I Don't understand If Should Fund my 401k or Not

[Dibs]

I had a bit of a slow start in life and am just now able to start saving money. I've got around 20k that's not doing anything, but I'm not sure what to do.
My unemployed mother also lives with me.
I am currently 29, single, have about 20k in student debt and have an income of 86k.
I can either contribute to a vanguard index fund or I can max out my 401k (w/o matching).
If I don't fund my 401k, this brings me to ~63k net.
I spend about 20k a year on rent and probably 15k on my other expenses. So this brings me to around a 45% savings rate. I imagine this would bring me to about 20 years until retirement. I was hoping for 10 years, but I guess that's the best I can do.

I just can't understand why people put their money in 401Ks if they plan on retiring before 59.5. I know there's that 72t loophole, but that sounds kind of dodgy.

At the same time, I know that Mr. Mustache himself had maxed out his 401k when he was working to save for end of life expenses.

So I'm at an impasse. If I max out my 401k I won't be able to retire until I hit retirement age from the remaining contributions which kind of defeats the purpose of saving separately anyway.

Ugh, this is very frustrating. I feel like if I don't fund my 401k, I'm going to regret it near the end of my life but if I fund it, I won't be able to retire early.

It seems like the only way to really make this work is if I had a girlfriend or wife whom I could share the costs with, but I have no intention of burdening anyone else down with my mom so that's not an option for a while.

Is my best case scenario to retire at 60 despite my relatively high savings? Is there no winning here?

Any help would be appreciated.

[iamlindoro]

OK, first things first-- Good job overcoming whatever your circumstances are and getting to a point where you could max out your 401k.

Second- Probably best not to refer to 59.5 as the "end of life."  People commonly live 40 years beyond that.  I realize it may seem pretty old at 29, but it ain't that old.

Anyway, MMM did *not* max out his 401(k) for "end of life expenses" (a term usually used to denote one's funeral expenses), but rather for his current living expenses.  There is more than just the 72(t) rule to get money out of a 401k , there's also the Roth pipeline, which is a better choice for many people (MMM included, as I understand).  There is also, although seldom discussed here, the option of simply paying the penalty if the other options were to disappear. 

At your income level, the tax savings are a real factor in where your money should go.  Could the various methods of getting money out of a 401k disappear in the medium or long term?  Sure, yes.  But you have no control over that.  As MMM says, that is not within your circle of control.  It's there now, and shows no sign of disappearing at the moment.  Even if those methods evaporate, in the worst case (paying the penalty) if you are in the 15% tax bracket in retirement, you are likely to be net even on the taxes + penalty. 

Simply put, there is just no reason to forgo the tax savings on the off chance that all methods to access the money early and penalty-free disappear.

You should also critically evaluate your retirement math.  It seems like maybe you're overestimating what your living expenses would be in retirement.  There are *lots* of variables you can control when it comes to costs (especially your costs in retirement) to reel in the early retirement date.  You also don't seem to take into account raises or bonuses or side hustles... 

For 63K net, 28K annual savings, 35K expenses, I get 17.1 years if your expenses in retirement are still 35K/year (7% return, 4% withdrawal rate).  Get the retirement expenses to 24K and you're at 13.5 years.  Get a few raises, you're at 10 years pretty easy.  All of that presumes that you don't get the tax advantage of the 401k, too.  Max out your 401k, put the other 10 in tax-efficient investments, find someplace less expensive to live in retirement, and you'll easily hit 10 years.

[jmusic]

At your income level, the tax savings are a real factor in where your money should go.  Could the various methods of getting money out of a 401k disappear in the medium or long term?  Sure, yes.  But you have no control over that.  As MMM says, that is not within your circle of control.  It's there now, and shows no sign of disappearing at the moment.  Even if those methods evaporate, in the worst case (paying the penalty) if you are in the 15% tax bracket in retirement, you are likely to be net even on the taxes + penalty. 

I think Congress likes this particular loophole as it helps to accelerate tax payments on retirement funds.  But if necessary, good point about simply paying a penalty if necessary.  Even so, OP should consider that it's still DELAYING (deferring) taxes which is a great deal, second only to avoiding them altogether. 

