included the $19,092 of tax at age 40 plus the $796 penalty plus the $8,409 of tax at the age of 60. So that's our baseline scenario, the traditional IRA. Now let's compare that to an all-taxable account.

And so here is where the tax rates possibly could change. We'll pay and assume the same 25% income tax rate in the beginning, but we could play a little bit with scenarios regarding how much money at a 15% long-term capital gains rate if we're paying long-term capital gains taxes, how much money if we're paying ordinary income taxes, or perhaps some of you might even be able to get to a 0% long-term capital gains rate if your earned income is low enough.

And that's where you got to play with these scenarios a little bit. But let's just walk through the simple math. So scenario B is what if we just take the money out, pay the tax, and we invested ourselves outside of any IRAs or Roth IRAs of any kind? So step one, we're going to earn $5,000 and we're going to invest it.

We earn it at age 30 and we're going to invest it after paying the tax. You earn $5,000, pay a 25% income tax, meaning that you're going to pay $1,250 of tax currently, leaving you with $3,750 to invest. We invest $3,750 from age 30 to 40, totaling 10 years, at a 10% annual rate of return, leaving us with no more contributions to this account, leaving us with a future value at the age of 40 of $9,726.53.

$9,726.53, let's keep our original $3,750 in the account and pull everything out. If we keep our original $3,750 in the account, we're left with $5,976.53 to spend. Now here would be the question of what is the appropriate tax rate for us to apply? Do we use a 25% long-term capital gains rate?

Do we use a 25% ordinary income rate? Or do we use a 0% long-term capital gains rate? By the way, excuse me, I misspoke. I meant to say 20% long-term capital gains rate. That's the current brackets, 0, 15, and 20. I was looking at my ordinary income rate number.

So what's the rate that we use? For the sake of my example, I'm going to start just simply by using a 15% long-term capital gains rate. So we had – we spent our – so we invested the money. We took out our $3,750 original capital, which left us with a $5,976.53.

We're going to pull off a 15% long-term capital gains rate. We assumed no taxes year by year over that 10-year period and we're just spending this at the end of 10 years, $896.48 of total tax due at a 15% long-term capital gains rate. That leaves us with $5,080.05 to actually spend on lifestyle.

Now we keep that $3,750 of original capital invested for 20 years, 10% return, etc. That leaves us with at the end of 20 years, we have $25,228.12 to spend. And here again, I'm going to assume that we incurred no taxes during that 20-year period. We just simply pay the taxes at the end of 20 years, leaving us with a 15% tax bill of $3,784.22.

So we pull that $3,784 from the $25,228, leaving us with $21,443.90 to spend on cruises and cocktails. I know the numbers are overwhelming when it's just audio. Forgive me. Total in this scenario that I've done using a 15% long-term capital gains rate leaves us with a total of $26,523.95 to spend.

We had $5,080 to spend at the age of 40, and we had $21,443 to spend at the age of 60. Now to compare that, our scenario A, the traditional IRA, we wound up with $30,407.79 to spend. Versus here, using a taxable account where we got to pay the tax up front, where we wind up with $26,523.95 to spend.

So the traditional IRA was superior to this approach where we had to pay the 25% ordinary income tax rate up front and a 15% long-term capital gains tax rate at the end of the term. The total taxes paid are very different. Under this scenario, all taxable, you wind up paying a total of $5,930 of tax, which is less than half or about half of the $11,198 of total tax that you paid with the traditional IRA.

But you had more money to spend with the traditional IRA. Interesting, huh? So what would be the variations? Well, first, is that 15% long-term capital gains tax rate going to continue or would that go to a higher rate? I don't know. That's where these things get to the point of being unknowable.

You will have to understand the concept and apply it yourself. Obviously, if you were paying a higher tax rate, whether you went up to the 20% long-term capital gains tax bracket, which is unusual because that's the highest ordinary income tax rate bracket, or if you incurred more long-term capital gains taxes along the way, or if you paid short-term capital gains taxes, or if you incurred ordinary income, all of those things would mean that you would pay more taxes.

So still, the traditional IRA would come out to be superior. Now what I wanted to test was I wanted to see what would be the difference if you paid a 0% long-term capital gains tax rate. What would the amount be? That one I think is interesting. So same assumptions as I've just gone through.

