Author Topic: How do I know when to switch from maxing out 401k to funding a taxable account?  (Read 429 times)

trc4897

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Hey everyone, I am fairly new to FIRE and have a question (sorry if this has been discussed already). I have been trying to wrap my head around how I figure out when I should stop maxing out my 401k and switch to just contributing enough to get the employer match, then using the extra money to fund a Roth IRA & taxable account? I know the actual numbers will vary based on my average spending, but is there a good rule of thumb I can follow? Thanks!
« Last Edit: April 10, 2019, 11:04:06 AM by trc4897 »

Lady SA

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I always follow the investment order as listed in this thread: https://forum.mrmoneymustache.com/investor-alley/investment-order/

WHAT           
0. Establish an emergency fund to your satisfaction           
1. Contribute to your 401k up to any company match           
2. Pay off any debts with interest rates ~5% or more above the current 10-year Treasury note yield.           
3. Max Health Savings Account (HSA) if eligible.
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level           
5. Max 401k (if
    - 401k fees are lower than available in an IRA, or
    - you need the 401k deduction to be eligible for (and desire) a tIRA deduction, or
    - your earn too much for an IRA deduction and prefer traditional to Roth, then
    swap #4 and #5)           
6. Fund a mega backdoor Roth if applicable.         
7. Pay off any debts with interest rates ~3% or more above the current 10-year Treasury note yield.           
8. Invest in a taxable account and/or fund a 529 with any extra.           

Boofinator

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In most cases (if you make enough money), you should never stop maxing tax-deferred accounts if you intend to FIRE.

Let's assume for a moment worst-case, and you'll never be able to put any money in taxable. Let's also assume combined federal and state tax bracket of 25% (22% + 3%). Finally, let's assume you're married, and your household expenses in FIRE are $50k per year.

If you put money in taxable, you pay 25% now plus dividend drag (~0.3%), but capital gains would be exempt when you retire so there's a plus. Meanwhile, in the 401k, you pay your annual expenses (whatever those are) plus 10% penalty plus your effective tax rate after you retire. This effective tax rate would be 0% up to the standard deduction of $24k, plus 10% for the next $19k, plus 12% for the next $7k, which works out to an average of 5.5% (plus a similar reduction for state, let's say 1.5%). So ignoring annual expenses, if you combine the effective tax rate with the penalty, you're still only paying 17%, which beats 25% any day.

But, this is all academic, since if you're FIRE and you truly have no taxable with which to do a Roth pipeline, you can do a SEPP, which would completely avoid a penalty.
« Last Edit: April 10, 2019, 02:57:42 PM by Boofinator »

RWD

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trc4897

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Thanks for the detailed responses! Seems like I have a little more reading to do

robartsd

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Ideally you'd retire early with about 5 years of expenses (plus emergency fund) in some combination of penalty free accounts (taxable accounts, 457 accounts, Roth contributions, HSA funds that you have medical receipts to claim) and set up a Roth conversion ladder for expenses beyond the first 5 years.

If you reach FI without sufficient funds in penalty free accounts, you still have options:
1) accept the 10% penalty in early retirement - your marginal rate in retirement may be low enough vs your marginal tax rate in accumulation that this is more optimal than if you had saved in taxable/Roth accounts instead.
2) set up SEPP to cover you needs - this does require that you commit to taking money out of the account every year until 59.5 (or at least 5 years if you're not retiring very early). You can choose how much to take out when you start by putting funds to be used into a new IRA and pulling the SEPP from that account. You are very limited in options to adjust withdraws once started - best you can do to reduce withdraws is switching to the RMD method of calculation which is driven by current value rather than initial value and tends to be the method with the lowest withdraw limit. If you want to increase withdraws later, you can roll funds into another new IRA and start a new SEPP (subject to a new 5 year minimum if applicable) out of that IRA to run parallel to your earlier SEPP.
3) semi-retire for 5 years while building up your conversion ladder.

I believe you can use option 2) from some accounts and option 1) from other accounts concurrently. Of course option 3 is not limited by your use of options 1 and 2.