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Optimize These 5 Accounts for Early Retirement [2017]

Posted on Posted in Guide, Invest, Retirement

How can I secure early retirement?

That's a question I think we've all asked ourselves at one point or another.

You've probably heard adages such as "spend less than you make" and "be frugal."

But what if there's a more actionable path to achieve early retirement than the typical, general advice?

This article covers the 5 most important investment accounts for you to focus on to obtain the ultimate goal of personal finance: early retirement.

1.The 401(k)

Man walking holding money bag labeled 401k
Optimize your 401(k)!

Created under the Revenue Act of 1978, the 401(k) is easily the most well-known retirement vehicle. These defined-contribution retirement plans are generally made up of a menu of Mutual Funds and Exchange Traded Funds (or ETFs), and investment options are somewhat limited. In many cases, upon initial signup, the employee is automatically set up with what's known as a Target Date Fund. The options within the fund will be based on the employee's age (and target date of retirement). Generally, the younger the employee, the more stock-heavy the fund will be; as the employee ages, the fund will lean more heavily towards bonds.

So how can you optimize your 401(k) for early retirement?

For target date funds, the devil's in the details. Some of these are perfectly fine, but in many cases, they can be on the expensive side. Here's what you need to do to find out how much you're being charged:

  • Locate the document called the Prospectus. These can be lengthy, but you only need to look for one item. There will be something called the Expense Ratio (might be abbreviated "ER"). This will be expressed in percentage terms and will show you how much is being taken off the top from your investment balance. Some administrators will "true up" the cost of the fund by adding in a "minimum" charge to the expense ratio. Make sure to examine all documentation the administrator has provided (which, luckily, is mostly online these days).
  • Generally, there will be other fees associated with the account, such as administrative costs. Almost all 401(k) providers will charge these, so it's somewhat of a necessary evil. Just make sure it's not an exorbitant amount.
  • Some funds are funds of funds. This means that it is a fund made up of several mutual funds or ETFs, each of which has its own expense ratio. If this is the case, then you'll need to research each fund individually. (don't forget about the expense ratio of your fund!)
How do you know if you're being charged too much?

Our rule of thumb is 0.5%. Anything over this amount deserves a close inspection.

MORE: Reduce Fees in Your 401(k) in 3 Easy Steps

Say we've uncovered some expensive funds. What can we do about it?

The important thing to remember is that, generally, you're not locked in to any specific investment. Most administrator websites have an easy to access Contributions page where you can easily adjust your allocations. Sometimes, they have tables that show the expense ratio, the rate of return over a set amount of time, and other helpful details. You'll just need to log in and do some perusing in order to find what you need.

Still wondering why it's so important to research fees? Consider this example:

23-year old Jeff just graduated from Purdue and is about to start his first job as an accountant in Indianapolis. He has been reading up on saving for retirement and wants to get a head start by allocating $10,000 annually to his 401(k). He knows that the act of saving is the most important part to success, so he didn't do much research into his investment options, and just chose the default selection.

READ: Investing for Beginners: What is an ETF?

Fast-forward 30 years. Jeff is happily married with 2 kids, a dog, and a fenced-in backyard. He's saved his way to a decent-size nest egg. Assuming an 8% annual rate of return, a continuous annual contribution of $10,000, and what seems like a low annual fee of 1.5%, Jeff ends up with about $863,000.

Early retirement has been on his mind a lot lately, so Jeff does some research into investment options and looks over his own portfolio. He realizes that there's another fund that has had identical performance over the last 30 years that holds very similar securities. He also sees that this fund only charges 0.5%.

Is a 1% difference in fees really that much?

"That's not much different" he thinks. But, curious, he does some quick math to determine exactly how much more he would've had.

"No...that can't be right..." he utters to himself. Jeff realizes that if he would've selected the cheaper investment option, his nest egg would've grown to about $1,033,000, or a difference of roughly $170,000

You read that right... Assuming $10,000 annual contribution and 8% annual return, the difference between 0.5% and 1.5% in fees over 30 years is about $170,000. 

Given that the 401(k) is the most prevalent retirement account these days, it takes the #1 spot as the most important account to optimize for early retirement. However, for several reasons, the next account is arguably just as important.

