A third way is to follow a blend of contributing out 401K and IRA contributions, while investing any remaining amounts in taxable brokerage accounts. I am somehow following this strategy today, as I max out tax deferred accounts in order to get the most tax benefit today, while adding any additional funds to taxable accounts. This was difficult to implement 5 – 6 years ago for me, but now it is easier.
For the first five to six years of my dividend investing pursuits, I purchased almost all of my investments in taxable accounts. As a result, I have been able to accumulate a dividend income stream, which can cover over 50% of my expenses. This income stream is somewhat tax efficient, as the top rate on dividends is approximately 20%.
In addition, the taxable brokerage accounts provide me with a lot of flexibility, as I can withdraw money at any time from my margin balance if I have a short term need for funds. I can also sell stocks short, sell naked puts and buy stocks on margin. I do not do those things, except for selling options, but it is nice to know you have options. I do have to pay taxes every year on the dividends I earn and capital gains I realize.
However, if someone is just starting out in investing, I strongly encourage them to start small in a taxable account, while taking advantage of 401 (k) plan company matches. That way, any mistakes you make in your brokerage account will be deductible on your tax returns. The distribution stream from a taxable account will also provide you with a nice buffer of income when you build your early retirement dividend machine.
This dividend is what will allow me to allocate so much money to max out my 401k and SEP IRA. Earlier this year, I discussed that I am now maxing out my 401k and am also planning on maxing out my SEP IRA. The goal of this exercise was to reduce the amount of taxes I pay each year. Unfortunately, I am not eligible to receive a tax deduction on the regular IRA at this time. I realized that I would much rather have a large amount of money sitting in a tax deferred account to my name, rather than pay taxes and receive no specific benefit attributable to me. I understand that in order to access this money I will have to jump through hoops such as early retirement penalties as high as 10%, in addition to paying ordinary income tax rates to withdraw the money before the age of 59 1/2 years. I will convert the 401k plan into a regular IRA at my retirement date, if I choose to leave current employer.
With 401k plans, there are limited investment options, such as index funds or target date funds. However, by rolling over the funds from a 401k to an IRA when I retire, I should be able to invest in individual stocks. Some 401k plans might also have a brokerage window, which would allow investors to buy individual stocks. I have to research to see if my provider offers this option, and what the costs associated with it are.
If I retire in five to six years, I can take out Substantially Equal Period Payments (SEPP) if I really needed to withdraw distributions from an IRA. It looks like the amount that I can take out in 5 years would be equivalent to somewhere close to 2.50% -3% of my net account value. If my dividend stocks in the IRA yield more than 2.50%, then I would essentially have a stream of income that would compound for life. I would essentially have distributions that are growing each year because companies are raising them, and also excess dividend checks would accumulate and would have to be invested into more shares. All of this money that is retained in the IRA would compound tax free for decades, until I reach the ripe age of 70.50 years. At that time I would have to take mandatory withdrawals, and pay ordinary taxes on it.