We earned the $5,000. We pay the taxes up front one time, but then from then on, pretend we never paid taxes on the growth of the portfolio. Well, under that scenario, you would wind up with a total of $31,204.65 to spend and you pay $1,250 a tax. So this would incur the lowest amount of tax, but still, you would have a very comparable amount, $31,204.65 to spend under scenario B, all taxable but a 0% long-term capital gains rate after you paid that initial amount versus $30,407.79 under scenario A.

So the difference between those two would be $30,407.79. The difference between those two is $796.86. So those are very, very comparable. Now, that was what really surprised me. Scenario A was a traditional IRA and that involved you spending the income from the portfolio and paying the 10% penalty tax.

Scenario B doesn't incorporate any penalty tax or any tax after that initial payment on income and still, they're very comparable. Really, really surprised me. I just share it with you as something that you might be interested in. There are other permutations. As with everything, I'm going to go through the Roth IRA in just a moment and illustrate that one to you as well.

But I just want to point out to you, there are other scenarios between – let me do the Roth first and I'll come back to the other considerations. So the Roth, now that you've got the flow of these steps, one, two, three, you earn $5,000. You pay 25% of income tax, meaning leaving you with $3,750 to invest.

You invest it for 10 years. You wind up with $9,726.53 at the end of 10 years. At the age of 40, you want to spend the income from the portfolio. Now, here is where you would have some choices with the Roth and I originally worked several variations of how much income to spend.

Do we spend the same amount of income as the traditional IRA? Do we spend the same amount as the alt-taxable account? What do we do? For the sake of the three illustrations I want to go on the show, I simply assumed that you spend the income from it. So you take your total account balance at age 40 of $9,726.53.

You keep your original $3,750 in the account, leaving you with a total of $5,976.53 to spend. Now, of course, you could take out $3,750 of that money as your return of contribution. So that money comes to you tax-free and penalty-free. So you take out $3,750. That leaves you with $2,226 of your distributions that's taxable as ordinary income plus a 10% penalty tax.

You pay $5,056 of ordinary income plus $2,222 of 10% penalty tax. Leaves you with, if you run the math, $5,197 to spend from the Roth at the age of 40. You then leave that original $3,750 alone for another 20 years. That grows at 10%. That leaves you with $25,228 to spend at the age of 60.

And remember, at that point, you could take it out with no income tax due, which is really nice. At the age of 60, if you total the amount of income that you have together, you've had $30,425.37 to spend and you have $2,029 of total tax. Now let's compare that $30,425.37 first against the traditional IRA.

Comes out to be slightly better than the traditional IRA, better to the tune of – what is this? Less than $20. In the Roth IRA, you have $30,425.37 to spend. In the traditional IRA model that we started from as our baseline, you have $30,407.79. So you have $17.58 more total income to spend in the Roth IRA.

One important similarity is you have a very similar number to spend at the age of 40 under those scenarios. So you have $5,197 to spend at 40 with a Roth and you have $5,179 to spend with a traditional IRA. So you still have a very comparable amount of money to spend.

Now the Roth IRA pays much less of total tax, only $2,029.28 of tax as compared to $11,198 of tax in the traditional IRA, but very comparable. So the Roth comes out slightly ahead, but very comparable numbers. Then if you were to compare the Roth to scenario B, all taxable, the Roth here under those constraints is superior.

So when comparing the Roth IRA to scenario B under that 15% long-term capital gains tax rate, you had $30,425 to spend from the Roth or you had $26,523 to spend from all taxable. So the Roth is superior to the tune of about $3,500, $4,000-ish. So what would be the scenarios that would cause you to – let's get out of the weeds of the numbers and what would be the scenarios that would cause you to choose one over another?

As with most things, I've not solved anything perfect here because there are a number of things you could do. First, with this Roth, remember, I kept this under the constraint of earning and investing the $5,000 and paying the tax from those earnings. But if you were deciding between the Roth and the traditional, if you had the money to pay the tax from another source of funds, then you would be able to get more money in the Roth than the $3,750.

But remember, you're actually contributing more. So now we've lost our sense of equilibrium and you can run the math on that. It just gets too complicated that I could do on audio. Point is there are other scenarios. What about the scenario of when you need the money or what about some of the scenarios of when you're going to move?

That was – those are one of the things that I wanted to demonstrate to Brian is even in my original response. There are three major tax planning scenarios that I talk about and I've covered them in episode 36 and episode 41. So they are timing, income timing, income shifting and income conversion.

