So, you want to retire early. That’s great! It’s probably one of the best ideas you’ve ever had, so I commend you on that.
Saving up to retire early isn’t a goal shared by many people. So you might be surprised to learn that, for the few people looking to go whole hog in saving for retirement, there is a shocking variety of accounts to choose from! Once you decide to start keeping your money instead of spending it, where the hell are you supposed put it? Under a mattress?
Today we solve that dilemma!
But first, there are a few Golden Rules to follow when it comes to investing your nest egg responsibly that I assume you have to know:
- Buy hugely diversified mutual funds instead of individual stocks. (Something like VTSAX, Vanguard Total Stock Market Fund, and its international cousin VGTSX)
- Make sure those mutual funds charge very low fees.
Diversifying between stocks and bonds, international and domestic, and small and large companies is simple and pretty fun*. But one area I found myself lacking knowledge in lately was the difference between retirement account choices. IRAs, 401(k)s, Roths, 457s, SIMPLEs,.. There are enough acronyms to fill a letter factory!
So I made a little summary for myself of the common options:
| Account | Max Contribution | W/D Taxed As | W/D Can Begin | Penalty on Early W/D |
| Roth IRA | $5,500 | No Tax | Immediate / 5 Yrs | N/A |
| Traditional IRA | $5,500 | Ordinary Income | Age 59 1/2, with exceptions | 10% |
| 457 Plan | $18,000 | Ordinary Income | Whenever | N/A |
| 401(k) | $18,000 | Ordinary Income | Age 59 1/2, with exceptions | 10% |
| HSA | $3,350 | Ordinary, unless for Medical | Whenever | 20% under Age 65, on non-Med |
How many do you have access to? Well, I can tell you right now that you have access to a Roth IRA. Because everyone does. The 457 Plan and 401(k) Plan are only available through your employer. The 457 Plan is optimal for early retirement planners because it lets you withdraw before age 59.5 for any reason, without a penalty.
As for the Traditional IRA, you have access to that, too, because everyone does. But there’s a hook, and it always messes with my head: You can invest post-tax dollars and take a tax deduction for that amount, essentially making them pre-tax dollars, but only if you do not have an employer-sponsored retirement plan.
If you have access to a retirement plan at work, your available deduction for a Traditional IRA starts getting phased-out when your income reaches $52k for individuals and $83k for couples. Oh, and did I mention the $5,500 limit covers your Roth and Traditional IRAs together? The Traditional IRA seems to have the most annoying rules to deal with, but we’ll leave that aside for now.
We had been doing most of our retirement investing in Roth IRAs as a way to guard against tax risk. Our income was taxed at 15%, and by saving in a Roth IRA, we wouldn’t have to pay taxes on that money again. We don’t know the future, but I would be willing to guess that tax rates will go up at some point. And who knows what the income brackets will look like? By investing post-tax money, you eliminate your risk that future tax rates will be sky-high.
But I realized recently that sometime in the past few years, we had entered the 25% tax bracket! So by investing mostly in a Roth, we were essentially gambling that our tax rate in the future would be more than 25%. At this point, I kind of doubt that, and here’s why:
You see, since we manage to live well on only about half of our income, then in the future, if we are only withdrawing that money which we need from our retirement accounts to live on, say $50,000 a year, we will be in the lower (15%) tax bracket. Again, assuming all tax brackets and rates remain level.
So what was I supposed to do? Invest it all in my employer’s 457 plan, or Marge’s 401(k) plan? What about those fees! What’s the best option?? Where are the best returns??? I demand only the best retirement option!!!
So I did an analysis comparing all of the retirement accounts available to us, and then some, to determine which ones would produce the best returns after twenty years, given a set of variables. Then we can rank them and max out our retirement funds in the correct order!
The results might be surprising…
The Types of Funds
1. 401(k) with low fees and no matching funds 2. 401(k) with low fees and matching funds 3. 401(k) with high fees and no matching funds 4. 401(k) with high fees and matching funds 5. Taxable account with low fees 6. Roth IRA with low fees
7. Traditional IRA with low fees
The Variables Used
Annual Investment: $5,000 (pre-tax) Annual Return: 10% Low Fee: 0.15% High Fee: 2%
Tax Rate At Retirement: 15%
Also, anywhere you see “401(k)” you can substitute a 457 plan or 403(b), since the effect is the same on those types. OK, and I know, a 10% return is a bit optimistic, but the rankings don’t change if you make that 7% or whatever you like.
You’ll notice I did not include any high fee mutual fund options in my Taxable Account or IRA options. That’s because if you open any of those accounts, you are the only one who has any say over what funds are bought. And you’d have to be insane to purchase a high cost mutual fund in that case. Remember the Golden Rules! But when it comes to employer-sponsored plans, you have to take what they give you, and in some cases that includes high fees.
