As I became a little more familiar with the idea of FIRE (financial independence / retire early), I needed to learn where I should be putting my money. And I’m not talking about the specific investments – I’m referring to the type of investment account.
Terms like taxable, tax-deferred, and tax-free can make a huge difference in the outcome of your portfolio. When I started out, I didn’t understand just how much of a difference each of these accounts could make in the long run.
Most of the articles you read or the standard investment advice you hear from planners on TV anticipates that you’ll be retiring at the traditional age… or even working for the rest of your life.
Because of that, each investment account they recommend making a priority is geared toward that ideal.
And that’s not a bad thing… if you’re aiming to retire later in life.
However, that’s not what I’m planning to do. I want to retire early.
Sure, I’ll probably be making money in one way or another down the line, but I don’t want the need for money to dictate what I do. I want it to be because I found something I enjoy doing.
Therefore, I need to plan each investment account accordingly.
Let’s talk about some of these accounts a little more…
Tax-deferred investment account
A tax-deferred investment account is one in which you get a tax break up front and defer those taxes until later on down the line.
Examples of this type of account include 401(k) plans, 403(b) plans, or traditional IRA accounts.
So why would you use this type of account?
The biggest motivator behind using a tax-deferred account is the idea that you’ll be in a lower tax bracket when you withdraw your money.
As you fund your IRA, you’re likely going to be in your big earning years, which also puts you in a higher tax bracket.
Once you retire, though, if you’re no longer working, you’ll ideally be in a lower tax bracket.
So the idea is that you don’t pay the taxes now while in the higher bracket and defer them until you’re in a lower bracket. This can mean a lot less money in taxes to pay, which is obviously a good thing for your portfolio.
Tax-free investment account
With a tax-free account, you’re actually funding it with after-tax dollars. In other words, you’re being taxed on the money at the start (Uncle Sam always gets his cut!).
However, once the money’s in the account, it grows tax-free and when you pull out the money, the earnings are tax-free as well.
A Roth IRA or Roth 401(k) are usually the types of accounts we think of when we talk about tax-free accounts.
An advantage to using an investment account like this is that what you see is what you get. Whatever’s in your account is what you can take out at a later point without having to worry about losing a cut.
For a traditional retirement, funding an account like this in the early days of your career makes sense. You’ll likely be earning less early on so the tax hits don’t hit you as hard.
Then, when you start drawing out money, it’ll be tax-free. That means you don’t have to worry about the hit later on when you might possibly be in a higher tax bracket.
Another benefit to these accounts is that decades of compounding interest can far outweigh the tax benefits you’d get from a tax-deferred account.
In fact, NerdWallet did a study that concluded that folks who make the annual maximum contributions to their retirement accounts are likely to come out further ahead in a Roth IRA than in a traditional IRA. They also noted that in some cases the difference could be significant.
Taxable investment account
A taxable investment account includes entities such as a traditional brokerage account, your bank accounts, or even a money market mutual fund.
It doesn’t get all the cool tax perks like the tax-deferred and non-taxable accounts do. You’re required to pay taxes on your investment income every year that you receive it. Any stock dividends, gains on stock sales, or interest on bank accounts are all taxable events.
So why would you use this type of account?
The biggest reason to use a taxable investment account is that they offer flexibility. Tax-advantaged accounts such as 401(k) plans, Roth IRA accounts, etc. have a lot of restrictions on how you can access your money.
That’s not the case in a taxable account.
I actually struggled to build up this type of investment account enough and that’s cost us a couple more years that I’ll be working.
We’ve chosen to do a Roth IRA Conversion Ladder to access our retirement funds. However, that presents a delay of five years before you can touch the money. That means we need to have enough money to cover our expenses until that waiting period is up.
And that’s where a taxable investment account makes perfect sense.
We’ve been funding our tax-advantaged accounts with everything we can and not growing our taxable accounts enough. Now we need to build up our taxable accounts more.
There are other reasons to use taxable accounts. NerdWallet did a nice job in their article, 7 Advantages of Investing in Taxable Accounts.
The FIRE factor
Now that we know a little bit about each type of investment account, it should be easy enough to know where to put your money, right? After all, the experts are telling us that a Roth IRA comes out further ahead than a 401(k) plan for instance.
As I mentioned at the beginning of this, all the hoopla you tend to hear from “the experts” focuses on a traditional retirement late in life. Following that kind of advice as someone who plans to retire early can actually cost you money in the long run.
