What's the benefit of a 401k for someone pursuing early retirement?

[Woof!]

I'm 22, debt free, and 3 months into a job that pays me $55k, of which I take home ~$39k. I just put my first $3000 into a Betterment account, and am getting down to about a 50% savings rate. As I finish my first 90 days this week, I'm currently signing up for benefits.

So my question is, if I plan to retire in ~10 years, is it really better for me to put money into a 401k instead of my Betterment account? I realize that maxing out the contribution would save me ~$4000 from taxes annually, but then I couldn't touch that money without penalty until 30 years after I hope to retire. Also important to note: my employer does not match any contributions. There's also $90 in fees every year, in addition to sign up fees and distribution fees, which seems excessive.

Am I underestimating the value of pre-tax investments? Or does focusing on more flexible accounts make sense for someone in my situation?

[MDM]

Woof!, welcome to the forums.

See http://www.madfientist.com/traditional-ira-vs-roth-ira/ for some ideas.  Yes, I know you asked about 401k plans - see the part in that post about converting a 401k to an IRA, then to a Roth IRA.

I think the short answer to "Am I underestimating the value of pre-tax investments?" is "yes".  Others are likely to amplify this thought.

Good luck!

[jawisco]

If you can invest in similar funds, and are not trying to save "contribution room" when you expect to be in a higher tax bracket within the next few years... then any savings in 401K is better due to the tax refund.    If you are in low tax rates, then look at a Roth instead, then finish with Betterment.


CAVEAT -- only put in enough in the 401k to cover your retirement needs from age 59.5 onwards... no more.     You will need money after you are 60 after all.... and only if your marginal tax rate on retirement will continue to be low.  If you plan to pay higher taxes later on, you may as well go for a Roth account or withdraw what you can, tax free.

This is not correct.  You should put as much money into a 401K as you can every year.  There are ways you can get money out of a 401K before you are 60 without paying a penalty and if you put some forethought into it maybe not even paying any income taxes ever on that 401K $ (after pre-tax money was allowed to grow for years).  http://forum.mrmoneymustache.com/ask-a-mustachian/help-me-understand-the-roth-conversion-pipeline-idea-and-its-benefits/

[Paul der Krake]

The employer match is just the icing on the cake.

On top of what everybody else has said: retirement accounts offer a much higher degree of protection against potential plaintiffs/creditors. Disasters happen.

[hodedofome]

You can get the money out before 59 years old without penalties if you do something like the SEPP plan. Max out that 401k and Roth if you want to be retired in 10 years.

[Roland of Gilead]

+1 on the Roth pipeline

Essentially you can take $18,000 pre-tax, put it in a 401K, let it grow, roll it over to a Roth, then in 5 years take it out tax free.

But yeah, if you like paying taxes then a 401K might not be right for you.

[G. Thomas]

Let's say i've slacked and have not maxed out the 401k but have that money sidelined for no reason.  Can one retroactively put money into a tax-advantaged account besides the roths?

[Gone Fishing]

Sounds like your employer picked a particularly fee laden plan.   It might be too early to tell, but the poor nature of the 401(k) might reflect other "cheap" qualities in your employer, but 55k is pretty good for a 22 year old, so maybe they just like to load everything into salary.  But, if they do turn out to be cheap, get some experience then don't be afraid to move on to some place with a better benefit package.

This is a tough one, usually a match can make up for fee heavy plans, but in your case that doesn't pan out.

What are the distribution/sign up fees?  Are they are fixed amounts or a percentage?  If the maintainance fees are fixed, the more you put in the 401(k) the more the fixed fees will be diluted.

What are the investment choices?  Are the individual fund management/purchase fees as onerous as the plan management fees?   

Does the plan allow "in-service" distributions? If so, you might be able to fund the account then periodically roll the balance into a Vanguard Traditional IRA to reduce the impact of the fees.
 
Assuming you are starting at absolute zero, you will need a 65-70% savings rate to retire in 10 years or so.  Or, based on your current expenses, a 'stache of around $500,000 to cover $20k of annual expenses.

