The first issue is that there are limited investment options for 401 (k) plans. For IRA’s however, it is possible to put individual dividend paying stocks. As a portion of my total portfolio however, I do not foresee the sum of 401 (k) and IRA accounts to exceed 15% – 20%. If I choose to retire in five years, I should be able to convert my 401 (k) into an IRA, and invest the money as I see fit.
This is not an ideal situation, but any money I put into a 401 (k) would translate into immediate returns of over 1/3 the invested amount, because of tax savings. To me, investing in index funds and not in individual dividend stocks is worth generating a 33% return through the instant tax savings. Most of my current 401 (k) money is in an old 401 (k) from my last employer that I left in the prior year. I plan to roll this into an IRA, which would allow me better flexibility with my investments.
The second issue is that funds in tax-deferred accounts such as 401 (k) and IRA cannot be easily accessed at a whim. There is a 10% early withdrawal penalty on money that is withdrawn prior to ages 55 for 401 (k) and 59 ½ for IRA’s. In addition to that, investors need to pay ordinary tax rates on money that is distributed. Investors in Roth IRA’s can withdraw contributions without any penalties, but they do not get a tax break for contributing today.
So to summarize, I am better off getting tax deduction today that allows me to save an amount each year, which is lost for me when paying taxes. I am much better off to have some claims to money in the future even if accessing it is more difficult, than to simply throw it away (by giving it to the federal and state and local governments). The rate at which I will accumulate individual dividend stocks in taxable brokerage accounts would decline from 3 new purchases a month to 2 purchases every month.
Throughout my early retirement, I expect that the majority of income will come in the form of dividends, distributions and some 1099 business income. This would put me in a lower tax bracket, which is why distributions from an IRA in early retirement would still be a cheap way to withdraw money if I had to, even with the 10% penalty on distributions.
However, if I choose to go to Substantially Equal Periodic Payment arrangement, I might end up withdrawing dividends from that IRA, without having to pay the 10% penalty. I found two calculators behind SEPP here and here. Depending on your age at retirement, the distribution you can take without paying the 10% penalty could cover 50% to 75% of your annual dividend income earned from that particular portfolio, assuming a current yield around 3.50% to 4%.
Full Disclosure: Long CVX, PM, JNJ, MCD, VOD, KMI