Author Topic: To 401k or Not to 401k, That is the Question....  (Read 11981 times)

MacGyverIt

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To 401k or Not to 401k, That is the Question....
« on: February 20, 2012, 08:29:13 PM »
Having read MMM's earlier bog posts about 401k investing as well as this article from frugaldad (http://frugaldad.com/2011/12/13/why-i-stopped-contributing-to-my-401k/) I'm curious if others here have chosen to cease 401k contributions?

I'm fully contributing to both 401k (and Roth, btw) b/c tax-wise I was getting hit hard these past few years (28% bracket). Purchased my first home Fall 2011 (great deal on a place + 4%@30 yrs!) so for the first time I have a "mortgage interest write off" in my favor (~5k for the next five years at regular payment schedule). Given this recent tax advantage, I'm left wondering if I should reduce my 401k contribution and put some of that 17k (at least past the point of matching) elsewhere to better my near to mid term (before I hit 59.5) passive income.

Anyone off set their 401k when there was no more need for the pre-tax break?
What considerations did you take into account during this process? Were you totally debt free first?

Are you considering reducing your contribution but unsure as to when/why?

foodguy

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Re: To 401k or Not to 401k, That is the Question....
« Reply #1 on: February 20, 2012, 08:56:15 PM »
Having read MMM's earlier bog posts about 401k investing as well as this article from frugaldad (http://frugaldad.com/2011/12/13/why-i-stopped-contributing-to-my-401k/) I'm curious if others here have chosen to cease 401k contributions?

I'm fully contributing to both 401k (and Roth, btw) b/c tax-wise I was getting hit hard these past few years (28% bracket). Purchased my first home Fall 2011 (great deal on a place + 4%@30 yrs!) so for the first time I have a "mortgage interest write off" in my favor (~5k for the next five years at regular payment schedule). Given this recent tax advantage, I'm left wondering if I should reduce my 401k contribution and put some of that 17k (at least past the point of matching) elsewhere to better my near to mid term (before I hit 59.5) passive income.

Anyone off set their 401k when there was no more need for the pre-tax break?
What considerations did you take into account during this process? Were you totally debt free first?

Are you considering reducing your contribution but unsure as to when/why?

Regardless of your age, if you are in the 28% bracket and stop the 401k contributions, it's not 17k that you have to consider what to do with.  Rather, it is $12240 less your state tax bite as well.  Putting it on the house wouldn't make sense, as 4% is pretty easy to beat in the market.  Putting it in a regular investment account could make sense if you need immediate or shorter term access to the money, but you haven't missed it thus far.

Do you do a backdoor Roth contribution?  Assuming your tax rate of 28%, you are probably above the limits for a direct contribution, but search for "backdoor Roth" and you'll learn about ways to get money into a Roth despite the income limit.  This would provide you with tax diversification come 59.5, allowing you to take from the 401k if your tax rate is low in retirement, or from the Roth if tax rates are high.  Plus, I believe Roth funds are tax-free to any heirs (don't quote me on that, but I know there are tax benefits to survivors in regards to Roth accounts).

I too max out my 401k and also max out a Roth IRA.  In addition, I have a couple thousand dollars left over a month. However, I'm very close to being upside-down on the house, and have found paying that down with this money is better than investing in a taxable account.  Others would argue that it doesn't make sense to pay down a 5% mortgage, but the faster I can get this paid down the quicker I'm out from under PMI and the threat of being upside-down and needing to sell, etc.  My long term plans with the extra cash are once I'm out from under the PMI, I'll start investing in an outside account of some sort.  Still allows for a bit of a tax break on the house, but also more liquidity and potential for higher returns if I head for stocks.  At this point I'm not sure if it will be stocks or just a money market, as I'm not sure what the funds will be for at that point.

Hope that helps.  I'd keep the 401k maxed, or if you lower it, lower to the point of being able to contribute some to a Roth.  Allows for tax diversification and survivor benefits.

(I'm not an accountant, attorney, or any other sort of financial professional.  Just a dude with a parallel situation and an opinion.  Take my $0.03 for what it is worth).

MacGyverIt

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Re: To 401k or Not to 401k, That is the Question....
« Reply #2 on: February 20, 2012, 10:08:26 PM »
I'm fully contributing to both 401k (and Roth, btw) b/c tax-wise I was getting hit hard these past few years (28% bracket).

