Author Topic: 401k questions for those retiring very early (30s/40s)  (Read 4948 times)

dignam

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401k questions for those retiring very early (30s/40s)
« on: July 24, 2016, 07:21:01 AM »
Hi all - so I frequently see advice here about maxing 401k and IRAs, which is no doubt good advice.  For those the have retired/are retiring very early though, does it follow that you have a substantial chunk in other investments given you can't really touch 401k without penalty until your 50s/60s?

Do your other investments sort of "hold you over" while 401k grows, and then you draw on that later in life?

Sorry for the possibly dumb questions.  :)

jorjor

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #1 on: July 24, 2016, 08:28:53 AM »
There are ways to access your 401k/IRA funds early without penalty. Read here and enjoy: http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

dignam

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #2 on: July 24, 2016, 09:17:22 AM »
Excellent, thank you!

boarder42

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #3 on: July 24, 2016, 09:26:04 AM »
Mad fientists most recent post also references this.
http://www.madfientist.com/how-to-access-retirement-funds-early/

Even paying the 10% penalty is better than taxable.

zolotiyeruki

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #4 on: July 25, 2016, 08:14:21 AM »
Yup, roll that 401k into a tIRA, and set up a SEPP, and you can withdraw something like 2.5% per year until you hit age 59.5.  If that's not enough, you'll need to supplement with income from traditional investments.

Incidentally, this is one reason why I'm no longer as much a fan of Roth IRAs as I once was--you don't gain access to the gains without penalty until 59.5.  Assuming your income in retirement is in the 15% bracket or lower, a traditional investment is a better bet.

meerkat

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #5 on: July 25, 2016, 10:34:34 AM »
I was actually thinking of making a post with essentially the same question!

Even paying the 10% penalty is better than taxable.

Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.

dignam

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #6 on: July 25, 2016, 11:31:02 AM »
I was actually thinking of making a post with essentially the same question!

Even paying the 10% penalty is better than taxable.

Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.

^ Great question, one I'm curious about too.  I mean no matter what you're going to be taxed on the money at some point, whether it's a pre-tax elective deferral or not.

Nick_Miller

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #7 on: July 25, 2016, 11:34:11 AM »
I was actually thinking of making a post with essentially the same question!

Even paying the 10% penalty is better than taxable.

Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.

^ Great question, one I'm curious about too.  I mean no matter what you're going to be taxed on the money at some point, whether it's a pre-tax elective deferral or not.

Isn't the (huge) difference due to gains being taxed in a regular account but in an IRA, the gains grow tax-free?

zolotiyeruki

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #8 on: July 25, 2016, 11:35:16 AM »
I was actually thinking of making a post with essentially the same question!

Even paying the 10% penalty is better than taxable.

Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.
If your marginal tax rate is 25%, and you expect to have a 15% marginal tax rate (or less) in retirement, then it works out like so, assuming you start with $10k and withdraw when it doubles:
IRA/401k: you invest $10k now.  Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes.  You walk away with $15k
Traditional: you pay 25% in taxes now, invest $7500.  Later, you withdraw $15k and pay zero taxes

In both scenarios, you end up with the same amount of money.  But let's take a more real-world example, say of $40k withdrawal per year.  Then the numbers for the IRA/401k look like this:
$40k withdrawn
-$20.7k standard deduction and personal exemptions (assuming married filing joint, no kids)
---------
$19,300 in taxable income.

The first $18550 (in 2016) would be taxed at 10%, and the last $650 would be taxed at 15%.  That gives you a total tax bill of about $1950.  Add that to the 10% penalty for early withdrawal, and you're looking at a take-home of about $34000.  The amount you pay to Uncle Sam is about 15%.

Let's assume that the $40k you originally withdrew started as a $10k investment that doubled twice, and back-calculate how much you'd have to invest via traditional investments in order to get that same take-home:
$34k/4 = $8500 original investment
$8500/(1-.25) = $11,333 (add back in the 25% taxes you paid)

In other words, you'd need to take more money from your paycheck now to get that $34,000 payout later if you opt for a traditional investment rather than a 401k/IRA.  This all assumes, however, that you're well into the 25% tax bracket.  If you're already in the 15% or 10% bracket now, then a traditional investment will make more sense.

seattlecyclone

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #9 on: July 25, 2016, 11:44:21 AM »
If your marginal tax rate is 25%, and you expect to have a 15% marginal tax rate (or less) in retirement, then it works out like so, assuming you start with $10k and withdraw when it doubles:
IRA/401k: you invest $10k now.  Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes.  You walk away with $15k
Traditional Taxable: you pay 25% in taxes now, invest $7500.  Later, you withdraw $15k and pay zero taxes

In both scenarios, you end up with the same amount of money.

Another thing to consider with this example is that dividends from a taxable account will be taxed every year as long as you're above the 15% tax bracket. This effect won't be too huge if it's just for a few years, but it does make it so that the traditional IRA does win out over a taxable account in this scenario rather than simply tying.