If you want to execute the previously mentioned IRA ladder (probably the most tax efficient method to date for a ER), you will need 5 years worth of living expenses in either ROTH contributions or taxable accounts, which I calculate to be around $100,000 in today's dollars based on the information you provided, or around $7k a year returning 8% for 10 years.   


This is what I would probably do:

Looks like you have about 19.5k/yr to invest, break it down as follows:

$5,500 (or max if it changes) in a ROTH IRA, you will need this to execute the IRA ladder.

$1,500 in taxable investments, you will also need this to execute the IRA ladder, it will also serve as a no-strings-attached emergency, house down payment, or other "opportunity" fund. The ROTH contributions can back this up but will have more strings/complications.

$12.5k in the 401(k).  Yes the fees are high, but the tax savings should be higher assuming you execute on ER and the IRA ladder.     

As your income increases, bump up your 401(k) contributions until you hit the max.  After that point, any additional income will go into taxable investments.  As you increase your taxable investments, you can begin to split your IRA contributions between the ROTH and a Traditional IRA, just as long as you stay on track to have enough to fund your first 5 years of ER between the ROTH and Taxable investments.  This plan will also give you some tax diversification in the event the rules change down the road.

This sounds complicated, because it is, but tax optimization can shave years off of your working career, so it is worth the effort to at least try to it get as close as you can to perfect.  But don't let it overwhelm you, you have the most important part down, saving.

Sounds like you are on the right track!  As things change along the way, be sure to "re-work" your plan accordingly.  This forum is a great resource to do that and has helped me immensely! 
 
 

[webguy]

+1 on the Roth pipeline

Essentially you can take $18,000 pre-tax, put it in a 401K, let it grow, roll it over to a Roth, then in 5 years take it out tax free.

But yeah, if you like paying taxes then a 401K might not be right for you.

Forgive me if I'm wrong, but wouldn't rolling a non-roth 401k into a roth IRA be a taxable event? I remembering talking to vanguard about rolling my wife's 403b into a roth IRA and they told me it would be a taxable event as I hadn't paid taxes on the contributed funds, so I ended up rolling it into a traditional IRA instead. Can anyone clarify this for me?

[Philociraptor]

+1 on the Roth pipeline

Essentially you can take $18,000 pre-tax, put it in a 401K, let it grow, roll it over to a Roth, then in 5 years take it out tax free.

But yeah, if you like paying taxes then a 401K might not be right for you.

Forgive me if I'm wrong, but wouldn't rolling a non-roth 401k into a roth IRA be a taxable event? I remembering talking to vanguard about rolling my wife's 403b into a roth IRA and they told me it would be a taxable event as I hadn't paid taxes on the contributed funds, so I ended up rolling it into a traditional IRA instead. Can anyone clarify this for me?

You are correct, you pay taxes when you roll it over.  The key is to roll it over when you're in a low tax bracket, so that the taxes are minimal.

[Cromacster]

+1 on the Roth pipeline

Essentially you can take $18,000 pre-tax, put it in a 401K, let it grow, roll it over to a Roth, then in 5 years take it out tax free.

But yeah, if you like paying taxes then a 401K might not be right for you.

Forgive me if I'm wrong, but wouldn't rolling a non-roth 401k into a roth IRA be a taxable event? I remembering talking to vanguard about rolling my wife's 403b into a roth IRA and they told me it would be a taxable event as I hadn't paid taxes on the contributed funds, so I ended up rolling it into a traditional IRA instead. Can anyone clarify this for me?

Yes, but you wouldn't roll it over directly to a Roth IRA in a retirement scenario.  There are ways to earn around 90,000 annually without paying taxes when living off dividends and retirements accounts.  Gocrrycracker did a good write up on the topic.  Also read madfientist  Tradional Vs Roth

From a retirement account stand point, a married couple without kids could withdraw around 20,000 per year from a traditonal IRA without paying taxes on it.  If you stay in the right tax brackets you can still earn substantially more through capital gains and dividends while paying a very low tax rate.