Regardless of your age, if you are in the 28% bracket and stop the 401k contributions, it's not 17k that you have to consider what to do with.  Rather, it is $12240 less your state tax bite as well.  Putting it on the house wouldn't make sense, as 4% is pretty easy to beat in the market.  Putting it in a regular investment account could make sense if you need immediate or shorter term access to the money, but you haven't missed it thus far.

Do you do a backdoor Roth contribution?  Assuming your tax rate of 28%, you are probably above the limits for a direct contribution, but search for "backdoor Roth" and you'll learn about ways to get money into a Roth despite the income limit.  This would provide you with tax diversification come 59.5, allowing you to take from the 401k if your tax rate is low in retirement, or from the Roth if tax rates are high.  Plus, I believe Roth funds are tax-free to any heirs (don't quote me on that, but I know there are tax benefits to survivors in regards to Roth accounts).

I too max out my 401k and also max out a Roth IRA.  In addition, I have a couple thousand dollars left over a month. However, I'm very close to being upside-down on the house, and have found paying that down with this money is better than investing in a taxable account.  Others would argue that it doesn't make sense to pay down a 5% mortgage, but the faster I can get this paid down the quicker I'm out from under PMI and the threat of being upside-down and needing to sell, etc.  My long term plans with the extra cash are once I'm out from under the PMI, I'll start investing in an outside account of some sort.  Still allows for a bit of a tax break on the house, but also more liquidity and potential for higher returns if I head for stocks.  At this point I'm not sure if it will be stocks or just a money market, as I'm not sure what the funds will be for at that point.

Hope that helps.  I'd keep the 401k maxed, or if you lower it, lower to the point of being able to contribute some to a Roth.  Allows for tax diversification and survivor benefits.

Thanks for your input, foodguy! (Great name, btw).

I do contribute to Roth (plus an additional $400 into my investment portfolio with LPL Financial which is doing very well, esp dividend-wise) but I'm one small promotion away from getting pushed into Traditional Roth territory. I googled "backdoor Roth" as you suggested and I did just this a few years ago b/c waaaay too much overtime pushed me out of Roth territory. Found this great article on the issue, btw: http://www.fivecentnickel.com/2012/02/01/will-the-irs-disallow-backdoor-roth-contributions/

Man, am I loving this forum. I was so focused on the The Man takin' my 'stache I totally forgot about The State Man taking *even more* 'stache. State taxes make me miss the days with municipal bonds were a safe investment....

Good point on my interest rate being so low on the mortgage not to expend too much energy on that debt (YET). I'm so, so thankful I didn't jump in during the housing boom like all my buddies. I put down 25% for a down payment and my mortgage is less than half of what i was paying for rent -- it just took A LOT of time and patience (and some good timing) to get a great deal at a strong interest rate that was walking/biking distance from work (pre-Mustachian decision, I just loathe commuting/traffic).

foodguy

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Re: To 401k or Not to 401k, That is the Question....
« Reply #3 on: February 20, 2012, 10:17:45 PM »
Sounds like you are doing well.  Sometimes just hanging tight with your financial situation and not making any changes is a tough thing to do.  Sounds like you have a good game plan and are comfortable executing it.  Keep working hard, studying and learning about personal finance, and look forward to the time in the not too distant future where you can appreciate the fruits of your labor.

MEJG

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Re: To 401k or Not to 401k, That is the Question....
« Reply #4 on: February 21, 2012, 06:04:31 AM »
From someone no where near there yet!!

I would decrease your 401k contributions  to match and use the difference in a taxable account only when I felt I had fully funded my 401k and Roth as late retirement income.  So, when I was there I'd be playing with firecalc for how much I think I need in the 60-90 age range and if my current tax sheltered accounts will get there by the time I'm 60.

Then I would focus on a pre-60 taxable account to get myself to FI.

So it totally depends on your 401k+Roth balance, current age and desired income ages 60-90 (plus the assumptions you're willing to make about investment returns).

salmp01

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Re: To 401k or Not to 401k, That is the Question....
« Reply #5 on: February 27, 2012, 03:54:56 PM »
My advice - Keep maxing out your 401k contribution. I've been putting the maximum in mine for years. Last year I was able to move my entire ROTH and a good chunk of my 401k into a self directed IRA which enabled me to pay cash for 3 rental properties. I'm thinking that when I retire my tax bracket will be lower so in the end I will pay less taxes.

arebelspy

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Re: To 401k or Not to 401k, That is the Question....
« Reply #6 on: February 28, 2012, 07:41:49 AM »
Last year I was able to move my entire ROTH ... into a self directed IRA...

