Set for Life question: using Roth as savings location

[Shawn Q.]

I just finished @Scott Trench's Set for Life (as you can no doubt tell from how often I reference it) and I had a thought/question I'd like to put to everyone. What do you think about using a Roth IRA as a component of the savings vehicle for the $25K-$100K initial steps? Any of your contributions can be withdrawn without penalty, the money would have an opportunity to grow, and there would be a tax advantage to your contribution. I know the limits are fairly low per year, but the rest of your savings could go elsewhere.

As long as I'm aware of and accept the risk, is there a downside to doing this I'm not considering? 

[Scott Trench]

@Shawn Q. Great Question! 

Let's overview this real quick. Most people save less than 5-10% of their take-home pay. At this rate, and achieving a 7% return, they will accumulate enough wealth to "retire" in just over 50 years. For this person, a 401(k) is a great way to save, because they will retire on much less income than they earn today, and therefore likely be in a lower tax bracket. If you earn a high income, and plan on retiring poor, the 401(k) is designed for you. Sadly, this is what most Americans think is good financial planning.

Let's take it up a notch. Suppose instead that you are better than average and save 30% of your take-home pay. You will accumulate the same amount of assets as the guy above in just about half the time, and by the time you hit 59 and a half, likely be very rich. So rich that you will likely have substantial investment and business passive income, even if you aren't all that great of an investor. As a result, you will be in a higher tax bracket than you are now. If you earn a low-moderate income, but plan on acquiring assets and getting rich over a long career, then a Roth IRA is designed for you. Sadly, too few people take advantage of this.

Now, let's kick this thing into high gear. Suppose you read Set for Life, agree with me, and decide that it is actually quite feasible to save more than 50% of your take-home pay starting out, house-hack, take direct responsibility for all of your financial and investment decisions, and otherwise rapidly accumulate a lifetime of wealth in less than a decade. A side effect of this is that you will create passive income very quickly, which accelerates your savings rate (because you have more income on the same level of expense). Therefore, you can accelerate very quickily towards this point of financial freedom. If done proractively, you might spend most of your adult life in a state of financial independence. 

The stakes are very high for achieving this goal very early in life, as the opportunities to try and fail numerous times at entrepreneurship will present themselves. Additionally, a state of financial independence does not preclude us from returning to wage-paying work at any point we so choose. The point is that if this is your goal, then not being able to access the gains from a Roth IRA IS A BIG DEAL. It may preclude you from pursuing the opportunity that could accelerate your progress. It may slow you by months in hitting some of the big milestones, like a house-hack, in good times, and produce no real advtantage in bad times.

The Roth IRA at first glance seems like a great vehicle for folks that might read Set for Life, as it allows you to set aside money to grow tax free over time as you start out in a low (median) tax bracket, and expect to create investment and business income such that you wind up in a higher tax bracket later in life. 

I actually DID contribute to a Roth IRA when I was getting started, and did empty it out (my contributions) when buying my first House-Hack. I remember getting up early on the first business day of each calendar year, heading on over to Scottrade, and putting in the $5,500 maximum contribution as early in the year as possible so that it could compound throughout the year.

Here's the thing - it didn't matter, and would have been slightly to my advantage/comfort to just keep the money in an after-tax brokerage account. Why? Becuase I was not able to access my gains when buying my first house-hack. The point of Set for Life is to achieve early financial freedom. If you are going to invest your savings in pursuit of early financial freedom, why not invest them in a place where you can take advantage of gains, should you see gains?

There is no tax advantage to your contribution (you can only defer taxes on pre-tax retirement accounts like the 401(k)), it's just a bit more complicated to withdraw/access the money, and the only advantage is that you will be able to harvest the gains tax-free at the age of 55. 

Personally, I subscribe to the belief that as a young, ambitious hustler that sustains a high savings rate and invests systematically, that I have a far greater chance of compounding my returns and seeing outsized yields on my own business (real estate) right now, in the prime of life, than I will by allowing my investments to grow tax-free in index funds inside a Roth or 401(k). 

That said, this is MY opinion. And I'm sure that smart, reasonable people can disagree on this point, and contribute to a Roth to advance their position!