2. The Individual Retirement Account (IRA)

Anyone hoping to achieve early retirement needs to understand how to utilize the IRA.

The most-discussed forms of the IRA are the Traditional and Roth IRA. There are some significant differences between the two, which we outlined in a recent article:

READ: Traditional vs Roth IRA: The Ultimate Guide [2017]

Calculating Individual Retirement Account

Arguably the biggest advantage of the IRA vs the 401(k) is the flexibility that comes along with it. It's your Individual Retirement Account... so you can basically choose whatever investment option you'd like. Selecting investment options within the IRA is essentially the same process as a typical brokerage account, with the added benefit of being tax-advantaged.

So what's the best way to optimize the IRA for early retirement?

Given you can choose whatever investment makes the most sense for your needs, our view is that there are two strategies to maximize the long-term benefit of your Individual Retirement Account:

  • Minimize Trading
  • Minimize Commissions

Wait a sec... aren't I minimizing commissions by minimizing trading? I see what you did there!

Actually, they're two separate (but related) concepts.

First, let's take a look at minimizing trading and why that's important. Generally, online brokerages will charge per trade, so money is taken off the top every time you buy or sell a security. Besides the obvious cost per trade that whittles down your balance over time, there's a school of thought called Dividend Growth Investing that has seen a meteoric rise in popularity over the last several years that comes into play here. 

Here's the basic premise of Dividend Growth Investing (DGI for short):

To DGIs, it is ideal for an investor to buy a security that has shown to increase its dividend over a significant period of time, and hold that investment forever. Proponents of DGI say that it lessens the psychological fear of losing money when the market is down. That's because the investor is focused solely on the steady and rising income stream. They say that by adopting this school of thought, it's the best protection for selling income-producing assets at the worst possible times.

Second, let's review how to minimize commissions. We know that the less trading we do, the less commissions we will suffer. The other item to consider is looking for the lowest-cost provider.

How do I find the lowest cost provider?

There are a multitude of reputable online brokerages. Each one has a different fee structure, but the setup is basically the same- there is a cost to the consumer for each trade completed. However, there is one brokerage we're aware of that currently doesn't charge per trade:

Robinhood.

Robinhood, a new investment brokerage, is the only one we're aware of that doesn't charge commissions for trades. When news of Robinhood was first released, there was a massive waiting list, and its app was only functional on the iPhone. It's now available on many devices and is a great way to save on commissions in your Traditional or Roth IRA:

READ: 3 Reasons the Roth IRA is Perfect for Millennials

The next account we'll cover is lesser-known than the 401(k) or IRA, but contains a unique advantage: read further to learn more.

3. The Health Savings Account (HSA)

Safety pin and stethoscope on medical papersThe Health Savings Account, when properly utilized, can be the most powerful retirement account available. This is due to the unique attribute of triple tax benefits. This means that the contribution is pre-tax, the earnings of the account are tax-free, and funds used for qualifying purchases are also tax-free.

You read that right-- the money in an HSA is potentially never taxed!

In order for someone to start an HSA, he or she needs to be contributing to a High-Deductible Health Plan (HDHP). As of this writing, an individual can contribute up to $3400 or $6750 for the family annually. Account owners over the age of 55 can contribute an additional $1000/yr. The account owner is issued a debit card so that he or she can pay for medical expenses. Most HSA investment administrators provide online access to check balances and select investment options.

One thing most people don't realize about HSA funds is when they can be used. This is a critical item to understand in order to optimize your HSA funds!

MORE: Why the HSA is the Hidden Gem of Retirement Investing

Let's say you opened your HSA at the beginning of 2017. You have a specific medical condition that required you to purchase medication that summer. However, you forgot to use your HSA debit card to buy your meds, but you did save the receipt.

Think you lost the ability to use your HSA funds for that purchase?

Nope!

Again, it's possible for you to use the HSA funds at any time so long as the purchase you made was a qualified expense.

Here's what this all means:

  • You can make qualifying purchases with any method of payment you choose (such as a rewards credit card to maximize your points!)
  • You then can reimburse yourself with the HSA funds at any time in the future for said qualified expense
  • This allows you to keep HSA funds invested, earning tax-free interest, until you absolutely need the money!
See how the HSA can be such a powerful retirement vehicle?

