Is it possible to overfund your retirement accounts?
The conventional wisdom about retirement planning is that as much as possible should be deposited into an individual retirement account or 401 (k) as early as possible. While this all-in strategy makes sense for those looking to retire in their 60s or later, savers seeking financial independence or early retirement may need to be more aggressive.
“Throwing whatever you can into your retirement account isn’t necessarily the best strategy for people who follow FIRE,” said Victor Gersten, certified financial planner and owner of San Diego-based Barley Financial Planning.
Traditional IRAs and 401 (k) have severe penalties for withdrawing before 59½, so individuals planning to retire in their thirties through early 50s must make wise decisions about where to make their investments. Gersten recommends FIRE employees to distribute investments into three areas whenever possible: investment accounts, real estate and an ancillary business.
Retirement and broker accounts: Traditional retirement accounts still play a role. If your employer compares posts to a 401 (k), make sure you are saving enough to make that match. “Don’t leave any free money on the table. That’s rule number 1,” says Gersten.
Many FIRE supporters have high-paying jobs that they don’t want to stay in for long. In this case, Gersten recommends reaching the maximum of 401 (k) accounts and also fully funding an IRA. FIRE supporters may want to consider a Roth IRA as contributions can be withdrawn at any time with no tax or penalty. However, all Roth earnings must remain in the account up to the age of 59½, otherwise there is a risk of a 10% early withdrawal penalty.
For additional long-term savings, consider holding low-cost assets like index funds in a regular brokerage account that allows you to withdraw cash before the age of 59 with no penalties. However, you still need to develop a strategy to cover the tax liability associated with selling assets to fund your retirement life. One way is to take advantage of the tax benefits that come from investing in a personal business or property.
Beyond investment accounts: Gersten suggests that FIRE supporters invest up to a third of their assets directly in rental properties, both for diversification and tax administration. Landlords can deduct mortgage interest, upkeep, and depreciation to offset the cost of owning the rental property as well as capital gains taxes incurred on selling brokerage investments.
Furthermore, Gersten compares renting properties to owning an annuity – more so than real estate investment trusts that offer dividends. Rentals can provide consistent cash flow that can help investors stay away from their investment accounts and trigger capital gains taxes well into the future. As a hard commodity likely to be upgraded, a single property can potentially provide a source of income for the rest of an individual’s life, he says.
Do the rush: Another option is to have any side business of any kind that offers a similar mix of cash flow and tax benefits. Entrepreneurs can write off certain business expenses to offset taxes on other investments.
Barley admits that there is no one formula for everyone. Some investors may think real estate is their golden ticket, while others may not be interested in being a landlord – or running a business.
His bottom line, however, is to look for other types of assets and accounts so that your future cash flow is not limited to vehicles specifically designed for those looking to reach a more traditional retirement age. “I can’t stress it anymore,” he says. “Diversify everything you can.”
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