Author Topic: 401K vs. Index Investing for Early Retirement  (Read 5028 times)

FreedomInc

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401K vs. Index Investing for Early Retirement
« on: December 02, 2014, 07:59:03 PM »
Hello everyone!

I'm currently a college student and am planning out what my first year of work life will be like. My goal is to "retire" 10 years from the day that I begin working. I will be entering a relatively lucrative field and believe this to be possible.

With this in mind, does it still make sense to use the 401K that companies provide? I know there are large penalties on taking your money out of these before age 59.5. Since I will be ~33 when I want to begin pulling funds from my investments (~4% per year), I am wondering if I will be better off just index investing on my own.

However, if my employer matches my contributions, I will probably want to take advantage of this even though I won't be able to access it until I'm much older (free money).

Am I correct in this line of thinking?

College Stash

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Re: 401K vs. Index Investing for Early Retirement
« Reply #1 on: December 02, 2014, 08:23:14 PM »
I'd say to use the 401k. Taxes can be pretty rough for a young, high earning, single. You could always withdraw heavier on the brokerage accounts until you needed the 401k and/or you could get into rental investments too.

You sound pretty similar to myself, although I'm a sophomore in college and plan to ER at some point to become a professor/hs teacher.

Best of luck!

MDM

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Re: 401K vs. Index Investing for Early Retirement
« Reply #2 on: December 02, 2014, 08:49:26 PM »
My goal is to "retire" 10 years from the day that I begin working. I will be entering a relatively lucrative field and believe this to be possible.

With this in mind, does it still make sense to use the 401K that companies provide? I know there are large penalties on taking your money out of these before age 59.5. Since I will be ~33 when I want to begin pulling funds from my investments (~4% per year), I am wondering if I will be better off just index investing on my own.

However, if my employer matches my contributions, I will probably want to take advantage of this even though I won't be able to access it until I'm much older (free money).

Am I correct in this line of thinking?
FreedomInc, welcome to the forums.

401ks are nice, but unlikely to provide enough for you to retire on in 10 years.  E.g, $18K/yr returning 5% real gives you ~$238K after 10 years.  4% of that is only $9.5K/yr.

Does that mean you should skip the 401k then?  Absolutely not! 

If you really are in a "lucrative field" you should be able to contribute the full $18K next year to your 401k, and whatever the maximum is in subsequent years.  You will run out of tax-advantaged options and "have" to use taxable investments.

That's the short version.  You'll want to do more detailed modeling to understand your situation better.  Perhaps www.cfiresim.com?

Good luck!

Calvawt

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Re: 401K vs. Index Investing for Early Retirement
« Reply #3 on: December 02, 2014, 08:51:12 PM »
The answer is yes for a couple of reasons.  You will want to do as much tax deferral as possible and the 401k will help (and max it out).  The company match is also a fantastic deal for you.  Don't forget to do a Roth IRA every year, too.  Between that and taxable accounts you will have money right away when you FIRE.

Once you leave the company you can roll it over into an IRA.  Then you can start doing a Roth conversion ladder and have access to some of the funds in 5 years and then each year after that.

Dodge

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FreedomInc

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Re: 401K vs. Index Investing for Early Retirement
« Reply #5 on: December 02, 2014, 10:42:17 PM »
Thank you for all your feedback. So in order to maximize tax sheltering, here is what I understand so far:

Max 401k
Max Roth IRA
The rest goes into index funds

When I want to retire, I rollover the 401k into a traditional IRA, and then convert that to the Roth IRA. I can then access the converted funds 5 year after they are converted.


Questions:
Should I start the Traditional IRA, since this is tax-sheltered as well?
With the IRA to Roth conversion ladder, am I only able to access the funds that I convert (5 years down the line of course), or can I access any funds in the Roth IRA (from what I have built up in there before)?


Dodge

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Re: 401K vs. Index Investing for Early Retirement
« Reply #6 on: December 02, 2014, 10:47:20 PM »
Traditional IRA vs. Roth IRA The Final Battle

Spoiler: For the typical early retiree, Traditional IRA wins.

After you start the ladder and wait 5 years, you will be able to access:

1. Any converted funds
2. Any contributions that were made before the ladder.

You will NOT be able to access any gains on contributions. This means contributions from before the ladder, and gains on the converted funds.

FreedomInc

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Re: 401K vs. Index Investing for Early Retirement
« Reply #7 on: December 03, 2014, 12:18:13 AM »
Traditional IRA vs. Roth IRA The Final Battle

Spoiler: For the typical early retiree, Traditional IRA wins.

After you start the ladder and wait 5 years, you will be able to access:

1. Any converted funds
2. Any contributions that were made before the ladder.

You will NOT be able to access any gains on contributions. This means contributions from before the ladder, and gains on the converted funds.

Oh interesting... So max 401k and open a traditional IRA and max that one too, then when retired convert 401k to traditional IRA and begin traditional IRA to Roth conversion ladder.

Dodge

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Re: 401K vs. Index Investing for Early Retirement
« Reply #8 on: December 03, 2014, 12:22:09 AM »
Traditional IRA vs. Roth IRA The Final Battle

Spoiler: For the typical early retiree, Traditional IRA wins.