So you could use an IRA. The great thing about using an IRA or a 401(k) is that you can use this very effectively if you're going to implement it as a timing strategy and as a shifting strategy. So here's the idea. Let's say Brian is working in California. Putting contributions into his 401(k) allows him to avoid the California – the 9% state income tax that he says that he's paying.

That's really valuable. Now let's say that he works for a decade or two. He's avoided paying income tax when he's working really hard, paying at the highest marginal tax bracket, having a professional job and he's avoided the California state income tax. Now, he takes this traditional IRA concept. He funds his 401(k)s with as much money as possible.

Let's say he's able to structure one of these things where he can put – with total of his contributions and his deferrals, he can put in $50,000 into that. Whether that's between just him or whether it's him and his wife or anything like that, he's put $50,000 into that.

Assume that he does it over a 10-year period of time, that's half a million dollars of contributions, all of which have avoided the high marginal tax bracket and have also avoided the high California state income tax. Now after that point in time, he moves to another state. He decides he wants to retire.

He moves to a low state tax – state income tax state or to a no state income tax state, refers his place of residence to a low state income tax state and also now he's able to cut his expenses because he doesn't have to live in high cost of living California.

He can move to a low cost of living state. So now he doesn't need to spend as much money. With that point in time, he starts taking income from his IRA and pretend that IRA through investment prowess has grown to become worth a million dollars and he starts taking $30,000 a year off of that IRA as income.

Even if he incurs the 10% penalty, well, it's the same as what he would have had to pay under the California state income tax rules. Now he's at a lower marginal bracket because he's only taking $30,000 of income off. So essentially in that scenario, essentially he would only be paying the penalty depending on his deductions, etc.

So that would be a good way of understanding how even this penalty, when you calculate it in, this could be very compelling. So I wanted to share this with you because I believe this can be a valuable tool in your tool chest. First, I invite you to see if there's any flaw in my math or in my illustrations and I mean that sincerely.

I love – so I'm a huge fan of the concept of the open source community. That's why I try to share this. The first thing I did was I said, "Let me do this to Brandon. Brandon has got a massive platform on the early retirement community and I want to share this with the early retirement community." So I expect him to publish an article on this in written form soon and hopefully this show will be a good verbal form to help some other people as well.

So we're going to get this out there and look to see if we can find any flaws in it. I can't find any flaws in it. But the real power of it is going to be when combined in conjunction with some of these other strategies. This will help many of you who are prioritizing the use of 401(k)s and 403(b)s, et cetera, as a primary source of your investment dollars.

I think this is a really great option. If you are a highly paid employee and you have a good, well-run 401(k) and if you're working hard at your job such that you're not going to have time, you're not going to go start a business on the side necessarily, this can be a really great option for you.

Under the constraint of only spending income, you can feel confident that you don't have to necessarily decrease those contributions in order to prioritize a taxable account versus this 401(k) account. That helps a lot. I think that will help a lot of you. Now of course remember there are other things.

So in this scenario, I've isolated only the example of which account to use. But the reality is there are many other factors. If you're going to earn a 6% rate of return net of taxes and fees in a 401(k), but if you have an opportunity with a side business that you see or some investment that you're going to manage much more actively to earn a 20% rate of return, but you can't invest in that type of thing through your 401(k), well, now you're in a much better situation.

So this is only one variable and I'm repeating this again and again because often people I think take one variable too far. You need to look at this in a comprehensive way. But I think it's a very useful variable for many of you. When you start to put these things together, again, think of Brian, earning income in California, high cost of living, high taxes, anything you can do to avoid some of those taxes and later be able to move to another place if that's the goal or just to be able to adjust the lifestyle in a way, this can be very valuable – a very valuable tool.

So I hope it's useful to you. I invite you to check it out. I invite you to see if you can find any flaws. And for the retirement community, there's a little gift. I will link to Brian's original article. Go buy his blog and give him some love, give him some comments and whatnot.

His blog again is smartmoneybetterlife.com. I did not come up with this idea. None of us come up with any ideas. Maybe Brian. I don't know. Maybe Brian came up with this. But I did not come up with this idea. I'm just simply helping to give a little bit of publicity here since I have that opportunity and that privilege now to have a platform where I can give good ideas a little bit of publicity.

So smartmoneybetterlife.com is Brian's blog. I think that's basically it. Thank you so much for being here for today's show. If this is your first time over here to the Radical Personal Finance podcast, on Wednesdays I usually try to do a technical financial planning show like this. Check out the show.

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