How should I handle my retirement contributions?

[Mike]

Basically what I'm trying to figure out is at what point can I reduce my 401(k) contribution to merely capture the match as opposed to contributing the maximum as I'm currently doing?

I'm looking to retire in 10 years (at age 44), so the tax deferred account isn't going to be touched for another 26 years (I don't want the tax complication involving the equal payments craziness).  Obviously, I don't want to shortchange myself and starve that account of funding, but I also need to contribute as much as I can to my taxable early retirement accounts.

Investments:
401(k) balance: $125,000
Roth IRA: $23,000
P2P (lending club): $25,000
Vanguard: $6,500
Cash (will be investing this in the Vanguard account this week): $12,000
Other retirement benefit: 20% income replaced via annuity starting at age 62

Liabilities:
Mortgage $93,000 @ 4% (making bi-weekly payments, so it'll be gone in ~9 years)

Annual expenses: ~$24,000 (roughly half goes to that mortgage)
Annual income after taxes+401(k) deduction: ~$42,000

Accounting for the max Roth IRA contribution, that leaves around $12,000 per year to go into the early retirement accounts.

Thoughts?

[secondcor521]

My recommendation would be to do the math.

Depending on the assumptions one makes, you can turn it down today.  Actually yesterday.

If you spend $24K per year and half of that goes to the mortgage, that means you're living on $12K per year.

Assuming you want to fully retire at age 60 (in 26 years), that $12K per year at 3% inflation per year means you'll need $25,879 per year to live on.

But you have that annuity.  Assuming it pays you 20% of that $42K income (this part is a little unclear) at age 62, that's $8,400 per year.  (I'm ignoring the difference between age 60 and age 62 here.  No need to get that precise, as you'll see in a minute.)

So you actually need a nest egg that generates $25,879 - $8,400 = $17,479 per year.

Assuming a very conservative 3% withdrawal rate, that means you'll need a nest egg of $17,479 / 3% = ~$577K.

If you just leave your $125K to grow for the next 26 years at 7%, this would grow to ~$726K.

$726K > $577K, game over, you win.

The above ignores Social Security and the equity in your home.

But really, check the many assumptions I've made and do the math yourself.

2Cor521

[TomTX]

With that timeframe? Just put in enough to get the full match.

[Mike]

My recommendation would be to do the math.

I tried and got bogged down in the quicksand of assumptions (namely attempting to identify a reasonable spread in 26 year returns and whether or not they'd produce an amount that would accommodate estimated retirement expenses - trying to allow a margin of safety here).

If you spend $24K per year and half of that goes to the mortgage, that means you're living on $12K per year.

It'd be a bit more than that since the mortgage includes property taxes + insurance.  There's also health insurance costs out-of-pocket; all in all, it pushes expenditures up toward $15,000 or so.

But you have that annuity.  Assuming it pays you 20% of that $42K income (this part is a little unclear) at age 62, that's $8,400 per year.

My apologies - the 20% is based on years of service (20 at time I retire) and is calculated off the average of my highest three earning years (gross pay).  However, it's not based on *all* of my gross pay since it ignores holiday, OT, and bonuses.  My best estimate is that it would pay $14k/yr...unless Congress changes the rules between now and 2040 due to budget problems.

Thank you for taking the time to run the numbers.

[mushroom]

Have you read http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/ ?

You're focused on strategy 1 and you mentioned that you didn't want to deal with the hassle of strategy 3, but have you thought about strategy 2 (rolling over to a roth IRA a little at a time)?

If your expenses are low, you will only have to convert a little every year to cover your expenses, paying a low tax rate (probably lower than your current tax rate). You do have to wait 5 years until you can access that money, but you have the original roth contributions to tide you over during that 5 year gap.

You can still focus on funding more liquid accounts to help you through early retirement, but I just wanted to point out that if you later realize you have too much in your 401K, you can convert some over to a Roth if need be. So I would err on the side of a healthy 401K, especially if you're currently at a high marginal tax rate and could really use the 401K contributions to bring down your current taxable income.

[sol]

Short answer:  yes, you can reduce your 401k contributions to just enough to get the matching funds, without negatively impacting your plan.