[MDM]

A few links that may be useful:

https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/

http://forum.mrmoneymustache.com/ask-a-mustachian/how-to-write-a-%27case-study%27-topic/ (also the spreadsheet downloadable from this link)

www.cfiresim.com

[Dibs]

Thanks a lot for your responses everyone! I feel much better about this now, but I still have some questions.

I believe what I'm being told here is to do the following as follows:
1- Max out 401k @18K each year
2- Max out Roth IRA @5.5K each year
3- Put the rest in index funds each year

Assuming I stay at my current job until FIRE (10-17 years), after I leave:
1- Roll over 401k to Roth IRA
2- Start withdrawing index fund earnings
3- Start withdrawing Roth IRA principle that has been in my account for 5 years

Is this right? Am I not going to run out of principle before I reach 59.5 so I would have to take the penalty anyway? It seems like I would only be able to withdraw 5.5K from the Roth IRA for at least the first 5 years and would have to supplement the rest using the index funds or other work for that time period. Am I missing something here?

[thd7t]

Thanks a lot for your responses everyone! I feel much better about this now, but I still have some questions.

I believe what I'm being told here is to do the following as follows:
1- Max out 401k @18K each year
2- Max out Roth IRA @5.5K each year
3- Put the rest in index funds each year

Assuming I stay at my current job until FIRE (10-17 years), after I leave:
1- Roll over 401k to Roth IRA
2- Start withdrawing index fund earnings
3- Start withdrawing Roth IRA principle that has been in my account for 5 years

Is this right? Am I not going to run out of principle before I reach 59.5 so I would have to take the penalty anyway? It seems like I would only be able to withdraw 5.5K from the Roth IRA for at least the first 5 years and would have to supplement the rest using the index funds or other work for that time period. Am I missing something here?

I don't think that a Roth IRA is a great idea for you.  Even after all of your deductions/exemptions, you'll be in the 25% tax bracket.  You should shield that in a traditional IRA. 

[jmusic]

Is this right? Am I not going to run out of principle before I reach 59.5 so I would have to take the penalty anyway? It seems like I would only be able to withdraw 5.5K from the Roth IRA for at least the first 5 years and would have to supplement the rest using the index funds or other work for that time period. Am I missing something here?

The thing to be careful of is in the conversion from 401K -> Roth then you pay taxes on that money.  You DON'T want to do this all at once as that would throw you in a high tax bracket.  The idea is to convert one year's expenses at a time.  Hence the term "Roth conversion pipeline."  With this philosophy, you will likely need some after-tax savings to cover years 1-5. 

I'd also recommend to do a 401K -> traditional IRA immediately though.  This will not be a taxable event, but it will give you more control of the funds...

[Dibs]

Ok, I think I've got it now:

1 - Max out the 401k every year @ 18K
2 - Max out traditional IRA every year @ 5.5K
3 - Put the rest in index funds

At FIRE:
1 - Consolidate 401k into traditional IRA immediately
2 - Convert traditional IRA to Roth IRA at expected annual requirements at year FIRE+5
3 - Live first 5 years off of index funds
4 - Live rest of life off of Roth IRA

Does that sound better?

[Eric]

Ok, I think I've got it now:

1 - Max out the 401k every year @ 18K
2 - Max out traditional IRA every year @ 5.5K
3 - Put the rest in index funds a post tax brokerage account

At FIRE:
1 - Consolidate 401k into traditional IRA immediately
2 - Convert traditional IRA to Roth IRA at expected annual requirements at year FIRE+5
3 - Live first 5 years off of index funds my brokerage account balance
4 - Live rest of life off of Roth IRA

Does that sound better?

I think you've got it.  With the caveat that all of your money should probably be in index funds.  Your 401k money, your IRA money, and the remainder that goes into a regular brokerage account.  So where you list "index funds" above, what you're really talking about is a regular brokerage account.  Then within that account, you'll be invested in index funds.

