I was recently going over my current and project savings as I am a few months away from getting married and realized, the way things are shaping up, our budget will make it difficult to save 5 years of expenses in a taxable account. A huge portion of our budget is going to our 401(k)s, HSAs, and to a 15 year mortgage at 3%. I began thinking maybe I should throttle back on the 401(k) to get that 5 year nugget that will bridge us until the Roth Ladder allows unpenalized access to the 401(k) money...

As those of us who have been around here for any significant amount of time know, there are basically three ways to access your 401(k) money before 55:

1. Build a Roth ladder of Roth conversions and pay income tax on the amount converted. After 5 years the contribution amount from 5 year ago will be available without any additional tax. This strategy of annual roth conversions continues throughout early retirement.

2. Set up Substantially Equal Periodic Payments (SEPPs) or 72(t) payments. This method allows you to access close to 4% of your 401(k) each year (calculations described here:

http://www.bankrate.com/calculators/retirement/72-t-distribution-calculator.aspx). However, big con: you are locked in until age 59.5. If you decide to start another career or your side gigs start paying off you may be paying a lot of extra taxes.

3. The dreaded 10% extra penalty on early withdrawals!!!!! Oh no!!! All of your tax advantages just went down the drain right?

Seeing a significant hurdle to saving 5 years expenses in a taxable account while maxing the 401(k)s and HSAs, and wanting to avoid the inflexibility of SEPPs (early retirement is all about flexibility right!), I started to look closer at #3. After doing the math, I was surprised to find the tax advantages to still outweigh even the supposedly painful penalty!

Let's take two scenarios. The MMM-like $25k/year couple and the notso-MMM $40k/year couple.

Let's say in both cases, the couples make $150k/year with two earners. The marginal tax rate for the couples while working would be firmly in the 25% bracket so all 401(k) contributions would avoid this 25% tax and, therefore, any money not put into maxing out the 401(k) (including any Roth contributions) would pay this 25% tax.

In the early years of retirement, the couples have a huge 401(k) balance but relatively little in outside accounts. Wishing to avoid the handcuffs of the 72(t) rule SEPPs, the couples start a Roth ladder AND take out enough to cover living expenses for the first 5 years.

Here's how the taxes come out (using 2014 tax brackets):

MMM-like couple ($25k/year expenses) takes out $25k and rolls $25k to a Roth for $50k total: Federal income taxes are $3,551 +

~~$5,000~~$2,500 penalty for a total of

~~$8,551~~$6,061. This is an effective tax rate of

~~17.1%~~12.1%

notso-MMM couple ($40k/year expenses) takes out $40k and rolls $40k to a Roth for $80k total: Federal income taxes are $8,051 +

~~$8,000~~$4,000 penalty for a total of

~~$16,051~~$12,051. This is an effective tax rate of

~~20.0%~~15.1% [Edited to correct penalty amount only on withdrawal, not Roth conversion]

Note, in both cases, the effective tax rate is less than the 25% tax they would have paid not maxing out their 401(k)s and contributing to a taxable account! So where is the break point?

~~$133,000 or expenses of $66,500/year.~~ About $235,000 total withdrawal or $117,500/year in expenses! Note the break point for those in the 15% marginal bracket is just under $40k/year in expenses as the notso-MMM couple is at 15.1% paying the "penalty."

So there you have it. For high earning mustachian, max out your HSA and traditional 401(k) first before you put your money elsewhere (unless you have some awful investment options). If you aren't maximizing your tax deferred accounts, you are likely giving the IRS more money than necessary. Tax deferral is a wonderful thing for a high earning mustachian! And then, of course, once those are maxed start putting money in your taxable account or Roth IRA.

Thoughts? Does the tax advantage in spite of the penalty surprise anyone else?