The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: FatCat on August 29, 2014, 10:21:55 AM
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I am wondering how the 401k helps with retirement if someone is wanting to retire at a younger age. I don't feel like I fully understand how it works. I know that my company does NOT do any matching at all, otherwise this would seem more appealing.
Please correct me if I'm wrong because this is something with which I have very little education or experience.
This is my understanding:
I can put up to $17.5k into the 401k and I don't have to pay taxes on that money now, but I pay the taxes on the year I take it out.
I can see tax benefits of this if my tax bracket is lower in retirement than it is now, and it probably will be. Otherwise I'm just paying taxes later, but still paying taxes.
However if I take it out before I'm 59.5, then I pay the taxes plus an additional 10% penalty.
This is the part where I don't understand the benefit for a very early retirement age. I don't consider late 50s to be "early retirement" even though some would.
So lets say I want to retire at age 40. I have to pay a 10% penalty on anything I take out? It seems like my money is just locked up until I'm 60 which is something I don't want to do.
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This comes up often - search for Roth pipeline here or on on the web.
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You can roll your 401k into a traditional IRA at any time with no penalty and then convert portions of the traditional IRA to a Roth IRA. When you convert funds from traditional to roth, you pay taxes on the converted amount and that amount is now considered a 'contribution' and can be withdrawn after 5 years tax and penalty free.
The idea is that you begin to convert your traditional ira funds to the roth account on a yearly basis following retirement so as to minimize the taxes paid in the initial conversion and setting up a 'pipeline' of future withdrawals to live off of after the 5 year period ends.
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You can roll your 401k into a traditional IRA at any time with no penalty and then convert portions of the traditional IRA to a Roth IRA. When you convert funds from traditional to roth, you pay taxes on the converted amount and that amount is now considered a 'contribution' and can be withdrawn after 5 years tax and penalty free.
The idea is that you begin to convert your traditional ira funds to the roth account on a yearly basis following retirement so as to minimize the taxes paid in the initial conversion and setting up a 'pipeline' of future withdrawals to live off of after the 5 year period ends.
Pretty much this.
Only thing to add is you should make sure you have money sitting in taxable accounts to cover the 5 years' expenses before you can start to access your converted funds.
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There's a nice outline of the tIRA to Roth conversion process in this post (http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/).
I'll also add that even without an employer match, for most people, shovelling as much as possible into a 401k or other pre-tax accounts will get you to FIRE faster, as you'll end up reducing your tax burden now, and then will withdrawal when your tax burden is much lower in retirement.
http://www.madfientist.com/retire-even-earlier/
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Since I do all my banking through Fidelity I can transfer money from my checking or brokerage account directly into my personal Roth IRA (I also have one through my job), so as a new Mustachian any extra money that comes my way--usually overtime--is going straight into the Roth.
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1. Leave work, convert 401k to Traditional IRA
2. Calculate yearly expenses, convert this sum of money from Trad. IRA to ROTH IRA
3. Wait five years, repeating Step 2 each year
4. Withdraw yearly expenses from ROTH IRA as needed.
5. Repeat Steps 2-4 ad infinitum.
When you convert from Trad. IRA to ROTH IRA, you will have to pay taxes on the money you are converting UNLESS you are in the 15% tax bracket based upon all income. If you are married, that means you made less than 92k in net federally taxable income. If you are in the 15% tax bracket, you do not pay capital gains taxes. This means that as long as you are converting capital gains, rather than principle, you pay no tax whatsoever.
This money must now sit in your ROTH for five years, after which it can be withdrawn without penalty or tax as a contribution.
Thus do you access your retirement funds without paying taxes, and well before traditional retirement age.
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When you convert from Trad. IRA to ROTH IRA, you will have to pay taxes on the money you are converting UNLESS you are in the 15% tax bracket based upon all income. If you are married, that means you made less than 92k in net federally taxable income. If you are in the 15% tax bracket, you do not pay capital gains taxes. This means that as long as you are converting capital gains, rather than principle, you pay no tax whatsoever.
This is not correct. The conversion is taxed at regular income rates, not capital gains rates, similar to any withdrawal from a tIRA or 401k. Therefore, any amount above your deductions will be taxed like regular income.
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When you convert from Trad. IRA to ROTH IRA, you will have to pay taxes on the money you are converting UNLESS you are in the 15% tax bracket based upon all income. If you are married, that means you made less than 92k in net federally taxable income. If you are in the 15% tax bracket, you do not pay capital gains taxes. This means that as long as you are converting capital gains, rather than principle, you pay no tax whatsoever.
This is not correct. The conversion is taxed at regular income rates, not capital gains rates, similar to any withdrawal from a tIRA or 401k. Therefore, any amount above your deductions will be taxed like regular income.
And it's also part of your MAGI, which will impact subsidies, if any, for your ACA plan.
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I can see tax benefits of this if my tax bracket is lower in retirement than it is now, and it probably will be. Otherwise I'm just paying taxes later, but still paying taxes.
Getting to pay your taxes even just 10 or 15 years after your incur them is a big deal. Even without the many ways to get at 401(k) and TIRA money before traditional retirement age, just the power of deferring the tax is something you should recognize as valuable.
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However, if you have a Roth 401K, then you can convert everything to a Roth 401K and start withdrawing in 5 years tax and penalty free.
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However, if you have a Roth 401K, then you can convert everything to a Roth 401K and start withdrawing in 5 years tax and penalty free.
I was doing a Roth 401k, but quickly determined I was getting a bad deal, as it is post-tax. Add in CA state taxes to boot, and it's clear the traditional 401(k) is the only way to go. With the regular 401k I can leave California and avoid state taxes entirely in FIRE, let alone the high marginal rates I'd be paying on that income.
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Something else to consider is that you don't pay taxes on qualified dividends if your ordinary income tax rate is less than 25%.
The nice thing about this is that you can split your earnings between a pre-tax 401K and a normal investment portfolio in stocks that pay qualified dividends. The 401k contributions/earnings won't be taxed. The portfolio contributions will be taxed, but if you're below 25% with your ordinary income tax rate the dividends can be reinvested and the entire portfolio can grow tax free.
When you're ready to FIRE, you can use the dividends, and possibly some of the principle from the portfolio to support yourself, and simultaneously convert ~$10k/year (counts as regular income) to a Roth IRA. After 5 years you can withdraw the principle you transferred w/o penalties/taxes.
Ideally, if your conversions plus inflation are less than the rate of return of your 401k, it will act as a generator for your Roth IRA, and once you're 59.5, you can tap it directly without paying penalties.