[jmusic]

Ok, I think I've got it now:

1 - Max out the 401k every year @ 18K
2 - Max out traditional IRA every year @ 5.5K
3 - Put the rest in index funds a post tax brokerage account

At FIRE:
1 - Consolidate 401k into traditional IRA immediately
2 - Convert traditional IRA to Roth IRA at expected annual requirements at year FIRE+5
3 - Live first 5 years off of index funds my brokerage account balance
4 - Live rest of life off of Roth IRA

Does that sound better?

I think you've got it.  With the caveat that all of your money should probably be in index funds.  Your 401k money, your IRA money, and the remainder that goes into a regular brokerage account.  So where you list "index funds" above, what you're really talking about is a regular brokerage account.  Then within that account, you'll be invested in index funds.

Agreed.  I think he was just a bit confused about "buckets" of money and what the money is actually invested in.  That's one of my pet peeves about banks that just say "Open a Roth IRA, and earn .85% APY TAX FREE!"  They simply further the confusion, and also happen to profit from it.  Of course, if I had my way, the word "Saving" would be banned from marketing materials... 

[TexasStash]

Thanks a lot for your responses everyone! I feel much better about this now, but I still have some questions.

I believe what I'm being told here is to do the following as follows:
1- Max out 401k @18K each year
2- Max out Roth IRA @5.5K each year
3- Put the rest in index funds each year

Assuming I stay at my current job until FIRE (10-17 years), after I leave:
1- Roll over 401k to Roth IRA
2- Start withdrawing index fund earnings
3- Start withdrawing Roth IRA principle that has been in my account for 5 years

Is this right? Am I not going to run out of principle before I reach 59.5 so I would have to take the penalty anyway? It seems like I would only be able to withdraw 5.5K from the Roth IRA for at least the first 5 years and would have to supplement the rest using the index funds or other work for that time period. Am I missing something here?

Hopefully you never run out of principle (values) or principal (money). :)

Sounds like everyone here has pretty much nailed it. I am very interested as I've been internally questioning whether I put more than my current 10% toward 401k. 10% still leaves me well under the 18k limit.

OP, I think a key point here is that your current living expenses of $35k are a key enabler for you to take advantage of the Roth pipeline. You could do it with higher expenses, but there would definitely be the additional tax. I assume even moving $35k per year from traditional IRA to Roth would generate some taxes.

Definitely consider finding cheaper rent if it's just you and your mom for the foreseeable future.

[Fuzzy Buttons]

That all sounds good, but I'd still vote for doing the Roth IRA now instead of the Traditional.  Yes, the Traditional will save you in taxes, since you'll get the deduction at your current 25% rate and then most likely pay tax when you take it out at the 15% rate.  But the Roth gives you the ability to withdraw your contributions tax and penalty free at any time.  This can help supplement your taxable investments during the first five years as you build your Roth pipeline from your former 401(k) money.

Also, the limit on getting the deduction for a Traditional IRA is pretty tight.  I make $74 gross, and maxing out my 401(k) and HSA gets me there no problem.  But you're earning $10k more.  If your MAGI isn't under the $61,000 limit to get the full deduction, then you're just flat out better in a Roth IRA. 

[MDM]

If your MAGI isn't under the $61,000 limit to get the full deduction, then you're just flat out better in a Roth IRA.

Perhaps "flat out better" might be a bit of an exaggeration.  E.g., with a MAGI of $61,100 putting ~$5,445 into the tIRA (whether or not one puts the other $55 into a Roth) seems worth doing.  But yes, I'd agree that with a MAGI of $70,900 it may not be worth putting $55 into the tIRA....

Presumably the OP's MAGI will only increase over the years, so why not take advantage of the tIRA now while eligible? 

[dandarc]

If your MAGI isn't under the $61,000 limit to get the full deduction, then you're just flat out better in a Roth IRA.

Perhaps "flat out better" might be a bit of an exaggeration.  E.g., with a MAGI of $61,100 putting ~$5,445 into the tIRA (whether or not one puts the other $55 into a Roth) seems worth doing.  But yes, I'd agree that with a MAGI of $70,900 it may not be worth putting $55 into the tIRA....

