Why contribute monthly to an IRA rather than a brokerage account?

Question

Hypothetically, if I had a long term investment in mind (let's use FNCMX) that I believed would perform well enough annually to allow me to retire at an early age, (call it 40 years old) what advantage is there to investing the money in an IRA?

If I'm not mistaken, I wouldn't be able to withdraw it (without a penalty) until 59.5. What if I want to retire at 40 and withdraw all of the money at that point. (Also curious how it would affect me if I only pulled 100k annually instead of all of it).

I understand the tax benefits of an IRA, but I wouldn't be closing my position until 40 (or whatever age, pre 59.5) so there shouldn't be any tax reprocussions in the years leading up to retirement age.

Am I missing something obvious here? Thanks in advance.

Answer 1

With a Roth IRA, you can withdraw your contributions at any point without tax consequences. If you have a traditional IRA (or withdraw more than just your contributions from a Roth IRA) then you are correct, early withdrawal can carry penalty. Since the different types of IRA already give you significant flexibility and they have a relatively low annual contribution limit, I can't think of any compelling reasons to forego IRA's altogether.

Most people don't liquidate their retirement accounts the day they retire, they just start drawing from those accounts. Taking just what you need from a traditional IRA/401k reduces tax burden for most people because more of their taxable withdrawals are done in lower tax brackets.

Even if you retire at 40, you will still need money at 60. So, when planning for early retirement you'll want some funds you can withdraw before 60 that aren't subject to tax penalty. That might mean you want to focus on Roth IRA, 401k, and a standard brokerage account. Most people use a combination of these accounts to suit their plan (many people don't seem to do much retirement planning at all, so good job thinking about it now). While not a retirement account, a paid off house is part of many retirement plans, having significantly lower housing costs could greatly reduce the amount of money you need as a bridge that period between 40 and 60 years old. Note that the retirement age for various programs can be changed, so make sure to include healthy amounts of cushion in your plan.

Answer 2

Most people stop earning an income from their job at approximately age 65 and will live 20+ years in retirement, the common advice is that they still have to be partially invested in stock even after they retire to increase the livelihood that their money will last and not be eaten away by inflation.

What if I want to retire at 40 and withdraw all of the money at that point.

With your plan you will retire at approximately age 40, which means that you money had to last for 45 years post retirement. You may find that at age 40 you will need to be invested 100% in stocks.

Now funds in an Roth IRA, Traditional IRA, Roth 401(k), traditional 401(k). and taxable accounts can be invested in anything from the equivalent of a bank savings account all to a fund that is only for investors with a high risk tolerance.

One approach is to invest some of your money in taxable accounts that you can tap into before age 59.5, and some of your money in retirement accounts that either defer taxes now (Traditional IRA or Traditional 401(k), or can be withdrawn tax free after you are 59.5 (Roth IRA or Roth 401(k)).

Also curious how it would affect me if I only pulled 100k annually instead of all of it

This is how most people want to access their retirement funds or other investments. They pull from their different accounts with an eye towards their income requirements, their need to stay ahead of inflation, and their tax situation.

You will also have to plan for things like health care during those 20+ years early retirement. You will also have to plan how you will manage your funds now to be able to address your housing situation in your retirement years.

With a goal of being able to retire at age 40 you should make use of a fee only financial planner that for a fixed price will help you construct a plan now. Then you should reevaluate that plan as conditions change or to check your progress.

Answer 3

The obvious thing you've missed is that (for traditional IRAs) you get an immediate tax savings on your contribution.

Second point involves closing your position. It's quite uncommon to hold a single stock for multiple decades, so any trading gains are taxed. Even if you do hold it for that long, the stock presumably pays dividends, which would be taxed if held in an ordinary brokerage account.

Answer 4

The major upside of assets in a retirement account is that those assets are not "re-taxed" as they grow. As pre-tax stocks in a retirement account grow and pay dividends, the resulting assets are also pre-tax assets, and you don't have to pay taxes until you withdraw the assets. Likewise, as after-tax stocks in a retirement account grow and pay dividends, the resulting assets are also after-tax assets, and you never have to pay taxes on them.

As a result, the annual growth of a retirement account is "what it says on the tin," so to speak. What I mean by that is that if you have an investment which returns 10% per year, then the value of your account really will increase by 10% per year.

Assets in a normal brokerage account, however, do get "re-taxed." If you have some after-tax stocks in a brokerage account, and they pay a dividend, you have to pay taxes on that dividend, even though you already paid taxes on the money you used to buy the stock in the first place. Likewise, when after-tax stocks in a brokerage account gain value, that additional value is a pre-tax asset, and you will eventually have to pay taxes on that.

As a result, the annual growth of a normal brokerage account is less than "what it says on the tin." If you have an investment which returns 10% per year, then the value of your account will not actually increase by 10% per year. It might increase by something like 8% per year instead.

This is a huge difference! If you have two accounts and you put $10,000 in each one, and the first one grows at 10% per year but the second one only grows at 8% per year, then after 40 years, the first one will be worth about $453,000, whereas the second one will only be worth about $217,000.

As for:

If I'm not mistaken, I wouldn't be able to withdraw it (without a penalty) until 59.5. What if I want to retire at 40 and withdraw all of the money at that point. (Also curious how it would affect me if I only pulled 100k annually instead of all of it).

Well, even if you retire at age 40, I'm guessing you don't want to spend your entire nest egg immediately and be broke for the rest of your life. So, don't withdraw all of the money at age 40.

Instead, withdraw the money in the form of a series of substantially equal periodic payments over your life expectancy. ($100,000 a year will probably count as "substantially equal periodic payments over your life expectancy," if you have enough money in the account to sustain that much rate of withdrawal for your entire life.) If you do this according to the rules, then you won't have to pay any early withdrawal penalties even though you're younger than 59.5.