For those who are on the path to FIRE, you have to take a step back and look at some of your options.
For example, a 401(k) plan means you get the tax savings when you contribute but you have to pay up later. However, that’s not necessarily all the info needed.
Using a Roth IRA Conversion Ladder or taking advantage of Rule 72(t) gives you the ability to pull your money out early. If you’re already FIRE with no additional income coming in and the amount you need to pull out of your retirement accounts is low enough, you can be looking at paying little to no taxes on those distributions.
Ideas like that need to come into play when looking at each investment account available to us.
To help maximize retirement income, tax efficiency is also very important for our accounts.
Tax efficient investments include stocks and mutual funds that pay qualified dividends. A qualified dividend is one in which capital gains tax rates are applied. The benefit is that these tax rates are usually lower than regular income tax rates.
Tax inefficient items include investments such as bonds, CDs and investing in real estate through a REIT (Real Estate Investment Trust).
The basic guideline should probably be to keep tax-efficient investments in your taxable accounts and non-tax efficient investments in tax-deferred accounts.
I’m definitely not a tax expert, but the concepts make sense. And the more complex your investments are, the more you’d want to be cognizant of this idea.
My current priority
We’re a little later in the game and planning to FIRE at the end of 2019. Because of that, my priorities might be – and in many cases should be – different from yours. Here’s our plan right now…
1) Continue to max out my 401(k) plan at work.
This is a no-brainer for us. The match I receive at work is 35 cents on every dollar contributed up to the federal max. That’s a 35% return before any growth from the market.
For now, my entire 401(k) plan is invested in the only Vanguard option available to us – a low-cost age-based index fund.
Tax-wise, we’re also planning to roll that over into a traditional IRA when I quit my job and then start a Roth IRA Conversion Ladder. Things might change as laws and tax brackets do, but for now, that should keep our taxes pretty low on the withdrawals.
Although Mrs. R2R is not currently working a traditional 9-5, she had a significant amount in her 401(k) plan that we already rolled over to an IRA. We’ll start a ladder on her plan as well, but not until I quit my job (to keep the taxes owed low).
2) Continue to max out my HSA.
A health savings account (HSA) might be the pick of the lot on the tax side of things when it comes to investment accounts. Pre-tax dollars going in, tax-free growth, and tax-free distributions (for medical).
And, as I learned from the Mad Fientist and I talked about in this post, that “for medical” reimbursement can be slightly re-worked to give you a better bang for your buck.
Finally, similar to my 401(k), I get a contribution from my company for going the HSA route. For those reasons, I’ll keep maxing that out.
3) Roth IRA vs taxable investment account
Here’s where things start to get a little fuzzy for us. I’ve recently gotten on track maxing out my Roth IRA. I like not having to worry about taxes on capital gains, dividends, etc.
However, we need to start stockpiling for that first five years during our ladder conversion. Because of that, you might think it makes more sense to focus on our taxable accounts where the money is freely available as needed.
I don’t think I’ll switch from the Roth though. We can pull our contributions out at any point without penalty so I’m Ok with funding that account. We’re continuing to build up our savings but only after my Roth is maxed out.
My future priority
Once we do FIRE, our investment account priorities will slowly change. Our 401(k) plans will slowly move into our Roth IRAs through the conversion ladder.
The investments we’ll keep in the Roth IRAs will likely be a mix of Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) and Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX). I’m anticipating that this will be weighted with 75% in VTSAX and 25% in VBTLX.
I feel all right being a little more aggressive in this as we’ll continue to have the cash flow from our rental properties as a little bit of a hedge against stock market volatility.
My HSA will continue to be invested in low-cost Vanguard index funds. The offerings are better than they used to be, but they’re still not fantastic. However, it’s still better than leaving it sit in cash in it in my opinion if you want it to grow.
Of course, we’ll also have a cushion of money sitting in the bank getting a smaller interest percentage. That’s Ok though because I want that security of some money being available without the worries of market ups and downs.
Taking the time to prioritize which vehicles you put your retirement dollars in is important. And if you’re on the path to FIRE (or already there), the de facto advice given might not be the most sensible for you.
You need to educate yourself on some of the nuances of each type of investment account to develop a strategy that works best for you.
Disclaimer: As always, don’t just take what I’m saying and run with it. This is just me talking out loud trying to figure out what works best for our particular situation. Consult a qualified financial planner for your specific needs.
Are you purposeful in each type of investment account you use to put your retirement savings into?
Thanks for reading!!