401K vs Index Investing - How to Choose?

[HopefulMustache]

This feels like a question that has been asked before, so I apologize if it's a repeat.

A quick search did lead me to threads that included this pro-401k post, but it hasn't convinced me that going all-401k is smart for my situation. The main problem is the 5 year window required to build up the conversion "ladder". In the scenario laid out there, the retiree so happens to have enough overflow cash on hand or in taxable accounts to completely support themselves for 5 years and also have a full 1 year's worth of cushion leftover by the time they can retire. While this is super convenient for that theoretical person, their situation is far from my own.

In my situation, I can't even come close to maxing out my 401K. I currently only do enough for the match. I am, however, learning to grow my stash and increase the amount I am able to save. So my question revolves around where to target my growing investment capital.

It seems to me that, assuming my FIRE date is 55 or earlier, I would need to end up with a 5-6 year safety cushion of accessible taxed investments by the time I FIRE. Plus a home down payment is a possibility in the future, so I will need additional assets to be accessible in taxable accounts for that. But every dollar I invest in a taxable account is a dollar I don't put in my 401K right now. If I go 100% taxable accounts until I have this cushion, it would mean $0 additional 401K investment for a good while, which seems counter-intuitive when it comes to "wise retirement planning". But going 100% 401K seems like it can't be right for my situation either.

Working this out as I go along, is the right thing to do, then, to determine what my cushion needs to be by my likely FIRE and/or house date, invest exactly the amount it'll take to get there in taxable accounts, and then put the remainder, whatever is left, into my 401K? Does it make any sense to ping pong, putting everything in one for X years and then swapping to the other? ie: Maybe I will change jobs and not have the 401K option, so I should emphasize it now. Or maybe I should consider another option, like a Roth IRA, that would make it easier to integrate withdrawals?

Thanks in advance for any thoughts or musings, and sorry this got a bit long! Just trying to figure out where it makes sense to put my novice stash, and I figured this community would have some helpful ideas for someone like me.

(PS: If it helps the calculus, I just checked the expense ratios of funds in my 401K and most are 1.2% or higher - the best (lo and behold, an S&P 500 Index) is only about 0.71%, which still pales in comparison to Vanguard. My funds are widely distributed as of now, but I have a non-mustachian 0% in the Index fund. Next time I reallocate my account I will be shifting most, if not all, thataways.)

[Beric01]

In my situation, I can't even come close to maxing out my 401K. I currently only do enough for the match. I am, however, learning to grow my stash and increase the amount I am able to save. So my question revolves around where to target my growing investment capital.

How much do you expect your savings rate to increase? Can you increase your income?

A critical part of this rollover strategy is indeed having enough money in taxable accounts to cover you for the 5-year period before you can access the rollover money. However, if you will be able to contribute to that account later down the road (before FIRE), I would definitely try to put as much as you can in the 401(k) for the short term, as you will lose the opportunity for those years completely otherwise.

So how much do you expect your income/savings rate to increase over the years before FIRE?

[Eric]

I think you've got the theoretical situation handled.  How about some real numbers?  What's your 401k balance?  How much are you saving per year?  How much are you spending per year and will this be more, less, or the same in retirement?  What's the approximate down payment amount?  And why do you want to buy a house if you can't even afford to max out your 401k?  (okay, that last one isn't a numbers question, but it needs to be asked)

Working this out as I go along, is the right thing to do, then, to determine what my cushion needs to be by my likely FIRE and/or house date, invest exactly the amount it'll take to get there in taxable accounts, and then put the remainder, whatever is left, into my 401K? Does it make any sense to ping pong, putting everything in one for X years and then swapping to the other? ie: Maybe I will change jobs and not have the 401K option, so I should emphasize it now. Or maybe I should consider another option, like a Roth IRA, that would make it easier to integrate withdrawals?

It could make sense to split them, or bounce back and forth.  Part of it depends on your income and tax bracket, since every dollar you invest in the 401k is a dollar that you don't have to pay taxes on.

Why can you only come close to the match and not the max?  Is it more of an income limitation or a spending limitation?  It's a lot easier for us to help with the spending side, so if you want to track and post your detailed expenses as well, people will help you figure out where to save more money.

[HopefulMustache]

How much do you expect your savings rate to increase? Can you increase your income?

A critical part of this rollover strategy is indeed having enough money in taxable accounts to cover you for the 5-year period before you can access the rollover money. However, if you will be able to contribute to that account later down the road (before FIRE), I would definitely try to put as much as you can in the 401(k) for the short term, as you will lose the opportunity for those years completely otherwise.

I'm looking into ways to increase my income. I'm relatively young and not earning a huge income presently, so I have some confidence that I will be able to increase it over time, but how much is another question. It could be many years before I add the net income that I would need to max out my 401K, and I may never add drastically more. However, I see your main point, which is that I can invest as much as I want in taxable accounts whenever I want, but I DO have a yearly limit on my 401K, so I should be mindful of the opportunity cost of that. Thanks for the thought.

[HopefulMustache]

I think you've got the theoretical situation handled.  How about some real numbers... And why do you want to buy a house if you can't even afford to max out your 401k?

Hard numbers are a bit tricky, as I'm married and the degree of joint-commit to FIRE is not a given. I'm also only about a month into more finely tracking our budget, so I'd have to do a lot of estimating. For the sake of brevity, suffice it to say that we have a long way to go for FIRE and that even if we both invested our maximum yearly savings into our 401ks, we would not max them both out. However, we do have funds in savings and non-ideal taxable accounts that I want to reallocate, as well as (hopefully increasing) monthly savings that I want to invest properly. Regardless of exact numbers, I want to find these assets a happy home and begin investing them more smartly.