O_o

So you took money that was already taxed, made it pretaxed, so it can be taxed again later?
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salmp01

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Re: To 401k or Not to 401k, That is the Question....
« Reply #7 on: February 28, 2012, 08:14:04 AM »
The ROTH portion of my self directed IRA will never be taxed. Moving it into a self directed allows me more freedom as to how I wish to invest the money.

arebelspy

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Re: To 401k or Not to 401k, That is the Question....
« Reply #8 on: February 28, 2012, 08:34:51 AM »
Ah, it sounded like you combined the Roth with the 401k into one self-directed vehicle.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
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mustachian.acolyte

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Re: To 401k or Not to 401k, That is the Question....
« Reply #9 on: March 01, 2012, 07:31:57 PM »
I've gotten more and more skeptical of the 401(k) program my company offers. I'm already contributing the minimum to get full employer matching contributions and I think I'll stay there for the forseeable future.

I haven't done all the research yet, but my preliminary findings are that we're totally getting screwed by their expense ratios. It looks like there's an average of 60-or-so basis points added on top of the underlying mutual fund. For example, you know those Target Maturity Vanguard funds, with expense ratios between 0.17 and 0.19? Under my 401(k), their expense ratios are between 0.91 and 0.94! I don't know what standard practice is in the industry, but it feels like I'm getting screwed.

When I'm done paying off my student loans, any additional retirement savings I'll almost certainly put in an IRA, probably with Vanguard.

drewstees

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Re: To 401k or Not to 401k, That is the Question....
« Reply #10 on: March 02, 2012, 07:27:36 AM »
Last year we dropped our 401k down to the minimum to maintain company match.  I used http://firecalc.com/ to model future performance, using both the historical data and manual entries.  After we reached 100% success upon reaching withdrawal age,  we pulled back the contributions.  It's tough to swallow the extra tax hit, but if I wanted to follow MMM's path into early retirement, I knew I had to stop locking up money in the 401k.

Still use the Roth IRA, if allowed by income limits, as contributions can be withdrawn at any time tax free.

I haven't done all the research yet, but my preliminary findings are that we're totally getting screwed by their expense ratios. It looks like there's an average of 60-or-so basis points added on top of the underlying mutual fund. For example, you know those Target Maturity Vanguard funds, with expense ratios between 0.17 and 0.19? Under my 401(k), their expense ratios are between 0.91 and 0.94! I don't know what standard practice is in the industry, but it feels like I'm getting screwed.

Yeah, that does seem high.  My 401k target retirement funds are run by State Street Global Advisors (SSgA), with an expense ratio of 0.17%.  You might want to consider manually managing your asset allocation, if the appropriate funds are available (assuming they would have lower individual expense ratios).

Guitarist

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Re: To 401k or Not to 401k, That is the Question....
« Reply #11 on: March 02, 2012, 08:06:14 AM »
I've gotten more and more skeptical of the 401(k) program my company offers. I'm already contributing the minimum to get full employer matching contributions and I think I'll stay there for the forseeable future.

I haven't done all the research yet, but my preliminary findings are that we're totally getting screwed by their expense ratios. It looks like there's an average of 60-or-so basis points added on top of the underlying mutual fund. For example, you know those Target Maturity Vanguard funds, with expense ratios between 0.17 and 0.19? Under my 401(k), their expense ratios are between 0.91 and 0.94! I don't know what standard practice is in the industry, but it feels like I'm getting screwed.

When I'm done paying off my student loans, any additional retirement savings I'll almost certainly put in an IRA, probably with Vanguard.

I have a book (will find it later to give you all the title) that slams companies who are doing that. Your company has no interest in maintaining a low fee for the 401k, in fact, I think some of these companies off kickbacks to execs. who pick them, meanwhile, the average employee is paying no attention to the expenses and thinks the matching they receive is just great. Meanwhile, their growth is curbed by ridiculous expense ratios. From what I remember, he said the teacher version of the 401k is among the worst, and the federal government version (TSP) is probably the best one out there (low expenses and limited options making it easier to understand what you are doing).

nondualie

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Re: To 401k or Not to 401k, That is the Question....
« Reply #12 on: March 12, 2012, 09:15:21 PM »
I may change my mind on this later, but for now I'm more interested in liquidatable and fungible assets than having all my eggs in the 401K basket.  My macro expectation is that the world is headed for a relatively long bout of contraction and deflation.  I'd rather have my money more accessible so I can buy tangible goods like property as prices come down..provided I still have a job in the long-recession. 

