Early Retirement and Taxes

[recursion49]

Hi everyone!

I'm a new member to this forum, who's taken an interest in retiring early. I am 23 years old this year, and hoping to retire between 45-55. I've just started work at a major corporation as a financial analyst, and have been offered numerous options for long-term savings. Since the system is as complex as it is, I was hoping for some advice from the more experienced people of this board, to guide me towards my goals.

Marital status: Single
Current income: $50,000/annual
Employee stock purchase plan: 15% discount below price at enrollment start and end date, whichever is lower.
Others: 401(k) and Roth 401(k), open to starting an IRA or Roth IRA.
Current actions: 10% ESPP, 6% 401(k), 6% Roth 401(k), 4.5% employer match for 401(k)
Situation: Managed to complete college debt-free, and just started career.

I understand that a Roth 401(k) makes more sense for people who expect to pay higher taxes in the future. However, if the best case scenario - that I retire before 55 - pans out, then I should be in a relatively low tax bracket later on. Therefore, should I just focus on the traditional 401(k)?

Also, are there any other suggestions for improving my chances of early retirement? I read plenty about Roth conversions and the like, but it all seems rather risky, especially when done incorrectly. There's also a lot of advice about maxing out on 401k and IRA plans, but I can't decide on how much would actually save.

Any help would be greatly appreciated!

[xyz]

I would give the same advice I have given my sons who are now a little older than you. Save, save and save now... the earlier you begin the better. You are a financial analyst do the math and look at what dollars invested today will become in 20 - 25 years for you. If you get used to living on less than what you earn (and if you work in a good comany your income will increase quickly) you can save easily and still have money left over to enjoy your life. I am a believer in working on both sides of the equation not only save but work on increasing your income. I would definitely put money into after tax opportunities while your income is in the guidelines (Roth/IRA) if your career takes off and you are making a large salary you can no longer get all the advantages of a Roth and an IRA. I am funding my early retirement with a combination of before and after tax dollars in order to maintain an income where I pay little or no taxes in retirement. Looks like you are off to a great start!!

[recursion49]

Thanks for the kind words! I'm trying to figure out ways to reduce my tax bills, while also saving for the future. However, it's a little tough, given the myriad of choices available, all with their own pros and cons. For instance, the HSA is a good tool for setting aside pre-tax dollars for healthcare uses, and can be converted into a retirement account later.

I'm hoping to find some guidance as to how to effectively optimize my tax position without compromising my future income. Still, saving now is definitely better than spending now!

[pb4uski]

One thing to keep in mind in your planning is that most tax deferred plans (401k's, IRAs, etc) have a 10% penalty for withdrawals prior to age 59 1/2 unless you do distributions over your remaining lifetime, so if you plan to retire at 45-55 you will need to have a lot of taxable investments to carry you from your early retirement age to age 59 1/2.

In addition to the normal stuff (save like crazy, LBYM, maximize company match, invest in low cost index funds, etc) one thing is to consider the diversity of your retirement income sources between taxable, tax-deferred and tax free accounts. There are many people on these boards who have a huge stash in tax-deferred accounts but find it hard to retire early because they don't have good sources of funds to carry them from ER to when they can begin tapping their tax-deferred savings without penalty.

[pb4uski]

I use my HSA sort of like a Roth. I fully fund it and when I was w*rking it served to extend the amounts that I could save tax free but I paid for all my medical costs out of cash flow so the HSA is sitting there and growing and I'll tap it for medical expenses later in life. I do keep track of medical expenses so I could access it penalty free if I needed to.

[recursion49]

That's a good point. However, I read that an exception can be made for 401(k) if I leave my job before 55 - the 72(t) or something. I do have some assets in nonretirement mutual funds (which I might convert to ETFs).

[recursion49]

I guess that's an interesting way of using an HSA to increase your annual contributions. I will look into more resources for saving for retirement. There's a lot of thinking to do, especially with a million different savings accounts!

[RunningBum]

Hi and welcome wzx!

It's hard to imagine what the tax laws will be when you retire. I disagree that Roth conversions are risky, as in fact you can reverse (recharacterize) them if they go wrong, but they are complicated.

