Oh, early retirement. How fabulous it would be to break away from that 9-5 and live the luxurious life you’ve always dreamed of. To finally have free time, the ability to sleep in as late as you want, and go on vacation for months at a time, all before the ripe old age of 60.
The dream of retiring early is a popular one. I don’t know a single person who doesn’t at least want the ability to retire as early as possible, even if they never plan on actually doing it. Maybe you love your job, or working in general, and can’t imagine ever actually retiring, but you probably still want the freedom of financial independence and the flexibility to say sayonara to your job if you ever change your mind.
Most people are trying to retire one day by investing in retirement accounts like 401Ks or IRAs. Those investment accounts are great to use if you don’t plan to retire early, but not so great if you do. The problem with these accounts is that they penalize you for withdrawing your money before your late 50s, which is exactly what you’ll need to do if you want to retire early.
To avoid losing money to these steep early withdrawal penalties, you’re going to need an investment account that allows you to withdraw your money before you near 60. The two investment accounts you need so you can retire early, penalty-free are a Roth IRA and a taxable brokerage account.
Roth IRA
A Roth IRA is the first type of investment account you should contribute to if dream of an early retirement. The contributions you make to your Roth IRA are after-tax, meaning you already paid income taxes on the money. A huge benefit of Roth IRAs is that any money you earn on your contributions is completely tax-free. Unlike with 401Ks and traditional IRAs whose earnings are taxed upon withdrawal, Roth IRAs allow you to withdraw your earnings in the future and pay absolutely zero taxes. This is a huge benefit whether you retire early or not, which is why it’s the first account I’m recommending.
The reason this one of the best types of investment accounts to use to retire early, in particular, is because you can withdraw your contributions at any time, penalty-free. The issue is that you still have to be 59 ½ before you can withdraw your earnings. With a contribution limit of $6,000 a year, even the most frugal people will have a hard time retiring off of their Roth IRA contributions alone. On top of that, you can’t contribute at all if you make more than $139k a year, so as your income increases and you progress in your career, you may exceed the limit. And that leads us to number two on the list of investment accounts you need if you want to retire early.
Taxable Brokerage Account
The biggest difference between brokerage accounts and all of the other investment accounts we’ve mentioned so far is that brokerage accounts offer no tax benefits. Retirement accounts like 401Ks and traditional IRAs offer tax-deferred contributions, and as we discussed all of your earnings grow tax-free through a Roth IRA. But you won’t find either of these perks when investing through a brokerage account. Any earnings you make on the investments in your brokerage account are taxed at the capital gains tax rate.
While these accounts won’t help you out with your taxes, by not offering any tax benefits, they do allow for much more flexibility with deposits and withdrawals. Unlike retirement accounts, which have contribution limits and restrictive withdrawal policies, taxable brokerage accounts have no limits on how much you can invest or when you can withdraw your money.
Both of these advantages are critical for people looking to become early retirees. Having no contribution limits means that you can invest as much money as you want, no matter what your current salary, and let compound interest start to work its magic. Then once you reach FI, you can take advantage of the second benefit these accounts offer and begin withdrawing your money penalty-free.
Before opening your brokerage account, there are a couple of different account types you should consider. How involved you want to be with managing your investments will determine which type of account is best for you.
Online Brokerage Account
Online brokerage accounts are great if you want to manage your own investments. You can buy and sell stocks, bonds, mutual funds, and many other investment types within these accounts. Remember that as a long-term investor, your goal is to build a well-diversified portfolio that you let grow for several decades, not to buy and sell stocks frequently. The temptation with these accounts will be to start trading “hot” stocks. Don’t fall into this trap! As many studies have shown, traders rarely beat the market, no matter how many of them post on Instagram that they’re up 1000% this year.
An easy way to build a well-diversified portfolio in your online brokerage account is to mimic a target-date fund. To do that, find the target date fund that is appropriate for your age group, and look at what funds make up that target-date fund. Then find similar funds through your brokerage account and invest in each at the same percentage that your target-date fund does. For example, if your target date fund is composed of 90% stocks and 10% bonds, you should find index funds and/or ETFs that mirror those holdings and invest 90% of the money in your brokerage account in the stock fund, and 10% in the bond fund.
The main thing to consider before opening this type of brokerage account is that your portfolio won’t be managed for you. To maintain your portfolio structure and reduce your risk over time, you will need to manually readjust your own investments.
Managed Brokerage Account
As the name suggests, this type of brokerage account will manage your investments for you. One increasingly popular category within this group is Robo-advising. These “advisors” manage your investments using complex algorithms. They’re a great alternative to a human advisor because they provide portfolio management services for investors who want to be hands-off but at a cheaper rate.
Another option to consider is a managed brokerage account with a human advisor. This is a more expensive option, but a good one for people who aren’t comfortable relying on computer code to manage their money. Before hiring a human advisor, it is important to make sure you understand their fee structure and verify that they are a fiduciary. Fiduciary financial advisors are legally required to make decisions that will be in their client’s best financial interest.
If you aren’t sure which type of account will be best for you, consider how you’re currently managing your retirement accounts. Do you enjoy using target-date funds because you can be hands-off with your investments? Then a managed brokerage account is a great option to consider using to invest for early retirement. On the other hand, maybe you like to regularly update your holdings in your retirement accounts. In that case, an online brokerage account would work wonderfully for you and you’ll save some money by not having to pay an advising fee.
Many people work hard to max out their 401Ks and IRAs so they can reach financial independence and retire. The problem with investing only in retirement accounts is that they have withdrawal restrictions that won’t allow you to access the passive income your investments generate if you want to retire early. To avoid having enough money invested to retire before 60, but not actually being able to do it, make sure to add a brokerage account into your investment portfolio. Investing in a Roth IRA and taxable brokerage account puts you on the fast track to becoming a rich bitch before 60, so you can live out your early retirement dream.