Why Savers Pursuing Early Retirement Should Consider Limiting 401(k), IRA Contributions

Barron's - November 23, 2020



Is it possible to overfund your retirement accounts?


The conventional wisdom about retirement savings says to put as much as possible into an individual retirement account or 401(k) as early as possible. While this all-in strategy makes sense for those planning to retire in their 60s or later, savers looking to achieve financial independence or to retire early might need to be more aggressive.

"Throwing everything you can at your retirement account is not necessarily the best strategy for people following FIRE," says Victor Gersten, a certified financial planner and the owner of San Diego-based Gersten Financial Planning.

Traditional IRAs and 401(k)s have stiff penalties for withdrawals made before 59½, so people planning to retire in their 30s through early 50s must choose where they put their investments wisely. Gersten recommends FIRE pursuants distribute investments among three buckets if possible: investment accounts, real estate, and a side business.

Retirement and brokerage accounts: Traditional retirement accounts still have a role to play. If your employer matches contributions to a 401(k), make sure you save enough to meet that match. "Don't leave any free money on the table. That's rule No. 1," Gersten says.

Many FIRE adherents have high-paying jobs they don't plan to stay in very long. If this is the case, Gersten recommends maxing out 401(k) accounts and fully funding an IRA as well. FIRE adherents may want to consider a Roth IRA, as contributions can be withdrawn at any time tax-and penalty-free. However, any Roth earnings must remain in the account until age 59½ or risk being subject to a 10% early-withdrawal penalty.

For additional long-term savings, consider holding low-cost investments, such as index funds, in a regular brokerage account that lets you withdraw money without penalties before age 59½. However, you will still need to strategize about covering the tax liability that comes with selling investments to fund your retirement lifestyle. One way to do so is by taking advantage of the tax benefits afforded by investing in a personal business or real estate. Beyond investment accounts: Gersten suggests that FIRE adherents invest up to a third of their wealth directly in rental properties, both for diversification and tax management. Landlords can deduct mortgage interest, maintenance, and depreciation to help offset the cost of owning the rental property along with capital gains taxes incurred by selling investments from brokerage accounts.

What's more, Gersten likens rental properties to owning an annuity —more so than real estate investment trusts that offer dividends. Rental properties can provide consistent cash flow that may help investors avoid drawing on their investment accounts and triggering capital-gains tax until well into the future. As a hard asset that is likely to appreciate, a single property can potentially provide a source of income for the rest of an individual's life, he says.

Do the hustle: Another option is to run a side business of any kind, which would provide a similar mix of cash flow and tax benefits. Business owners can write off certain business expenses to offset taxes from other investments.

Gersten acknowledges that there's no single formula for everyone. Some investors may feel like real estate is their golden ticket, while others may not be interested in being landlords - or running a business, for that matter.

His bottom line, though, is to look for other types of assets and accounts so your future cash flow isn't restricted to vehicles that are specifically designed for people targeting a more traditional retirement age. "I cannot stress it more," he says. "Diversify all you can."


By Donna Sellinger



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