If your 401K and exemption and deductions are pushing you down into the 15% bracket, that's where I'd stop with the traditional IRA. It doesn't make sense to me to defer taxes from a 15% rate to what might be a higher rate later. You might even think that the 25% bracket isn't worth deferring and you'd be better off with the Roth 401K or Roth IRA. It's not clear to me. As your income grows and puts you into a higher tax bracket, the traditional 401K looks better. Some people have found out that they put so much into a 401K over the years that when they retired and had to take RMDs that they were still in a high tax bracket. You might look at what 30 years of maxing out your 401K gives you and what that's going to mean in retirement taxes. It may be that you want to focus on the Roth now at a lower income level, and defer taxes with a regular 401K when your income is higher.

Roth 401K vs Roth IRA? Make sure you get the full company match with the 401K. After that, you'll have more choices opening your own Roth IRA, unless the company has access to some great funds that you couldn't get on your own. Fees are almost always higher in 401K plans. You could also get to your Roth IRA contributions without taxes or penalty if you needed them in an emergency or major purchase like a house. But the Roth 401K has a higher limit, I think $16.5K instead of $5K.

As far as maxing out, I would first make sure you get the company match on whichever 401K you do. Then you might want to put some in a taxable account to save for major purchases such as a house or car. Mortgages are low in interest and deductible, but car payments start getting into the credit card interest range and should be avoided. Of course you need the discipline to keep from dipping into this money for luxuries you don't need. A taxable account also helps bridge the years from ER until you can start withdrawing from IRAs and collecting social security (and possibly pensions).

You're on the right track with starting to save as much as you can now and thinking about all of these things. It also helps a lot to keep an eye on your spending. Obviously stay out of credit card debt. If you can maintain a modest lifestyle, not only will you be able to save more, but with that lifestyle you'll need less in retirement and can retire early. Enjoy life and don't live like a monk, but if you're the type to eat every meal out or get the latest in electronic gadgets (and it doesn't sound like you are), think about what that's doing to your retirement plan.

Not sure if I really answered any questions or just caused you more puzzlement. fairmark.com does a good job of explaining what the various options are with some comparisons between them. Note for example the advantage of rolling a Roth 401K into an existing Roth IRA with respect to the 5 year distribution rule.

[RISP]

If you decide to take part in the employee stock purchase plan, be aware that having both your work income and an investment tied to the same company constitutes a concentration risk. I'm not saying you shouldn't do it, but make sure you don't have a major part of your portfolio in the stock of your employer. If the company should ever get into trouble, you may get burnt twice (job loss and falling stock price).
I personally don't own stock of my employer as we don't have an employee stock purchase plan, but if I did, I would want to keep that below 5% of my total portfolio. YMMV.

[RunningBum]

RISP has a good point, and what some people do is to immediately sell it when they get it to get the 15+% profit. If it's gone up a lot during the purchase period you could hold it long enough to get LTCG treatment on those gains and then sell.

[RISP]

@RunningBum: Every such plan I ever heard about has a vesting period where you can't sell the stock. That may be a European thing, but if you can actually sell immediately, a free 15% (minus transaction costs and taxes) is obviously fantastic! I would definitely max that out, and invest the increased amount afterwards.

[East Texas]

In order to reach your goal, you need to understand the basic lifestyle that's allowed most of us to retire early and in reasonable comfort.

Live below your means. Support your financial savings and investment plans before you splurge on "gotta have" stuff. Just because you can afford that new car doesn't mean you need it. Also, learn to cook because eating out takes a chunk of money. Think before you buy. It's a lot cheaper to have a good pair of shoes half-soled and heeled than buy new ones. I also brown-bagged my lunch every day except on special occasions.

Surround yourself with friends who have similar financial values. Spenders and savers have polarized co-dependent relationships. It's easier for savers to get sucked into the spender's lifestyle than the other way around.

DO NOT CO-SIGN for anyone. Never. Carve that line in stone. That means your mother / father/ grandma / favorite cousin / sister / brother / (unmarried) significant other. Anyone who needs a co-signer has (1) already messed up their credit or (2) is buying something they can't afford. It's the easiest way to blow up your financial plan. Your mantra is "I don't co-sign." You don't need to defend your decision.

I have a dog-eared copy of The Millionaire Next Door and Dave Ramsey's Financial Peace and I can highly recommend both books.

I was just a few years older than you when I decided I wanted to retire at 55. And I did. Living frugally just wasn't that hard to do.

[grasshopper]

Ms G and I were over the income limit on Roth's most year before retiring, so starting early contributions is a good thing. Because our deferred contributions were limited, we made a lot of taxable investments, which was a good thing. Retiring at 54/51 with a large taxable portfolio, gave flexibility in retirement. We are now converting tIRS's to Roth's to avoid RMD's later down the road, and will be able to take SS later.