To your other question, our expenses would probably slightly decrease in retirement, but certainly the biggest decrease would be a result of reduced rent, assuming we moved to a cheaper location or owned our home at some point. The buying of a house itself is an open question. I had initially thought we'd buy within a few years as the "next step," but I'm questioning that assumption and timeline, in part due to this site. For what it's worth, the PITI on a the kind of home we'd want in this area would be roughly comparable to what we pay in rent for a tiny 1BR apartment right now. You'll probably tell me I need to move somewhere else (and fast!), but it's why I think that with a modest income increase to accommodate for repairs, we could afford such a place. Not saying it'd be ideal for FIRE or anything, as the down payment would likely wipe out a large percentage of our savings. Just thinking about it because we like the idea of it.

Working this out as I go along... Does it make any sense to ping pong, putting everything in one for X years and then swapping to the other?

It could make sense to split them, or bounce back and forth.  Part of it depends on your income and tax bracket.

Why can you only come close to the match and not the max?  Is it more of an income limitation or a spending limitation?  It's a lot easier for us to help with the spending side, so if you want to track and post your detailed expenses as well, people will help you figure out where to save more money.

I did think that the tax bracket might be a good way to decide on the 401k... if I'm close to the line I could use the 401k to get under. But I think we're likely to already be in the high end of our fairly low tax bracket... maybe in the future if we dip over the line that will come into play.

When I was reading about the Roth IRA I saw it suggested that, if I expect my income tax to rise, that may be a savvy place to store my stash. It would also remove the need to have a bonus 5 years stored elsewhere since I could withdraw the principle. What do you think about that, at least while our present income is in a low tax bracket? Think it's a route worth going down?

As you may now be able to guess, income limitation plays a big role in this choice - we're already relatively frugal. I may submit a case study at some point to fine tune expenses, but I'm not sure we're there yet. Thanks for the suggestion though.

[rugorak]

Investing in your 401k will reduce your taxes. Most people find that for every dollar they put into a 401k (assuming non-Roth) works out to be a $0.66-0.75 reduction in their take home pay. So it takes more to invest in your taxable account. Especially when you were taxed on income and then will be taxed on capital gains and dividends on top of that. So regardless of where you are in your tax bracket it should make sense to put into there.

Ideally in your position I would do both the 401k and Roth IRA. I would suggest you start by doing your 401k until the match. Then max out your Roth, then max out your 401k. Once you can do this then you can do taxable investing.

This should strike a balance with your concerns and give you all the tax benefits you can get. Your Roth you can start tapping on day 1 of FIRE (and even earlier for a few select reasons should you need to, not that you want to). After all this is the account you'll be converting your 401k to. But you won't be leaving free money on the table. Honestly for myself I find that even maxing both of these I still need to have excess saving on top of that to truly get to FIRE. So chances are you'll be saving in 3 locations before you can seriously consider FIRE.

[Eric]

When I was reading about the Roth IRA I saw it suggested that, if I expect my income tax to rise, that may be a savvy place to store my stash. It would also remove the need to have a bonus 5 years stored elsewhere since I could withdraw the principle. What do you think about that, at least while our present income is in a low tax bracket? Think it's a route worth going down?

Yes, absolutely.  Roth IRAs are great, and as you mentioned, very flexible in that you can always withdrawal your principle if you needed to in an emergency.

[HopefulMustache]

Rugorak, thanks for the insights. I like that 401k Match-->Roth-->401k-->Other Investing plan. It actually can make me feel like a badass since those numbers start pretty small and scale up to infinity, making it easier for me to hit the max of each section gradually.

Your Roth you can start tapping on day 1 of FIRE (and even earlier for a few select reasons should you need to, not that you want to). After all this is the account you'll be converting your 401k to.

I did have a question on this though. Is there a point where I should definitively plan on converting my employer 401k to a Roth IRA? I skimmed some info on that conversion and it seems like it would incur taxes, and so I'd think it wouldn't make sense to do that later in life if I'm at/near my peak tax rate. Could you explain what you meant?

Eric, thanks for confirming the Roth IRA as a good option too - I'm glad I mentioned it, as it clearly wasn't as much on my mind when I first framed this topic. If anyone knows of other amazing retirement vehicles I've completely missed, please feel free to share :)

[rugorak]

I did have a question on this though. Is there a point where I should definitively plan on converting my employer 401k to a Roth IRA? I skimmed some info on that conversion and it seems like it would incur taxes, and so I'd think it wouldn't make sense to do that later in life if I'm at/near my peak tax rate. Could you explain what you meant?

This is where the ladder approach comes into play. When you leave your employer you should convert your 401k to a Rollover IRA. It gives you full control over it independent of your former employer but otherwise is the same thing tax wise. Then you slowly convert the Rollover IRA to a Roth IRA. It is all explained here -
http://www.madfientist.com/retire-even-earlier/

Short version is you do not start the conversion until after your income is close to 0 because you have started retirement. Then the conversion will be low enough each year that your yearly income will basically be below the minimum you have to make before you pay income taxes. The whole point is to just allow you to retire earlier and still taking advantage of the tax breaks. Otherwise you would have to wait until you are 59 1/2. 

Glad you like my plan. But try and max out your 401k as quickly as possible since you are paying income tax on your Roth. From a purely tax efficiency point of view my suggestion isn't the best. But there is the emotional/control/life happens aspect which is why I suggest doing it that way and used it myself. For me it helped knowing every dollar that I put into my Roth IRA I could withdraw without penalty (you just cannot take out any growth until 59 1/2) if I really needed to.

[HopefulMustache]

Ah ok, I think I see that now regarding the ladder - thanks for clarifying. That HSA strategy is interesting too, something I hadn't heard of.

I will be working on my 401k and keeping it in mind, but the peace of mind from penalty-free withdrawals is very attractive to me right now too.