[Cheddar Stacker]

Let's say i've slacked and have not maxed out the 401k but have that money sidelined for no reason.  Can one retroactively put money into a tax-advantaged account besides the roths?

You can increase your contributions to the 401k plan through HR or the 401k website. Contribute the maximum allowed, which is usually 20-75%. If you contribute 75% your paycheck will virtually disappear. But since you have the money sidelined, use that for your living expenses. Do this today so you can get the most benefit into 2014. Once the current year window closes, it never opens again.

Depending on income, you can also make a deductible contribution to a T.IRA if you haven't already done a Roth IRA contribution. $5,500 total between the two each year, must be made by 4/15 to count for the previous tax year. Add $1,000 if you are 50 or older.

[G. Thomas]

Let's say i've slacked and have not maxed out the 401k but have that money sidelined for no reason.  Can one retroactively put money into a tax-advantaged account besides the roths?

You can increase your contributions to the 401k plan through HR or the 401k website. Contribute the maximum allowed, which is usually 20-75%. If you contribute 75% your paycheck will virtually disappear. But since you have the money sidelined, use that for your living expenses. Do this today so you can get the most benefit into 2014. Once the current year window closes, it never opens again.

Depending on income, you can also make a deductible contribution to a T.IRA if you haven't already done a Roth IRA contribution. $5,500 total between the two each year, must be made by 4/15 to count for the previous tax year. Add $1,000 if you are 50 or older.

Thank you. I bumped it to the max 86% for the remaining pay periods. My Roth is already maxed.

[Philociraptor]

Let's say i've slacked and have not maxed out the 401k but have that money sidelined for no reason.  Can one retroactively put money into a tax-advantaged account besides the roths?

You can increase your contributions to the 401k plan through HR or the 401k website. Contribute the maximum allowed, which is usually 20-75%. If you contribute 75% your paycheck will virtually disappear. But since you have the money sidelined, use that for your living expenses. Do this today so you can get the most benefit into 2014. Once the current year window closes, it never opens again.

Depending on income, you can also make a deductible contribution to a T.IRA if you haven't already done a Roth IRA contribution. $5,500 total between the two each year, must be made by 4/15 to count for the previous tax year. Add $1,000 if you are 50 or older.

Thank you. I bumped it to the max 86% for the remaining pay periods. My Roth is already maxed.

Out of curiosity, why is 86% the max? FICA taxes only add up to 7.65%, where'd that other 6.35% go?

[Cheddar Stacker]

Some plans max out at 15-20%. For no apparent reason. Some argue it's to prevent HCE's (highly compensated) from contributing too much, but they're dead wrong as it has the exact opposite effect.

200,000 * 20% = $40,000
50,000 * 20% = $10,000

What ends up happening is both get screwed. The $50k guy can't max out. If he were allowed to his contribution % would be higher bringing up the overall average contribution %. The HCE's can't contribute much more than the average contribution %, so they end up with excess deferrals coming back to them as taxable income.

Broken logic.

[G. Thomas]

Let's say i've slacked and have not maxed out the 401k but have that money sidelined for no reason.  Can one retroactively put money into a tax-advantaged account besides the roths?

You can increase your contributions to the 401k plan through HR or the 401k website. Contribute the maximum allowed, which is usually 20-75%. If you contribute 75% your paycheck will virtually disappear. But since you have the money sidelined, use that for your living expenses. Do this today so you can get the most benefit into 2014. Once the current year window closes, it never opens again.

Depending on income, you can also make a deductible contribution to a T.IRA if you haven't already done a Roth IRA contribution. $5,500 total between the two each year, must be made by 4/15 to count for the previous tax year. Add $1,000 if you are 50 or older.

Thank you. I bumped it to the max 86% for the remaining pay periods. My Roth is already maxed.

Out of curiosity, why is 86% the max? FICA taxes only add up to 7.65%, where'd that other 6.35% go?

86% is just the max I can contribute per pay period to my plan.  Nothing about taxes/FICA.