For early retirees, the decision between maximizing 401k contributions and investing in a taxable brokerage account can have significant implications for retirement savings. To illustrate this, let's consider an example: suppose you contribute $10,000 per year to a 401k, with an expected 7% annual return, compounded annually. Over 10 years, this would result in a total contribution of $100,000 and an estimated balance of $196,715. In contrast, if you were to invest the same amount in a taxable brokerage account, with a 24% tax bracket and 7% annual return, you would owe $1,680 in taxes per year, assuming all gains are taxed as ordinary income. This would result in an estimated balance of $173,919 after 10 years, a difference of $22,796.
This disparity highlights the importance of understanding the tradeoffs between these two investment vehicles. A 401k (retirement account) offers tax-deferred growth, meaning you won't pay taxes on the investment gains until withdrawal, typically in retirement when you may be in a lower tax bracket. In contrast, a taxable brokerage account requires you to pay taxes on investment gains each year.
Tax Efficiency and the Roth Conversion Ladder
The Roth conversion ladder strategy involves converting traditional 401k or IRA funds to a Roth IRA, which allows tax-free growth and withdrawals. This strategy can be particularly beneficial for early retirees who expect to be in a higher tax bracket during their working years than in retirement. For example, if you convert $50,000 from a traditional 401k to a Roth IRA and it grows to $75,000, you won't owe taxes on the $25,000 gain, providing a tax-free source of income in retirement. Here's a step-by-step breakdown of the conversion process:
- Convert $50,000 from traditional 401k to Roth IRA, paying 24% taxes on the conversion, or $12,000.
- The remaining $38,000 grows to $75,000 over 10 years, with a 7% annual return, compounded annually.
- The $25,000 gain is tax-free, providing a source of income in retirement.
Bridge Strategies for Early Retirement
Bridge strategies, such as using a taxable brokerage account or a Roth IRA as a bridge to cover expenses until other retirement accounts can be accessed penalty-free, are crucial for early retirees. The Freedom Calculator can help you determine how much you need to save in each type of account to achieve your early retirement goals, considering factors like savings rate (the percentage of income saved per year), real return (the return on investment after inflation), and the 4% rule (withdraw 4% of your portfolio per year, indexed to inflation), which is a common guideline for sustainable retirement income.
For instance, suppose you want to retire at 45 and expect to need $50,000 per year in retirement, with a 25x rule (save 25 times your annual expenses) savings target. You could use the following calculations to determine your required savings:
- Determine your total savings needed: $50,000 per year x 25 = $1,250,000.
- Calculate your required monthly savings: $1,250,000 / 20 years = $62,500 per year, or $5,208 per month.
- Consider using a taxable brokerage account or Roth IRA as a bridge to cover expenses until your 401k or other retirement accounts can be accessed penalty-free.
When Taxable Brokerage Wins
While tax-deferred accounts like 401k are beneficial for long-term savings, there are scenarios where investing in a taxable brokerage account makes sense, especially for those pursuing LeanFIRE (living frugally in early retirement, with a focus on minimizing expenses) or FatFIRE (maintaining a high standard of living in early retirement, with a focus on maximizing income) strategies. For instance, if you expect your income in early retirement to be very low, the tax implications of a taxable brokerage account might be minimal, making it a viable option for accessing funds before traditional retirement accounts without penalty.
In conclusion, the choice between maximizing 401k contributions and investing in a taxable brokerage account for early retirement depends on your individual financial situation, tax bracket, and retirement goals. By understanding the tradeoffs between these two investment vehicles and considering bridge strategies and Roth conversion ladders, you can optimize your retirement savings and achieve your goals. For example, if you have a high income and expect to be in a lower tax bracket in retirement, maximizing 401k contributions may be the better choice. However, if you expect to be in a higher tax bracket in retirement, investing in a taxable brokerage account may be more beneficial.
New to FIRE? See our primer at https://freedomcalc.app/what-is-fire.
Tools worth looking at
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- Empower — Free net worth tracking, portfolio analysis, and retirement planner. The dashboard serious FIRE chasers actually use.
- Acorns — Round-ups that invest your spare change automatically. The lowest-friction way to start investing if you have been putting it off.
- Wealthfront — Tax-loss harvesting, a 5% cash account, and direct indexing once you cross $100k. Solid robo for the set-and-forget crowd.