Maximize the annual contribution, leave funds in the account to grow tax-free, then reimburse yourself later. The power of compounding potentially turns that investment account into a substantial amount of money.

One caveat: You'll need to be very organized in order to utilize this strategy. Make sure to save all your receipts or download a scanning app where you can keep them.

The next account is critical for a large segment of the population who certainly don't get enough credit for what they do: Teachers.

4. The 403(b)

pencil writingThe 403(b) has been around the longest of this group. It was introduced in 1958 and originally classified as a Tax Sheltered Annuity. That term is now out of date as 403(b) account owners have been able to invest in mutual funds within 403(b) accounts since 1974.

We can't understate the importance of this change, for a variety of reasons:
  • Annuities are typically expensive
  • It is generally difficult and fees are high to move funds elsewhere (called surrender charges)
  • The contract documentation is lengthy and complicated

That being said, the 403(b) can be a great tool to add to your retirement investing arsenal. As of this writing, rules allow for $18,000 maximum annual contribution with an additional $6,000 catchup contribution for account owners over the age of 50. This can help reduce the current tax bill and allow money to grow tax-deferred.

So what's the key to optimizing the 403(b) for early retirement?

Our opinion is that you should look to invest in mutual funds instead of an annuity.

Sounds easy, right?

Problem is, it can be difficult to find an employer-approved mutual fund vendor. It's common that employers partner with an annuity company to assist with the 403(b) program. Why? In many cases that annuity company will cover the administration costs of the program, savings employers a boatload.

So how do I find a 403(b) mutual fund provider?

We would first recommend checking with your employer to obtain a list of approved vendors. Our favorite 403(b) mutual fund provider is Aspire Financial Services. Another great resource for comparing 403(b) providers is California's 403bCompare.

Lifelong student? Want to assist your kids to pay for higher education? Read on to learn about the final account on this list. It's a lesser-known option that packs a punch.

5. The 529

Apple on stack of booksThe 529 plan, legally known as the Qualified Tuition Program, is the new kid on the block of this list. Introduced in 1996 as part of the Small Business Job Protection Act, the 529 provided parents a tax-advantaged avenue to build up a college nest egg for their children.

What many people don't realize about the 529 is that it can also be used for your own education (and with great tax benefits to boot). A saver can change the beneficiary for the account at any time, so a great way to begin is to name yourself as beneficiary. Utilizing the 529 for your early retirement can be a great way to enhance your knowledge and skillset while ditching the 9-5.

Here's an illustration using Indiana's 529 guidelines:

John decides he wants to start saving for his kids' education. He does some research and decides to start a 529 plan and names himself as beneficiary. Indiana has a great plan to incentivize this. John can earn a 20% annual tax credit for each dollar he contributes to the plan, up to $5,000. This means that if he contributes $5,000 in 2017, then he will get $1,000 as a credit back when he files his taxes.

What if his kids don't go to college?

John can simply keep himself as the beneficiary and utilize the 529 for his own education. Maybe he will pursue an MBA. Or maybe John has an interest in becoming a college professor, and would like to earn his Doctorate. Again, he can use these funds to develop his own skills and enhance his knowledge.

So how do I optimize the 529?

Most 529 plans will have an easy-to-navigate website that describes the investment options. Generally, the saver can choose from mutual funds, ETFs, or cash options like FDIC-insured savings accounts. We believe that the key to optimizing these accounts is to simply look for low-cost funds.

So... It's clear that optimizing these accounts is important for retirement.

But what about early retirement?

What many people don't realize is that it is possible to access your funds in these accounts whenever you need. There are a few steps involved to do so, but the process isn't complex. That's why, in combination with spending less than you earn, optimizing these accounts is key to early retirement.

Thanks for Reading!

Is there an account you believe is worthy to be on this list? Let us know in the comments below.

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The author of this article is not a licensed professional. This article and all information presented is for informational purposes only and should not be taken as financial or legal advice. We recommend our readers to consult with a licensed professional in the appropriate field prior to making any investment decisions.

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