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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{ 4 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….

Reply

Eric B January 25, 2019 at 12:58 am

If you like the tax benefits of the IRA (and long-term capital gains), consider reinvesting dividends in your IRA and then selling a dollar-equivalent number of shares in your taxable account, assuming you have enough money in your taxable account to last you until age 59 and 1/2.

Reply

Michael Scepaniak January 30, 2019 at 7:45 am

That’s an interesting thought. So, you’d sell down your taxable account in order to buy into your sheltered account. I can imagine doing this in years where I have some room to do tax-gain harvesting.

One pillar of my retirement strategy has been to cover my expenses with dividends, without requiring me to tap into principal. Going too aggressively with this (your) strategy could compromise that. But, the closer I get to 59 1/2, the less of a concern that becomes. I like having this option to consider. I’ve made a note to myself. Thanks!

Reply

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