Presumably the OP's MAGI will only increase over the years, so why not take advantage of the tIRA now while eligible?

That's my vote - wish I had done way more traditional money earlier in my career.  Was doing both Roth IRAs and 401Ks for a while when neither was necessary nor made sense, knowing what I know now.  Now we make too much for tradtional IRAs.

[Dibs]

Holy cow! I've been gone for half a day and my financial future is all but planned out for me! :D

Thanks guys!

I have some student loans that I am paying off so I'm going to have to calculate my MAGI before I know how much I can put in the traditional ira.

It sounds like the best bang for my buck would be to shield as much of my money from the 25% tax bracket as possible so I'll put as much as I can into a traditional ira and I guess the balance of the 5.5K would go into a roth.

The only problem is I would have to make sure my post taxed brokerage account is sufficient for the 5 years I'm going to need it. That shouldn't be too hard though. I would only need like 200k or less there. Then again I might need more if I ever want to buy a house (there ain't no way no bank will give a loan to someone they consider unemployed). It's not like they can secure a loan against a retirement account.

Also... yes... principal*...
I didn't know how to express a brokerage account so I called it an index fund, but I do understand that all of my contributions should be to brokerage accounts that exclusively contain index funds. I've got a coworker that's been investing for 20 years and he can usually pick pretty good stocks so I might take his advice with some of the money that was destined for a brokerage account, but not too much of it (maybe 20%).

Just curious, TexasStash mentioned that the 35K spending is what allows me to take advantage of the Roth pipeline. Are most people not able to do this on this forum? I mean, isn't the point of this website to promote frugality? I'm 1 person living off of like 2x what the MMM family lives off of so I know I could do better. I haven't optimized everything yet.

dandarc... why do you regret putting money into a 401k? Why would this ever be a bad thing? What else would you have done with it instead of putting it into a 401k?

Finally, I did use another term incorrectly. I didn't meant to write end of life expenses, I meant to write near end of life expenses. So from the age of 80 onwards, don't most people's expenses go way up? Am I not going to need some serious cash for medical expenses and home care here?

[Eric]

The only problem is I would have to make sure my post taxed brokerage account is sufficient for the 5 years I'm going to need it. That shouldn't be too hard though. I would only need like 200k or less there. Then again I might need more if I ever want to buy a house (there ain't no way no bank will give a loan to someone they consider unemployed). It's not like they can secure a loan against a retirement account.

There are ways to get a home loan after FIRE.  Check out this thread (and the linked threads within) for some ideas:

http://forum.mrmoneymustache.com/welcome-to-the-forum/crazy-mortgage-qualifying-standards/

[dandarc]

I specifically regret putting it into a Roth 401K.  Not so much bad, as less-good.  I should have gone traditional and done way more.  Been in the 25% bracket or higher for my entire post-college career (9+ years now - holy crap).  The first 2 years of that, I was even in a state with an income tax on top of the federal.  Up until last year, I had a strong preference for Roth accounts of all types.  Now it is like "what the fuck was I thinking?" 

Very expensive lessons - I figure my younger self has cost current-dandarc on the order of 200K today in various moronic decisions that were made in the past, some knowingly (gambling was a "hobby" for a long time), some just because I was too lazy to do adequate research.  The earlier you figure this stuff out, the better off you'll be.  It really is a pity so many take until their 50's or beyond to figure out how to handle money.

Point on the taxable brokerage - your 5-year funding to prime the Roth doesn't necessarily have to come from a taxable brokerage account.  Roth IRA contributions (not earnings) can be withdrawn at any time, so depending on where you are when you retire, you might be able to use that.  Then if you ever find yourself in a government job, or perhaps with a SO who works for the government, there's this thing called a 457 which is absolutely fantastic for early retirement - tax deferred like a 401K, but with no early-withdrawal penalties if you have separated from the employer.  And push comes to shove, you could always pay the penalty too, or do something with a SEPP if necessary.  So I wouldn't worry that you don't have enough to cover those 5 years until you are pretty close to hitting your number.