After you start the ladder and wait 5 years, you will be able to access:

1. Any converted funds
2. Any contributions that were made before the ladder.

You will NOT be able to access any gains on contributions. This means contributions from before the ladder, and gains on the converted funds.

Oh interesting... So max 401k and open a traditional IRA and max that one too, then when retired convert 401k to traditional IRA and begin traditional IRA to Roth conversion ladder.

You got it!  Just make sure you have money in your taxable accounts for the 5 years you'll be waiting out the ladder.

FreedomInc

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Re: 401K vs. Index Investing for Early Retirement
« Reply #9 on: December 03, 2014, 12:38:49 AM »
Traditional IRA vs. Roth IRA The Final Battle

Spoiler: For the typical early retiree, Traditional IRA wins.

After you start the ladder and wait 5 years, you will be able to access:

1. Any converted funds
2. Any contributions that were made before the ladder.

You will NOT be able to access any gains on contributions. This means contributions from before the ladder, and gains on the converted funds.

Oh interesting... So max 401k and open a traditional IRA and max that one too, then when retired convert 401k to traditional IRA and begin traditional IRA to Roth conversion ladder.

You got it!  Just make sure you have money in your taxable accounts for the 5 years you'll be waiting out the ladder.

That's a pretty freaking cool strategy! Granted it's a more hassle but you could save SO much money doing this. I'm actually surprised that I haven't heard of this before... It seems like a giant loophole that more people should take advantage of.

 

Dodge

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401K vs. Index Investing for Early Retirement
« Reply #10 on: December 03, 2014, 12:43:35 AM »
Traditional IRA vs. Roth IRA The Final Battle

Spoiler: For the typical early retiree, Traditional IRA wins.

After you start the ladder and wait 5 years, you will be able to access:

1. Any converted funds
2. Any contributions that were made before the ladder.

You will NOT be able to access any gains on contributions. This means contributions from before the ladder, and gains on the converted funds.

Oh interesting... So max 401k and open a traditional IRA and max that one too, then when retired convert 401k to traditional IRA and begin traditional IRA to Roth conversion ladder.

You got it!  Just make sure you have money in your taxable accounts for the 5 years you'll be waiting out the ladder.

That's a pretty freaking cool strategy! Granted it's a more hassle but you could save SO much money doing this. I'm actually surprised that I haven't heard of this before... It seems like a giant loophole that more people should take advantage of.

Most people won't be in a low enough tax bracket, for long enough to take advantage of something like this. And if they are, they likely don't have $400,000 saved up in those accounts, like you will :)

We are in a unique situation, best take advantage while we can!

FreedomInc

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Re: 401K vs. Index Investing for Early Retirement
« Reply #11 on: December 03, 2014, 01:00:54 AM »
So I still have a question about funding a 401k and a traditional IRA simultaneously. From what I've been reading, if you are maxing your 401k, then you can still contribute $5,500 extra to the traditional IRA, but it won't be before taxes if you make over $60,000 or $70,000.

Obviously it is beneficial to get this tax break before your income surpasses that level, but what about after that? Say you make $80,000 a year and your traditional IRA contributions won't be before taxes. What is then the benefit of funding a traditional IRA vs a standard taxable account?

I'm assuming it is that you can still take advantage of the roth conversion ladder later on, but in this scenario you will only receive the tax break once (vs. twice for the 401k and for contributions made to the traditional IRA before taxes)



Source: http://money.usnews.com/money/retirement/articles/2014/01/06/how-to-max-out-your-retirement-accounts-in-2014

Dodge

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Re: 401K vs. Index Investing for Early Retirement
« Reply #12 on: December 03, 2014, 01:25:45 AM »

So I still have a question about funding a 401k and a traditional IRA simultaneously. From what I've been reading, if you are maxing your 401k, then you can still contribute $5,500 extra to the traditional IRA, but it won't be before taxes if you make over $60,000 or $70,000.

Obviously it is beneficial to get this tax break before your income surpasses that level, but what about after that? Say you make $80,000 a year and your traditional IRA contributions won't be before taxes. What is then the benefit of funding a traditional IRA vs a standard taxable account?

I'm assuming it is that you can still take advantage of the roth conversion ladder later on, but in this scenario you will only receive the tax break once (vs. twice for the 401k and for contributions made to the traditional IRA before taxes)



Source: http://money.usnews.com/money/retirement/articles/2014/01/06/how-to-max-out-your-retirement-accounts-in-2014

If you qualify for the tax deduction, then IRA is the way to go. Otherwise, go for the Roth IRA. Note, the 18,000 (next year's limit) you'll be putting into the 401k does not count. So if your income is 80k, it calculates to 62k when determining the IRA deduction.

Also, don't forget about the Mega Backdoor IRA :P

http://whitecoatinvestor.com/the-mega-backdoor-roth-ira/

Mr. Frugalwoods

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Re: 401K vs. Index Investing for Early Retirement
« Reply #13 on: December 03, 2014, 05:43:40 AM »
Hopefully you can invest in Index Funds inside your 401k.  My company has a total market index and a bond index that have reasonable (for a 401k) fees.