Long answer:  I'm in a very similar situation, though a few years farther along.  Here's how I did the math.

Take your 2012 net expenses of 15k and inflate them forward to your projected retirement date.  I used 3%.  3% growth on 15k for 10 years works out to about 20k in expenses in 2022 and 35k in expenses in 2040.

Your annuity pays 14k in 2040.  Also figure social security at 10% replacement due to short working career for another 6k or so, total income in 2040 is 20k leaving a 15k/year shortfall in retirement.  If you never add another penny to your current retirement assets, that 148k will grow to 552k in 2040 if they make an average of 5% annually, which would then provide you with 22k/year in additional income at 4% SWR, far more than the 15k/yr in additional income you will need.  This means that you can survive returns lower than 5% before 2040, or you can draw less than 4% for your SWR in retirement, or you can inflate your standard or living and have a more luxurious retirement.

So the remaining problem is the intervening years between your retirement in 2022 and your annuity/SS/401k payments in 2040.  That's 18 years of expenses you need to come up with at between 20k and 34k/year, or a total of about 440k in non-sheltered funds, and you've currently got about 43k invested.  If you throw the additional 12k/year you have to invest into those accounts and make 5% returns, you'll hit about 205k in 2022, far less than the 440k in income you will need for that 18 year period.  But it's not quite as dire as it seems, because your 205k will continue to earn interest for those 18 years, which at 5% is about 10k/year in investment returns, which means your 205k only drops by 10k in the first year (20k in expenses minus 10k in returns leaves 10k of principal withdrawal).  In the next year, your remaining 195k will earn a little less than 10k, and your expenses will go up, so your balance will drop by 12k, and so on until you run out of money in 2034.

So you have a couple of options.  You can do an early withdrawal from your 401k, which will be larger than quoted here if you continue to contribute enough to get the match, which I recommend.  You can use your Roth principal contributions to float you for at least two or three years.  You can save more than 12k/year in your taxable accounts at some point in the future.  You can reduce your expenses further.  Or you can do better than 5% ROI on your portfolio, which I think is likely over a 28 year time frame.  If you make 7% in the markets, you're golden; you could retire even earlier.

...
edited for clarity.

[sol]

Just to complicate the issue slightly, consider that the current 10% penalty for early withdrawals from your 401k isn't that onerous.  Any money you're putting into your 401k now is taxed at your marginal rate of 25%.  If you wanted to withdraw that money in 10 years without jumping through the hoops of a Roth IRA rollover pipeline, you'd pay a 10% penalty on top of your regular income tax, which (fiscal cliff negotiators willing) is likely to be 10% or less because it will be your ONLY income and you'll still get the standard deduction, for a grand total of 20%.  Note that 20% is less than 25%, and in the 401k you'd get the additional benefit of tax-free growth. 

This is the reason I'm still contributing to my 401k even though I will have too much money in it and may have to pay the 10% penalty.  It's STILL a better deal than investing in my taxable accounts, even after the penalty.

[Mike]

I believe the numbers being tossed around are nominal and not real rates of return, so all of the numbers used are future dollars and not 2012 dollars.

Speaking of which, I ran the numbers on a bankrate savings calculator last night for the 401(k) assuming a 5% contribution+match for 10 more years.  With a 5% return, it works out to a little over $600,000 by 2038.  Combining that with the annuity and whatever social security I would qualify for, I would have no problem whatsoever covering costs.

As far as the early retirement accounts are concerned, a 5% return there + $1750 / month in contributions would translate to around $340,000 in 10 years.  The extra $750 / month would come from the increased take-home pay I would get from dropping my 401(k) contribution down to 5% from the maximum.

A couple other things worth mentioning:
- I can carry 240 hours of paid leave into each new year and earn ~200 hours annually; so if I retire at the end of the year, I could have around 440 hours, which translates into somewhere north of $13,000 in today's dollars (gross).  This strategy will fund the first several months of retirement.
- On the medical side, I also have an HSA - current balance is around $5000, and that will climb to somewhere around $12000 at retirement if I don't use it between now and then (I'm healthy, so it's unlikely that I'll need it, but who knows).