Why I Stopped Funding My IRA

by Michael Scepaniak on May 21, 2013 in finance

Big Butte at Dusk

I don’t put anything in my IRA or 401(k). Zilch. Don’t get me wrong. I save for retirement – a lot. But, out of all of the saving and investing I do these days, none of it is tax-sheltered. None of it is going to grow tax-free. And that’s a conscious choice on my part. Tax-sheltered saving/investing no longer makes much sense for me. And it might not make sense for you, either.

Let me explain my situation and rationale – so you can determine if it applies to you. (Full disclosure – if you’re like most people, it probably doesn’t.)

Investing Background

I’ve been investing for a little over a decade now. I started in my mid-twenties (late 2001), soon after setting up my S-corporation (the one I set up when I became an independent software developer). I set-up two investing accounts – a SEP-IRA funded with before-tax money and a completely non-tax-sheltered account (non-IRA) funded with after-tax money.

I was a value-oriented investor – putting my money in a mix of mutual funds and individual stocks. There wasn’t a whole lot of difference between the investment choices I made in the SEP-IRA account vs. the non-IRA account.

Several years later, in mid-2005, a friend of mine clued me into the existence of the i401(k) – also known as the Individual 401(k). Because business was good at the time, I was flush with money, and the contribution limits for the i401(k) were much higher than those for the SEP-IRA, I opened an i401(k) and started funding it with before-tax money. This i401(k) got paired with the existing 401(k) that my then-wife had been funding for many years through her employer.

Fast-forward several years again and, unfortunately, in mid-2010, my wife and I agreed to divorce. As part of the divorce, we basically divided our assets 50/50. So, post-split, my savings were bucketed as follows:

In short, the large majority of my assets were not tax-sheltered. This financial and lifestyle reset, while painful, gave me the opportunity to re-evaluate my saving and spending habits.

Saving

For the couple years leading up to the divorce, my investment focus had shifted from value stocks and mutual funds to dividend-paying stocks. I had come to see the appeal and power of receiving a steady stream of earnings in the form of dividends (cold, hard, cash money). One of the many benefits of that shift was that it made somewhat-reliable forecasting of my eventual investment income a doable endeavor. Instead of guessing wildly at a probable rate of return based on volatile capital gains, I was now able to create realistic projections based on much more stable dividend payout ratios.

Skip ahead to today. From where I currently stand, I’m now able to calculate how much income I, personally, passively derive from my stock holdings. That’s not a calculation that is based on benchmarks, rules of thumb, or other peoples’ behavior. It’s based on my own portfolio holdings and results.

Spending

Pre-divorce, I was a frugal guy. Post-divorce, that didn’t change. In fact, my newly-independent living situation gave me the impetus and flexibility to reconsider all of my spending. And so, I actively sought to get by with less. I turned down my thermostat during the Winter, turned off my air conditioning during the Summer, canceled the cable television service I rarely ever watched, switched my phone service to a combination of a prepaid phone and Skype, etc.

The result? For the past two years, my annual enduring expenses have been in the range of $40-45,000. Now, that doesn’t include my mortgage payments (which I don’t consider “enduring” because they will stop someday before I exit the workforce). But, it also contains some expenses that I’d probably be able to and want to trim further – such as dining out sometimes twice a week, buying produce that I should be able to grow myself, disability insurance, commuting-related costs, corporate tax preparation, etc.

Untouchable Income

At this point, I derive enough dividend income from my investments to cover nearly 50% of my expenses – on an annual basis. And you can probably see where I’m going with that. Once I get to the point where my portfolio-derived income reaches and exceeds my enduring expenses, I can feel free to exit the workforce. And that’s great! However, there’s a wrinkle here that bears scrutiny. From where exactly is that income coming? Which investments?

Ah, yes, there’s the rub. For me, at present, only 85% of that income is being derived from accessible, non-tax-sheltered assets. Meaning, 15% of that income can’t be touched (without penalty, at least) until I’m 59 1/2 years old. And if I was at the point where my portfolio-derived income was greater than my enduring expenses, and my asset mix remained the same as it is today, but I wasn’t yet 60 years old, I’d still only be 85% of the way to living off of passive income.

How frustrating! Imagine that scenario: you’ve got all the money you need to exit the workforce – and yet you can’t touch it because you aren’t old enough.

Cutting Contributions

And that is exactly why I stopped funding my IRA and i401(k). If I continue along the trajectory I’m on now (which, I’m full well aware, could change at any time), I’ll be cash flow positive (investment income exceeding enduring expenses) well before I turn 59 1/2. And I’ll definitely want full access to that investment income should/when that time come(s).

The only asset income I have full access to is the income I derive from my non-IRA account. So, that’s the only account I contribute to anymore.

The downside of plotting and following this course is clear: more taxes owed. I’m not sheltering any earned income these days. And all of the dividend payments and capital gains I reap from my portfolio each and every year are tax-eligible. But, as far as I can tell, for me, that downside is worth it. Bringing those tax costs onto myself is actually the smart thing to do.

Truth be told, though, initially, I wasn’t 100% positive about the wisdom of going in this direction. After all, it’s not a topic or strategy that you see discussed much – if at all. (Not even by Mr. Money Mustache. 🙂

I eventually had a conversation with a financial planner buddy of mine, though, and he validated the soundness of my approach. The only option he brought up that I didn’t know about was a 72(t) distribution. But, with a 72(t), the distribution caps/rates are basically pegged to interest rates, which I find too limiting.

Unconventional

Today, I continue to shepherd along the existing money I have in my IRA. I keep it fully-invested in the same manner as my non-IRA assets, keeping it growing as best I can. But, I have no plans to make any further contributions to it and I don’t factor it into my workforce exit estimates. I tend look at it more as a safety net for covering the unknown expenses of health insurance when I enter into my sixties.

While I wish 100% of my investment income was fully accessible, I’m fairly happy that I figured out this gotcha’ when I did. I mean, not funding your “retirement plan” goes completely against conventional wisdom, right? Yes, right. But, the older I get, the more I come to realize that, in a lot of ways, for better or worse, I’m not very conventional. Maybe you shouldn’t be, either. 🙂

Are you in a similar position as I? Did you arrive at a similar conclusion? Or have you gone in a different direction? Please leave a comment. Thanks!

Mike
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{ 2 comments… read them below or add one }

Dave Seinberg May 24, 2013 at 9:23 am

If you make enough money at some point I guess it doesn’t really matter what way you end up going, but you do forego a fair bit of compounding returns with your strategy. Obviously you know this, so have considered it, but I didn’t see it mentioned in your post so I figured it’d be worth mentioning. Have you done the math to see what it might look like if you did continue investing in tax-sheltered accounts?

Reply

Michael Scepaniak May 25, 2013 at 11:30 am

I’m actually in the process of doing that. I’ve been debating this approach with a buddy of mine for the past few days. I’m thinking it warrants a follow-up post. Stay tuned. And thanks for reading, Dave.

Mike….

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