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Should I Stop Contributing to Retirement Accounts if I’m Planning on Early Retirement?

A reader writes in, asking:

“The conventional wisdom of retirement saving is to put as much money as possible into retirement accounts rather than normal brokerage accounts. I’ve done this for years, but I’m considering if I should stop contributing to my 401 and IRA because I am planning on an early retirement. My employer does not offer a match, so I wouldn’t be missing anything there.”

As with any tax-planning question, the answer is, “it depends.” In most cases, however, it makes sense to continue contributing to retirement accounts, even if you’re planning on retiring early.

For people (unlike our reader) for whom a 401(k) match is available, it definitely makes sense to get that match, regardless of planned retirement age.

Accessing Your Money

A concern that many people have if they’re planning to retire prior to age 59.5, is that they will have to pay a 10% penalty to get to their money. But the 10% penalty can typically be avoided with sufficient planning.

For instance, any money that you contributed to a Roth IRA (as opposed to earnings in the account or amounts in the account as a result of Roth conversions) can be taken out of the account at any time, free from tax or penalty.

And if you retire in (or after) the year in which you turn age 55, money in your 401(k) with your most recent employer will be available penalty-free. (For public safety government employees, it’s age 50 rather than 55.)

Then there’s a whole list of other exceptions to the 10% penalty that you might be able to take advantage of. Most importantly, you can take money out of a retirement account penalty-free if you do it as part of a “series of substantially equal periodic payments” that lasts 5 years or until you’ve reached age 59.5, whichever comes later. (This rule is available to anybody, so it can be super helpful as part of an early retirement plan. It is, however, complicated. So it’s important to do your research and, most likely, work with a tax professional.)

Finally, it’s worth noting that if you’re planning to retire very early, it’s likely that you’re going to be saving more per year than you can contribute to retirement accounts anyway. So you’re going to have some savings in taxable accounts even if you continue contributing as much as possible to retirement accounts.

Other Considerations

All of the above deals with whether you would have tax-free/penalty-free access to the money. But that’s only part of the analysis.

Once you have a good idea of whether the penalty will be applicable or not for the money in question, you would want to consider the following factors:

  • What is my current marginal tax rate?* (That is, how much value would you get from having a smaller taxable income this year as a result of contributing to a tax-deferred account?)
  • What will be my marginal tax rate (including 10% penalty, if applicable) when this money comes out of the account?
  • How much value would I get as a result of having the money in a retirement account? (That is, how valuable is the faster rate of growth that will occur as a result of not having to pay tax each year on interest/dividends?**)

*As always, “marginal tax rate” might be something other than just your tax bracket. For instance, your current marginal tax rate could be greater than your tax bracket if making a contribution to a tax-deferred account would allow you to claim the retirement savings contribution credit — or if it reduces your adjusted gross income to a level such that you can claim some other deduction/credit.

**The longer your money is expected to be in the account, the more valuable this faster rate of growth. Also, a key point is that if you’re in the 15% tax bracket or below — and you expect to stay there — qualified dividends and long-term capital gains are already tax-free in a normal taxable account. So having the money in a retirement account won’t provide nearly the same benefit as it would for somebody in a higher tax bracket.

Is It a Good Idea to Front-load 401(k) Contributions?

A reader writes in, asking:

“On dollar cost averaging, if you can frontload your entire max 401(k) contribution to the first half of the year, is there a reason not to? It seems like you’d give it more time to do its compound interest thing, and in general the market trend is up over time.”

In many cases, yes, it makes great sense to max out your 401(k) contributions as early in the year as possible, in order to get the money invested as early as possible. (Ditto with IRA contributions, for the same reason.)

In some cases, however, doing so can cause you to miss out on part of the employer matching contribution — if your employer offers one. It all depends on how the plan actually calculates the matching contribution each pay period.

For example, consider three different hypothetical 401(k) plans, each of which could be described as having a “dollar for dollar match, up to 4% of compensation.”

With Plan A, the employer matches every dollar you’ve put in, until you hit 4% of your annual compensation. So by front-loading, you get your maximum match, and you get it early in the year. Great!

With Plan B, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you have contributed an equal amount already in the year. So by front-loading you get your own money invested as soon as possible, and you still get the maximum match, but it doesn’t speed up the rate at which you get the matching contribution (i.e., you still only get 4% per pay period). Still, front-loading is probably a good idea, if you can do it.

With Plan C, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you contributed an equal amount in that pay period. In this case, if you front-load your contribution, you actually end up missing out on part of the match. For example, if you max out the 401(k) in the first quarter of the year, you would not get any matching contribution in the final three quarters, because you didn’t contribute anything in those pay periods. In other words, you’d miss out on 3/4 of your total possible maximum match.

So, in short, it’s important to have a discussion with the plan administrator about how exactly the matching contribution is calculated (if there is one). Or, if you really want to be sure, get a hold of the plan document and read for yourself how the matching contribution is calculated.