[East Texas]

My one regret is I didn't have more of my savings and investment monies taxed. I fear I'm going to get hit as hard, if not harder, by the tax man in retirement (proportionately) than I did when working. Thank goodness I don't have FICA to figure into the equation.

But, if that's my only woulda / shoulda/ coulda then I'm pretty far ahead of the game. In another year my after-tax income will be more than I brought home when I was working. Sweet!

[Bestwifeever]

Quote:

Originally Posted by wzxchange Hi everyone! I'm a new member to this forum, who's taken an interest in retiring early. I am 23 years old this year, and hoping to retire between 45-55. I've just started work at a major corporation as a financial analyst, ...!

Welcome to the forums! And you know we're going to be asking YOU for your opinion on handing financial matters too .

[Animorph]

Roth conversions are easier than ESPP's. Be sure to read the tax rules on ESPP's before you sell. And double check to see if your company has included the "normal income" portion of your gains in your W2 or not.

I'd go heavily into the Roth contributions, half and half is not a bad choice. It depends on future tax rates. Consider that pre-tax contributions now probably save you exactly 15%. Withdrawals in the future (assuming no tax changes) might be taxed partly at 0% and partly at 15%, so the average tax rate might be below 15% coming out. That favors the regular 401k. On the other hand, you can save more after-tax value in a Roth account since the contribution limits are the same but no taxes are taken out when you withdraw the money. So if taxes are close to equal in and out, the Roth comes out ahead. Used together now and in retirement, you can try to stay within a lower tax bracket using the traditional/Roth combo to minimize taxes.

Contributions (but not investment gains) to a Roth IRA can be taken out without penalty, but there is a 5-year aging rule to watch out for there. That might serve as emergency fund and pre-59 1/2 funding. A healthy taxable account can also be useful, but most likely only after you have maxed out the 401k.

[RunningBum]

Quote:

Originally Posted by RISP @RunningBum: Every such plan I ever heard about has a vesting period where you can't sell the stock. That may be a European thing, but if you can actually sell immediately, a free 15% (minus transaction costs and taxes) is obviously fantastic! I would definitely max that out, and invest the increased amount afterwards.

The last place I worked (in the US) had a 6 month purchase period. Up to 10% (your choice) was deducted from each paycheck, and at the end of the 6 months they bought at a 15% discount of the lower of the two prices at the start and end of the purchase period. It might take a few days for the stock to be place in your account, but then you were free to sell. I'm under the impression this was pretty standard.

[RISP]

Ok, let's do an example: Stock price at the beginning of the purchase period 200$, stock price at the end 100$. I buy for 100$-15%=85$ and sell for 100$ immediately. -> 15$ gain on an 85$ investment per share, or 17.6% risk free profit before taxes and transaction costs.
So the worst case is that the stock price fell during these 6 months, and if you sell immediately, you gain 17.6%? More if the price went up during the purchase period? How would anybody not max this out? That's the closest to a free lunch I've ever heard about.

[Animorph]

Quote:

Originally Posted by RISP Ok, let's do an example: Stock price at the beginning of the purchase period 200$, stock price at the end 100$. I buy for 100$-15%=85$ and sell for 100$ immediately. -> 15$ gain on an 85$ investment per share, or 17.6% risk free profit before taxes and transaction costs. So the worst case is that the stock price fell during these 6 months, and if you sell immediately, you gain 17.6%? More if the price went up during the purchase period? How would anybody not max this out? That's the closest to a free lunch I've ever heard about.

That's pretty much it, with a lot of other tax rules thrown in. It does tie up your money for the half year, so there is an opportunity cost. And there is the tax complications that can be a pain.

DW just finished an ESPP period with a big drop in her company stock before we managed to sell (some companies will automatically sell it for you at the final price, but her's doesn't). We made enough to pay for taxes and fees and a few hundred extra by waiting for the stock to rise a little bit again before selling. Not part of our AA, no desire to hold it for a bigger gain.

[kumquat]

Welcome.

I can't make any specific suggestions since I'm subject to different tax laws than you. My general suggestions are:
- do what it takes to get the max employer match
- save early and often
- defer taxes when you can
- don't let the tax tail wag the investment dog
- ENJOY LIFE, it may be shorter than you think