Pop quiz: If you could choose to save $10,000 using one of two retirement income strategies, either a 401k or a regular taxable stock brokerage account, which one would you choose?

If you said “401k” (or really any other tax deferred savings account), then that’s what I would have expected you to say.  Why?  Because that’s what conventional financial planning advice teaches us.  We all know that if we want to have a solid retirement income, then we need to max out our tax-deferred savings, let it grow, and then worry about paying the taxes later.  And why not?  Things like 401k’s and IRA’s are perfectly valid strategies for saving as much as you can and building up your nest egg.

So you can imagine my hesitation and apprehension as I’m about to do the opposite with some of my money.

Funding My Early Retirement Ambitions With Taxable Savings:

Because early retirement is a strong goal of mine, I’ve been seriously contemplating changing my money design by moving some of the funds I normally invest in my 401k or 403b into my taxable brokerage account.  My intention would be to buy relatively safe dividend paying stocks.

Don’t worry.  I wouldn’t move all of it.  Just a little bit.  I still consider my tax deferred savings to be a major player among my retirement income strategies later on down the line.

So why even consider this?  Well, as I’ve discussed before in my plan for how to become financially independent. your taxable savings could play a HUGE part in accomplishing the dream of an early retirement.  Remember that your taxable accounts are accessible before age 59-1/2 whereas your tax-deferred accounts are not (unless you’re willing to take a devastating penalty).

But that move would pose a MAJOR concern:

• If I choose to save even just a portion of my money in my taxable investment account over my 401k or other tax deferred account, would that hurt me in the long run?  Would I be doing something I regret years later and sabotaging my own financial efforts?

That’s no joke.

The last thing I personally want to do (or inadvertently encourage any of you to do) is adhere to a plan for decades only to find out that you should have been doing something totally differently that would have yielded you a lot more money.

This has become one of my biggest challenges to planning and executing an early retirement.  Surely I do not want to shoot myself in the foot by diverting perfectly good money from my tax deferred accounts to my taxable accounts.

But at the same time, the writing is on the wall when it comes to early retirement.  If all you’ve ever done is save your money in a 401k or IRA, then you have NO early retirement income strategy.  It would be nearly impossible to access any of my fortune unless I want to file a 72T or pay the devastating 10% penalty.

So then it’s a question of opportunity .  How much potential investment or income potential am I willing to give up in order to satisfy this goal?

The answer may surprise you …

Re-Evaluating My Retirement Income Strategies:

Like anything in personal finance, there is only one thing I can do when you want to compare multiple strategies:

• Collect the facts.
• Build a model.
• Run the numbers and see what you get.

The Facts:

What do we know about investments using both types of accounts?

For the tax-deferred savings, let’s assume we’ll use a 401k plan.

• Contributions go in tax-free (before income taxes are taken out of your paycheck)
• Contributions grow tax-free
• Once you retire, you pay ordinary income taxes on whatever amount you withdrawal each year.  Typically that would be about 25% for most people.
• Taxes are paid on both the principal and gains withdrawn.

For the taxable investment account, let’s assume a brokerage stock full of regular common stocks.

• Contributions go in with after-tax money (after ordinary income taxes have been taken out of your paycheck)
• Contributions grow tax free until the stocks are sold .  In other words, if you buy a stock and hold it for 10 years, then you will not have to owe any taxes on it until the day you sell those shares 10 years later and receive proceeds of those gains.
• Capital gains and dividends are taxed at lower rates than ordinary income taxes (up to 15% for most people, 20% in high income situations) as long as they are held more than one year and are qualified by IRS standards.
• Taxes are paid on just the gains (and dividends).  You get to subtract your cost basis (what you paid).

The Model:

So now that we know how it all works, let’s create our hypothetical situation:

Suppose I have $10,000 per year I could contribute to a 401k.  But I’m considering alternative retirement income strategies and might just put it into a taxable investment account instead.

• That means I’d either contribute $10,000 each year to a 401k or $7,500 ($10,000 – 25% for ordinary income taxes) to my brokerage account.
• We’re going to contribute and invest over a period of 30 years.
• For each portfolio, we’ll purchase Dow Jones Industrial Average investments earning an average annualized rate of 8% per year.
• In both cases our money will grow tax free until we decide to finally start making withdraws in 30 years.
• At the 30 year mark we’ll start making withdrawals of $60,000 per year.  (With the 401k, we’ll assume that we’re of legal age and will not owe any penalties.)
• Once withdrawn, we’ll pay the ordinary rate of 25% for everything we withdraw from the 401k account.  For the stock account we’ll pay the lesser tax rate of 15% on just the gains using either FIFO or the Specific ID method for cost basis .  (Note: In this example it will actually be a mute point.  After 30 years of savings your gains would be substantially higher than your initial contributions.  SO you’d end up paying taxes on almost everything you withdraw.)
• For simplicity, we will not adjust our figures for inflation.  That just makes everything more complicated …

Run the Numbers, See What You Get:

So even though we initially said the 401k was the better option, the question is: By HOW MUCH is one of our retirement income strategies better than the other?  A lot?  A little?  Is there even a noticeable difference?

You be the judge.  Here are the results:

What Does This Tell Us?

As suspected, by the time you decide to retire, you will have more money with the tax-deferred savings account (the 401k).  But not by much.  The difference will only be by about $23K (for our example).

But then fast forward 20 years into retirement.  Not only will you have more money (in theory), but potentially a LOT more!  In our demonstration, you’d have approximately $108K more!  Is that pretty significant?  I know I’d feel a lot better right now with an extra $108K in my pocket …

So perhaps we could stop right here and say that our opportunity cost for a chance at an early retirement is $108K less than what our total fortune could be.

But is that really a fair summary?

Consider the following: Do you plan to spend every last cent you own during retirement?   I’m guessing the answer is probably not .

In fact if you plan to use 4% withdrawal rule of thumb for retirement income, than you fundamentally don’t plan to ever run out of money.  Otherwise you’d have nothing to withdraw from.

So when you put it in that context, $108K x 4% is only $4,000 less per year in retirement income from your savings.  Now your opportunity cost of going down the taxable path vs the tax-deferred one just dropped to a sacrifice of $4,000 per year.  Does that make it worth it now?  To me that seems fair.  But I think that is personal question that will vary from person to person.

Honestly – this post is now really to sell you on one or the other of the retirement income strategies that are out there.  This post was an exercise.  A chance to think.  No matter what your retirement goals look like or what you want to achieve, I believe its very important to objectively collect the facts and then see for yourself how your two options would differ.  We could have very well found out they were drastically different.  Or perhaps they ended up the same.  You never really know until you work it out and see what you get.  And in this scenario, I learned what I wanted to about the opportunity cost of using one option versus the other.