Should I Put Stocks in My Roth IRA and Bonds in My Traditional IRA?

A reader writes in, asking:

“If I have a Roth IRA and traditional IRA, is it better to put my stock funds in the Roth and the bond funds in the traditional IRA? That seems preferable, because as long as stocks do earn more than bonds it would leave me with more money down the road because the Roth is tax-free.”

Yes, it is often preferable to put your investments with higher expected returns in Roth accounts rather than tax-deferred accounts — but not for the reason you mentioned.

Loading up your Roth accounts (as opposed to tax-deferred accounts) with investments with higher expected returns will (assuming “expectations” pan out) leave you with more money to spend after taxes than if you had taken a different approach. But that’s simply because you took on more risk.

By putting your high-risk investments in a Roth, you expose yourself to more risk than you would if you had an equal allocation in both tax-deferred and Roth. The reason for this is that you feel the full effect of fluctuations in the balance of your Roth IRA, whereas you only feel a portion of the effect of fluctuations in the balance of tax-deferred accounts.

For example, imagine that you expect to have a marginal tax rate of 25% during retirement. If your Roth IRA’s value changes by $20,000, that changes the amount of money you have available to spend by $20,000. In contrast, if your traditional IRA’s value changes by $20,000, the amount of money you have available to spend only changes by $15,000 (because $20,000 in the traditional IRA is only worth $15,000 to you, given a 25% marginal tax rate).

In other words, using your Roth IRA entirely for high-risk investments is very similar to just bumping up your allocation to high-risk investments in the first place — it will likely result in more money in the end, but at the cost of higher risk.

Now, having said that, it does typically make sense to prefer to use the Roth for investments with higher expected returns.

Why?

Because Roth IRAs Have No RMDs

As long as a Roth IRA is owned by its original owner (as opposed to being owned by a beneficiary after the death of the original owner), RMDs do not have to be taken from the account at any point.

So, in that sense, you would prefer to have a Roth IRA of a given size rather than a proportionally-larger traditional IRA, because the Roth gives you better control over your money.

For example, you would rather have $75,000 in a Roth IRA than $100,000 in a traditional IRA with a 25% marginal tax rate, despite the fact that the two amounts are functionally equivalent in terms of how much they leave you with after taxes.

For that reason, it does typically make sense to use your Roth accounts for the investments with the highest expected return. But you should be aware that in doing so, you increase your overall risk, so you may want to compensate by reducing risk slightly in some other manner.

Can You Double-Count Earnings for IRA and 401(k) Contributions?

A reader writes in, asking:

“My spouse is retired, and I recently began semi-retirement, working just a few days each month. Because of a pension and paid off house, we won’t be spending from our retirement savings. My question regards contributions to retirement accounts with a small amount of income.

My employer offers a 401k. Let’s say I earn $10,000 in 2016. Can my wife and I each contribute the maximum to a Roth IRA? Essentially what I’m asking is can we each count the $10,000 as income? And does that change if I contribute to the 401k?”

First let’s back up a step for readers unfamiliar with this topic. In addition to the normal IRA contribution limits, there is also a rule which says that your IRA contributions for each year are limited to your compensation for that year (i.e., wages, commissions, self-employment earnings, alimony, and nontaxable combat pay).

There is an exception to this compensation-related limit for married people, but for the moment let’s focus on the simpler situation of an unmarried person.

Contributing to a 401(k) and IRA

Your IRA contribution is limited to your compensation for the year. For people earning wages (as opposed to self-employment income) the relevant amount is the amount reported in box 1 of Form W-2. Of note, that figure has already been reduced by any pre-tax (i.e., “traditional”) 401(k) contributions that you make for the year. In other words, if your earned income is low enough, contributing to a pre-tax 401(k) would reduce the amount of IRA contributions that you can make.

Example: Beth earns $5,000 this year. If she doesn’t contribute anything to a retirement plan at work, she can contribute the entire amount to a Roth IRA.* However, if her employer offers a 401(k) and she decides to make pre-tax contributions to that plan, those contributions would reduce the amount of wages that show up in box 1 on her W-2, thereby reducing the amount she can contribute to her Roth IRA.

Things work differently, however, if it is a Roth 401(k) to which you are contributing at work. Specifically, the amount of wages reported in box 1 on Form W-2 is not reduced by the amount of Roth 401(k) contributions that you make. In other words, you can essentially “double count” your earned income by contributing to a Roth 401(k) and a Roth IRA.

Example: Beth earns $5,000 this year. If she contributes $5,000 to a Roth 401(k), she can still contribute $5,000 to a Roth IRA.

Spousal IRA Contribution Limits

As mentioned above, there is an exception to the rule that your IRA contributions for each year are limited to your compensation for that year. Specifically, in a married couple, for the spouse with the lower amount of compensation for the year, the compensation-related limit is calculated as:

  1. The compensation of the spouse in question, plus
  2. The compensation of the other spouse (i.e., the one with higher earnings), minus
  3. Any IRA contributions the other spouse (the higher-earning one) has made for the year.

