I am on a one-man crusade, and I will not rest until you max out your tax-deferred retirement accounts. When I say tax-deferred I’m talking about pre-tax retirement accounts - 401(k)s, 403(b)s, 457s, IRAs, and whatever other alphabet soup the IRS is currently dreaming up. They look complex all lined up together, but they’re actually pretty simple and mostly work the same way: they let you invest money before it actually ‘hits’ your paycheck. Why is this so powerful? For a few reasons:
- You pay less taxes today. This gives you extra money to invest earlier in life, accessing the magic of compound interest. Think of it as a free loan from the government.
- When you do eventually pay taxes on the money, there’s a good chance you’ll pay less. This is because retirees generally make and spend less than they did in their prime earning years and their taxes are lower.
- The fact that it’s administered through your job and funded through your paycheck makes it less work to set up. This means it’s the plan you’re most likely to have and actually use.
- You can move money around in these accounts all you want, buying and selling without paying capital gains tax at the end of the year. Yearly dividends escape taxation too.
- Some companies offer matching funds up to a certain percentage. This is the holy grail of investment: free money and a guaranteed return.
Combined, these benefits are an adrenaline shot into the heart of your investments. They will quite literally shave years off of your journey to financial independence. So why isn’t everyone stuffing these accounts until they’re bursting?
One reason is that tax-deferred accounts act as a kind of tax jail for your money. It’s a plush jail, to be sure, with great food and a state of the art recreation center - but a jail nonetheless. The IRS warns of penalties for breaking this money out of jail before you’re age 59 ½. For a certain kind of person who wants liquidity and access to their money, this sounds like a bad deal. What if they need their money in a pinch? What if they over-save and can actually retire early, except then their money is just out of arm’s reach? Shouldn’t these people hedge their bets and put some money in an after-tax, vanilla investment account?
No. The best advice for almost anyone is still to completely max out tax-advantaged accounts as much as possible. If you need the money early, you can get it. There are lots of ways. I’ll show you a few:
Personal or Residential Loans. If you need access to your money, you are allowed to borrow from your pre-tax accounts. This ‘borrowing’ is in essence taking a loan out from yourself. Your plan provider will enforce payback of this loan including interest, which you pay back to yourself. You can borrow for any reason, but there is a special case identified in most plans: purchasing your first home. Generally the terms are better home loans. While this sounds great on the surface (you’re paying the interest to yourself!), it is inadvisable unless there is a true emergency. If you want your money to grow, it has to be in the account. Remove it and you’re missing out.
Substantially Equal Periodic Payment (SEPP). If you’re one of the lucky few to amass enough savings to retire before age 59 ½ , SEPP might be your best friend. SEPP, also called 72(t) after the IRS provision that created it, allows you to remove a small portion of your pre-tax money each year without paying a penalty. The exact amount allowed is determined by the IRS and is based on life expectancy and a few other variables. It’s complicated, to be honest. But for our purposes, let’s just pick 3% as a rough guestimate. You can remove 3% of your account’s value each year. There is one catch: you must withdraw this amount every year until you’re 59 ½ or you’ll pay a substantial penalty. Think of it like a rollercoaster: once it starts up, please don’t try getting off until it’s over.
The Roth Conversion Pipeline. No, this is not a controversial piece of energy legislation. The Roth Conversion Pipeline allows a careful planner to phase money from a pre-tax account to a taxable account without paying a penalty. It’s a bit complicated, but here’s how it works.
Step 1: Each year, roll some money from your pre-tax account into a Roth IRA. The IRS allows you to do this once per year. You pay regular income tax on the conversion but you do not pay a penalty.
Step 2: Wait five years. The IRS allows principal to be withdrawn from a Roth IRA without penalty after five years. Their thought is that it’s your money and you’ve already paid taxes on it.
Step 3: Withdraw the money. As long as it’s the same amount as you put in five years ago, you’ll pay no taxes or penalties on the principal (gains would be taxed).
Here’s a crude visual of your money as it sloshes its way down a Roth IRA pipeline:
The benefit of this method is that you have total control of how much money you’re removing. Also, your tax bill upon transfer is a function of your income bracket. Meaning if you transfer during low-income years, you may pay little or no tax on the transfer itself.
The problem with this method is that it requires you to plan five years ahead, something not all of us are capable of doing. And if the IRS stops by to check in on you, you’d better have some detailed notes to show them.
Straight up Taking the Money. I could write ten articles about why not to do this. In fact, I’ll save you the reading time and give you one simple sentence: removing money from a pre-tax account is worse than never having saved it in the first place. You pay your original taxes and a 10% penalty. You’re stealing from your future self as a steep premium. But I’m being thorough, so I have to list this as an option. If you’re desperate for money, you can remove it and pay the penalty. No one’s going to arrest you for doing so; after all, it’s your money. But I’d suggest taking the self-loan over this option.
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I referred to pre-tax accounts earlier as a kind of money jail. If that’s true, it’s a poorly run jail. The guards nap on theirs shifts and no one is mending the giant holes in the yard fences. Hundreds of inmates escape every year, and the warden does little more than wave a friendly goodbye to them. Worry about the money jail should not stop you from maxing out your tax-advantaged accounts. Try as hard as you can to hit the 2016 limit or $18,000. If you need the money later, you can get it.