As you might expect, I speak regularly with folks about their investing goals. To their credit, and my great satisfaction, most people have a well-conceived vision of their financial future. However, all too often, the investing game plan they describe doesn't mesh with their vision. By far, the greatest disconnect occurs between when the person wants to retire and how they're saving for retirement.
Specifically, when I ask folks at what age they'd like to tell their boss to "take this job and..." well, you know, the most common answer is "preferably 50, but no later than 55."
That's a terrific goal; in fact, I feel the same way (unless my boss, Bob, is reading this, in which case I love my job so much I cannot imagine retiring). But unfortunately, when I ask those same folks how they're saving for retirement, the most common answer is "My 401(k)" or "My IRA."
The space between your years
See the trouble yet? It's the same problem we all have: age -- except I'm not simply referring to wrinkles this time. It's very likely the earliest you'll be able to withdraw funds from your 401(k) or regular IRA, with no penalty, is 59 1/2 (yes, they threw in the "1/2" just to complicate your very existence). There is an oft-cited "loophole" whereby you can make withdrawals as long as they're taken in equal amounts for the longer of five years, or until you reach age 59 1/2. However, due to the restrictiveness of both the time frame of the withdrawals, and the process for determining the payout, I generally don't recommend this strategy.
If you're counting on Social Security to fill the gap, don't. At the earliest, you won't receive benefits until you're 62 years young. And, for most of us, full benefits won't actually arrive until we're 65 or 67.
If you're playing along at home, that leaves anywhere from five to 10 years of living expenses that are going to have to come from somewhere else. Further, that doesn't account for the fact that most people tend to spend more in their first few years of retirement, as they feverishly purchase Winnebagos, black socks, and Bermuda shorts -- gotta see the world before our vision goes, don'tcha know.
Don't get me wrong. It's great that these folks have a plan, and it's great that they are employing the most efficient means of saving possible. My point is, sometimes the most efficient means won't actually achieve your goals.
Don't get so caught up in growing your 401(k) that you neglect funding accounts you'll actually have access to before you have to start using the automated blood pressure machine in the pharmacy.
Mind the gap
The best way to fill this coming void is, hands down, the Roth IRA. The beauty of the Roth, besides the fact that your withdrawals from it are tax-free, is that you can withdraw your contributions to the account at any time, with no penalty. The reason for this is simply that contributions are made to the Roth on an after-tax basis, so Uncle Sam has already taken his slice.
Let's say you're 45 years old, and you'd like to retire at 55. You have a 401(k) account that should be sizable enough to meet your retirement needs beyond age 59 1/2. To fill the gap between ages 55 and 59 1/2, you begin making the maximum annual contribution to a Roth IRA.
The contribution limits are scheduled to increase over the next several years, ultimately reaching a high of $6,000 per year when you reach age 50 (some income limits apply). If you contribute the maximum contribution allowed in each year, you'd have $48,000 in contributions by the time you're 55.
Now, let's assume you invested your contributions in a stock index fund that returned an average of 8% per year. In this case, your $48,000 in contributions would have grown to a total of about $70,000 by age 55.
Here's the sweet spot. You can begin withdrawing your $48,000 in contributions, without tax or penalty, at age 55, which will leave the $22,000 in earnings to continue growing until age 59 1/2, or beyond.
OK, obviously $48,000 isn't likely to be enough to meet your living expenses for five years, but it will help you supplement your income. In order to make up the difference, you will have to either start contributing at a younger age or allocate additional funds to a regular old brokerage account.
If you need some help allocating your funds between various accounts, or throughout your portfolio, join Jeff Fischer, Tom Jacobs, Robert Brokamp, and little ole me in the Fool's Asset Allocation seminar. Upon sign-up, you'll receive 30 free days of TMF Money Advisor, our answer to personalized, unbiased financial advice. My biased opinion is that this feature alone is worth the price of admission. But most importantly, you should just come out and play because we're having a blast in the seminar.
The Foolish bottom line
Don't be so fearful of a tax burden that you leave yourself without adequate funds to meet the spending needs of early retirement. All in all, I wish I were paying $100,000 a year in taxes, because that would probably mean I was making $400,000 in income. Planning for the years between your retirement date and the date that you'll have access to your tax-deferred accounts is the key.
If you have the means, you should contribute funds to your 401(k) first, but only up to the level that your employer matches -- you can't beat the return on free money. Then, if your income qualifies, max out a Roth IRA. Finally, if you're fortunate enough to have funds left over, allocate them between your plain old brokerage account and some additional 401(k) contributions according to your needs. Of course, this assumes you've already stashed enough cash to meet your short-term goals and established an emergency fund.
No matter which route you take to achieve your dream of an early retirement, the best way to ensure success is to get an early start. The power of compounding works even harder than you do. And let's face it; you're not getting any younger!