Example: Bob and Jane are married, both age 60. Bob is retired. Jane still works part-time, earning $20,000 per year. Jane does not contribute to a retirement plan at work. She does, however, contribute $6,500 to a Roth IRA for the year. Despite having zero compensation for the year, Bob can also contribute $6,500 to a Roth IRA, because Jane’s compensation is sufficiently high for both of them to make contributions.*

A key point here is that spousal IRAs do not allow for “double counting” of income. For example, if Jane in our previous example only earned $5,000 for the year and she contributed $5,000 to a Roth IRA, Bob wouldn’t be able to make any Roth IRA contribution.

*For the sake of simplicity, we are assuming here that the MAGI-related income limits are not an issue.

Transferring an IRA and 401(k) in a Divorce

A reader writes in, asking:

“My divorce was finalized a few weeks ago, and I am supposed to receive a portion of my ex-husband’s IRA and 401k. Are there any specific rules to follow as far as how to move the money from his accounts to my IRA? Or does he just take the money out, write me a check for the appropriate amount, and I deposit the money in my IRA?”

Yes, there are specific rules to follow. And it’s important to note that the rules are different for IRAs than for employer-sponsored retirement plans. Let’s talk about IRAs first.

Transferring IRA Assets in a Divorce

Publication 590-A speaks to transferring an IRA after a divorce. There are two key points here.

The first key point is that there are two ways to do it:

  1. Change the name on the account (in cases in which the entire account is being transferred to you), or
  2. Move the money via a direct trustee-to-trustee transfer, in which the money is sent directly from one financial institution to the other.

A check written to you is a problem, because it does not fall under either of these options. That is, it is not possible to do a “rollover” in which the money is sent to you, then you put it into your own IRA. It has to be a direct transfer from one financial institution to the other (i.e., from the custodian of your ex-spouse’s IRA to the custodian of your IRA).

The second key point is that the divorce decree (or a written document incident to such decree) must specifically state that you are supposed to get this interest in your ex-spouse’s IRA.

Transferring 401(k) Assets in a Divorce

The rules for an employer plan — such as a 401(k) or 403(b) — are different.

First, rather than the divorce decree needing to state that you’re supposed to get an interest in the account, it has to be a “qualified domestic relations order” (QDRO) that states that you get an interest in the account. Also, it’s critical that the order includes certain specific pieces information in order to qualify as a QDRO.

Second, with an employer plan, a rollover is possible. That is, as long as there is a QDRO ordering that you get the part of the account in question, the plan can make out a check to you, and you can then deposit it (i.e., “roll it”) into your IRA — though you only have 60 days (from the date you receive the distribution) to do so.

Can I Take a Loan from my IRA?

A reader writes in, asking:

“A friend recently told me that he took a loan from his IRA so he could take money out for a short time without having to pay penalty. I had never heard of that, so I called Vanguard and asked about it. They said that only 401k accounts have loans, not IRAs. Is that true? Was my friend wrong?”

The Vanguard representative is correct that IRA accounts do not have loan provisions, whereas many 401(k) plans do have such an option. (For more on 401(k) loans, see this MarketWatch article from Elizabeth O’Brien.)

Perhaps your friend was talking about the ability to “borrow” from an IRA by using the 60-day rollover provision.

To back up a step, there are two ways to move money from one IRA to another:

  1. Via a direct “trustee-to-trustee transfer,” in which you never have possession of the money, as it goes directly from one financial institution to the other, and
  2. Via a “60-day rollover.”

With a 60-day rollover, the first financial institution sends the money to you, and as long as you deposit an equal amount of money into an IRA within 60 days from the day you receive the distribution, it will be treated as if the distribution did not occur.

The 60-day rollover option exists so that you can move money from one retirement account provider to another. But it can also be used as a sort of short-term “IRA loan” mechanism, because it’s possible to simply deposit the appropriate amount of money back into the same account (rather than into an IRA with a different financial institution).

There is, however, one very important point to be aware of: You can only do one such 60-day rollover per year. So if you have executed such a rollover within the last year, you cannot “borrow” from your IRA in this manner, because you would not be able to put the money back into an IRA. (That is, the distribution would simply count as a normal distribution, potentially subject to the 10% penalty.) Similarly, if you do “borrow” from your IRA in this manner, you won’t be able to do so again within the next year, nor would you be able to do a normal 60-day IRA-to-IRA rollover during that period.

Of note, the one-per-year limit does not apply to:

  • Roth conversions (i.e., rollovers from a traditional IRA to a Roth IRA),
  • Direct trustee-to-trustee transfers, or
  • Rollovers involving an employer-sponsored plan (e.g., from a 401(k) to an IRA or vice versa).

Also, the one-per-year limit is no longer one rollover per IRA per year as it used to be, but rather one rollover per year regardless of how many IRAs you have.

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