Ergo, I'm still contributing up to my company-match, but the rest is going in savings to be invested in real goods at some point (I have a pretty pre-pubescent 'stache, so we're not talking much here..but at least I have no debt).

I do realize I'm giving up around 25% though given my bracket..hopefully I can make that up through market timing ;)

Also, my fund choices suck as well.  We have T.Rowe and the only bond fund is PIMCO's general one..I'd rather have access to Vanguard, but c'est la vie.

sol

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Re: To 401k or Not to 401k, That is the Question....
« Reply #13 on: March 12, 2012, 09:48:14 PM »
Even with management fees over 1%, it seems to me that the vast majority of folks on the early retirement path would benefit from maxing their 401k plans.

My reasoning is that if you're living off of like half of your current income, and plan to continue that lifestyle in retirement, then your retirement tax rate will be very low compared to your current tax rate.  In fact, your current working tax rate is probably then the highest taxes you will ever pay in your entire life.  With that in mind, it makes sense to max your pre-tax deductions and then take the money back out in retirement when you're in a lower bracket.  Why opt to pay more taxes than you have to?

Even for folks who can't manage the five-year pipeline method for getting 401k money out penalty free at any age, the usual 10% penalty is still a good deal for folks whose effective tax rate will drop more than 10% as they transition to retirement.

I'm having a hard time thinking of anyone who is more than about five years from retirement who shouldn't be maxing their 401k plan before investing anything in taxable accounts.

nondualie

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Re: To 401k or Not to 401k, That is the Question....
« Reply #14 on: March 13, 2012, 12:04:48 PM »
Sol has a good point..  Maybe I'll look at maxing out the 401K once I get my nest egg up over $50K (what we'll be using for a 20-30% downpayment on a house in the next few years).  I do think post ERE we'll be in a much lower tax bracket, especially factoring deductions and credits from having kids and a house.  Also, with a good amount in the 401K, I can keep that as the "worst case" emergency fund and keep a smaller emergency fund more liquid.

I did just rebalance a bit of my T.Rowe account:

I'm now 80% in the PIMCO bond fund (PTTRX w/ an expense ratio of 0.46%) and 20% in the Vanguard Institutional Index fund (VINIX w/ an expense ratio of 0.04%).

The Vanguard fund tracks the S&P500, so it's probably a decent hedge against hyper-inflation.  I may go 60/40 later in the year when I get a larger nest egg together and feel better about putting on a little more exposure.

I only have $26K in the 401K though due to a $20K raid on it I made in 2008 prior to the crash when I was unemployed..

drewstees

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Re: To 401k or Not to 401k, That is the Question....
« Reply #15 on: March 14, 2012, 11:53:03 AM »
Even for folks who can't manage the five-year pipeline method for getting 401k money out penalty free at any age, the usual 10% penalty is still a good deal for folks whose effective tax rate will drop more than 10% as they transition to retirement.

I'm having a hard time thinking of anyone who is more than about five years from retirement who shouldn't be maxing their 401k plan before investing anything in taxable accounts.

Just looking at this in a little more detail for myself, we're currently at an effective tax rate of 20%.  Therefore, assuming the 10% penalty during early retirement, we'd need a rate of 10% or less.  This equates to a taxable income of $17,000 or less at 2011 rates (calculated here http://www.moneychimp.com/features/tax_brackets.htm). 

Is that a reasonable income level to assume?  MMM's comfortable living expenses were right around $27,000 (2 adult + 1 child, no mortgage).  With appropriate deductions, it looks like any expense level below $40,000 would work in our case:

   $17,000 taxable income
+ $11,600 standard deduction (married, joint)
+ $11,100 exemptions (2 adult + 1 child)
-----------
= $39,700 total income

Any other early retirees with kids able to comment on their taxable income levels?

Another big factor to consider is the tax rate on capital gains and dividends versus distributions from a 401k.  Until 2013, you get a pretty sweet 0% tax rate on long term capital gains and qualified dividends, if you're in the bottom two brackets (10/15%).  Whereas all distributions from a 401k (pre-tax contributions + gains) are taxed as regular income.  Definitely a better deal to have the taxable account in place with a steady stream of dividend payments, in that case.   

Again, after 2013 the rates change, but that's always a big unknown with this analysis...none of us know how tax rates or early withdrawal penalties might change in the future, for better or worse.  I'd rather have my money freely available to use and invest, with similar justification as MMM describes in his post.  It's a personal choice, similar to the decision to pay off a mortgage vs. invest.