Now, I’ve done two analyses based on my/your current tax bracket. The results change if you are in the 15 or 25% brackets, which should cover most everybody. Here are the results after 20 years of investing…
If you are now in the 15% tax bracket:
| Retirement Account | Value After 20 Years |
| 401(k) with low fees and matching | $478,621.64 |
| 401(k) with high fees and matching | $388,976.70 |
| 401(k) with low fees and no matching | $239,310.82 |
| Roth IRA with low fees | $239,310.82 |
| Traditional IRA with low fees | $239,310.82 |
| Taxable Account with low fees | $207,439.18 |
| 401(k) with high fees and no matching | $194,488.35 |
Those values are post-withdrawl, meaning the 401(k) taxes, deferred until retirement (we’re assuming 15%, remember) are taken out. So they are all on an equal footing. These are all post-tax amounts.
Clearly, what pushes a few retirement plans ahead of the pack are the matching funds. If you have an employer that matches your contributions dollar-for-dollar up to a certain amount, you should be maxing out that match first, regardless of the fees. Once an employer stops matching funds, the return drops off significantly, which you should expect. After all, a match is just an immediate 100% return!
I was a little surprised that, under the 15% tax bracket example, the Roth IRA and 401(k) with low fees were exactly the same. Your annual $5,000 contribution is actually $4,250 into the Roth once taxes are taken out. But in that example, your 401(k) is also taxed 15%. It’s just on the way out as withdrawls. So although they actually grow looking completely different, you end up with the same amount in the end.
I was also very glad to see my suspicions confirmed that high fee 401(k) funds kill your retirement! If you take my high fee estimate of 2% out every year from that 401(k), then under the 15% tax bracket, you would’ve been better off opening a regular old account and letting it get taxed every year! To the tune of $13,000!
People complain about Uncle Sam taking their money constantly. But what about Investment Advisor Greg?
“GIMME ALL YOUR MONEY!” – Greg
If you are now in the 25% tax bracket:
| Retirement Account | Value After 20 Years |
| 401(k) with low fees and matching | $478,621.64 |
| 401(k) with high fees and matching | $388,976.70 |
| 401(k) with low fees and no matching | $239,310.82 |
| Traditional IRA with low fees | $239,310.82 |
| Roth IRA with low fees | $211,156.61 |
| 401(k) with high fees and no matching | $194,488.35 |
| Taxable account | $166,353.15 |
Once you are in the 25% bracket, investing post-tax dollars in a Roth IRA becomes a worse proposition. I guess that’s obvious, but it’s good to see just how much worse. The account is worth about $28,000 less after 20 years than if you had been investing dollars that will only be taxed 15% post-retirement.
I should also mention that, in that 25% tax bracket example, if you play with the fees on the high-fee 401(k), it actually does better than the Roth IRA if the fees are 1.2% or less, so that’s something to consider. Even if I reduce the gains to 7% annually, the 1.2% fee rule still held. So if you can get your fees down below 1.2% on average, the employer-sponsored plan is better than the Roth.
Also, the 25% tax bracket is where the value of postponing taxes outweighs the horrible high fees of that 401(k) account! You’ll notice that the high-fee 401(k) account does better than a taxable account getting funded with post-tax money. Notably, I also taxed all of the gains at 25%, which isn’t really right. How much that taxable account is actually taxed depends on lots of factors, but for simplicity’s sake, I’m just going to leave it like that. In reality, the gains would probably be taxed less. But having taxable accounts and being in the 25% bracket just isn’t the best choice for retirement funds no matter how you shake it.
Using Norm & Marge As An Example
To illustrate exactly how this plays out for a married couple in the 25% bracket like us, I’ll use us as an example! The retirement accounts we have access to fall into the following categories:
– Marge’s high-fee retirement account, which is matched up to 3%
– Norm’s low-fee retirement account which has no matching.
– Roth IRAs
– Taxable accounts
Going by the rankings then, here is where our priorities are:
- Invest in Marge’s high-fee retirement account at work only to the extent of the match. At that point, it becomes a high-fee account without matching.
- Max out Norm’s low-fee retirement account at work.
- Max out our Roth IRA contributions.
- Max out Marge’s high-fee retirement account at work without matching..
- Invest any excess retirement funds in taxable funds, or start looking at other options.
I will be working up a super cool Retirement Account Decision Tree based on these findings to make this all easier to follow both for me and for you. This decision tree will go viral, and Ridinkulous, the most dope personal finance blog on the internet, will take its rightful
Tell me everything that’s wrong with my assumptions and everything I should add to make my rankings more reflective of reality.
* (ed. The description of diversification as “fun” is subjective)