Look into the Roth conversion ladder or "substantially equal periodic payments" to get around the 10% early withdrawal penalty; just keep in mind that if you plan to have a tax bracket at least 10% lower in retirement than now you'll be better off simply paying the 10% penalty than paying a higher tax rate to make post-tax investments now.

meerkat

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #10 on: July 25, 2016, 11:46:45 AM »
IRA/401k: you invest $10k now.  Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes.  You walk away with $15k
Traditional: you pay 25% in taxes now, invest $7500.  Later, you withdraw $15k and pay zero taxes

Is the IRA/401k above Roth or does it matter? When you say Traditional do you mean non-Roth or non-IRA/401k?

zolotiyeruki

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #11 on: July 25, 2016, 01:10:25 PM »
IRA/401k: you invest $10k now.  Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes.  You walk away with $15k
Traditional: you pay 25% in taxes now, invest $7500.  Later, you withdraw $15k and pay zero taxes

Is the IRA/401k above Roth or does it matter? When you say Traditional do you mean non-Roth or non-IRA/401k?
Traditional investments are where you by X shares of company Y or mutual fund Z.  It refers to investments that are not tax-advantaged in any way, i.e. non-IRA, non-Roth, non-401k, etc.

Look into the Roth conversion ladder or "substantially equal periodic payments" to get around the 10% early withdrawal penalty; just keep in mind that if you plan to have a tax bracket at least 10% lower in retirement than now you'll be better off simply paying the 10% penalty than paying a higher tax rate to make post-tax investments now.
Good point--my calculations above did not take into consideration the use of a SEPP.  Adding that in will further tilt the scales in favor of IRA.  Let's say you are withdrawing $20k using a SEPP, and another $20k with the early withdrawal penalty.  Now, you pay only $2k in penalties, and the same nearly-$2k in taxes, for a net percent of 10% to Uncle Sam.

johnny847

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #12 on: July 25, 2016, 01:14:21 PM »
I was actually thinking of making a post with essentially the same question!

Even paying the 10% penalty is better than taxable.

Can someone explain this with numbers? Because I've been trying to do reading and that's not really sinking in. I'd like to understand it rather than just taking someone's word for it. My husband was asking why not just invest in a mutual fund outside of a 401k/IRA to avoid having your money be locked up for years and I didn't really have an answer.
If your marginal tax rate is 25%, and you expect to have a 15% marginal tax rate (or less) in retirement, then it works out like so, assuming you start with $10k and withdraw when it doubles:
IRA/401k: you invest $10k now.  Later, you withdraw $20k, pay $2k in penalties, and pay no more than $3k (15%) in taxes.  You walk away with $15k
Traditional: you pay 25% in taxes now, invest $7500.  Later, you withdraw $15k and pay zero taxes

In both scenarios, you end up with the same amount of money.  But let's take a more real-world example, say of $40k withdrawal per year.  Then the numbers for the IRA/401k look like this:
$40k withdrawn
-$20.7k standard deduction and personal exemptions (assuming married filing joint, no kids)
---------
$19,300 in taxable income.

The first $18550 (in 2016) would be taxed at 10%, and the last $650 would be taxed at 15%.  That gives you a total tax bill of about $1950.  Add that to the 10% penalty for early withdrawal, and you're looking at a take-home of about $34000.  The amount you pay to Uncle Sam is about 15%.

Let's assume that the $40k you originally withdrew started as a $10k investment that doubled twice, and back-calculate how much you'd have to invest via traditional investments in order to get that same take-home:
$34k/4 = $8500 original investment
$8500/(1-.25) = $11,333 (add back in the 25% taxes you paid)

In other words, you'd need to take more money from your paycheck now to get that $34,000 payout later if you opt for a traditional investment rather than a 401k/IRA.  This all assumes, however, that you're well into the 25% tax bracket.  If you're already in the 15% or 10% bracket now, then a traditional investment will make more sense.

You just described a Roth, not a traditional

Jack

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #13 on: July 25, 2016, 02:06:50 PM »
Traditional investments are where you by X shares of company Y or mutual fund Z.  It refers to investments that are not tax-advantaged in any way, i.e. non-IRA, non-Roth, non-401k, etc.

Please call those "taxable" instead. Around here when people say "traditional" they're usually talking about non-Roth IRAs (or 401ks).

johnny847

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #14 on: July 25, 2016, 02:11:00 PM »
Traditional investments are where you by X shares of company Y or mutual fund Z.  It refers to investments that are not tax-advantaged in any way, i.e. non-IRA, non-Roth, non-401k, etc.

Please call those "taxable" instead. Around here when people say "traditional" they're usually talking about non-Roth IRAs (or 401ks).

Yeah that's incredibly confusing (note my confusion in my earlier comment).

And it's not just us using the term traditional to talk about non Roth IRAs or 401k's. That's what the IRS calls them too (and I would also believe the US tax law itself).

zolotiyeruki

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #15 on: July 25, 2016, 02:17:57 PM »
You just described a Roth, not a traditional
True, but I was assuming the retirement income would be within the 15% tax bracket, in which case capital gains would be tax-free.

johnny847

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Re: 401k questions for those retiring very early (30s/40s)
« Reply #16 on: July 25, 2016, 02:22:56 PM »
You just described a Roth, not a traditional
True, but I was assuming the retirement income would be within the 15% tax bracket, in which case capital gains would be tax-free.

Under current tax law, yes. That's a relatively new provision---it was instituted in 2008. I wouldn't necessarily count on that being there decades from now, though I am fairly confident that LTCG will continue to be taxed at lower rates than standard income (though perhaps the time for gains to become long term might increase).

You could make the same argument about Roth IRAs--that Congress could change the law and tax withdrawals---but there's a TON of money in Roth IRAs, and it would be political suicide to renege on such the promise of no future taxes on withdrawals.


Furthermore even if that 0% LTCG bracket exists in the future, that's only for federal taxes. You still have to pay state taxes on LTCG, so long as your state actually has an income tax.

 

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