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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: RavensBrew on May 08, 2016, 04:15:36 PM

Title: Very NOOB question about the 4% rule
Post by: RavensBrew on May 08, 2016, 04:15:36 PM
Hi guys! My SO are looking to reach FIRE in about 5 or 6 years. Or at least the assets portion of it as we may still work at our day jobs if we feel that way when the time arises. Here's my super NOOB question- we are maxing out all of our pre-tax savings we can (IRA, 401k.) If we choose to live on the 4% return how does that work with cash we can't access without tax penalties? Maybe there is an obvious answer I am missing here. In 5 years our ages will average 40 which means we will have two decades+ before we can utilize our retirement funds. Is the idea that you never access them and live off other interest/dividend bearing accounts? Right now we have most of our cash in Vanguard accounts.

Thank you!
Title: Re: Very NOOB question about the 4% rule
Post by: sol on May 08, 2016, 04:48:04 PM
After you retire and quite working, money in a 401k or traditional IRA can be converted to your Roth IRA in annual rollover amounts that stay in the lowest tax bracket(s), which could be 0%.  Roth IRA rollover contributions can then be withdrawn without paying taxes or penalties if you let them sit in the account for five calendar years (hypothetically four years and one day, if you timed it right).  This is the Roth IRA pipeline methods (search the forums for that phrase) and you can use it to access your retirement accounts at any age, as long as you have five years of expenses saved up in more accessible locations.

One of those accessible locations is your existing Roth IRA contributions.  You can only contribute $5500/year so the amounts are unlikely to be large, but if two of you have been maxing it out for ten years you might have nearly $100k in there.  Only your contributions, not the earnings, can be withdrawn at any time for any reason, without paying taxes or penalties.

There are some additional ways to access your 401k money, like 72(2) withdrawals, but they are generally not very useful right now because interest rates are so low.   

The other alternative is to just take the damn penalty.  You can always pull from your 401k early if you pay the taxes and the 10% penalty, and sometimes it's worth it.  For example, if you are currently earning money in the 25% tax bracket, then you save 25% of each dollar you contribute because you're avoiding paying your marginal (highest) tax rate.  In retirement, if you have no income, you can withdraw that money in the 0% or 10% tax brackets (which are pretty large after deductions and exemptions, over $50k/year for a family with kids), pay the 10% penalty on top of your effective tax rate on the withdrawal, and STILL come out with a much better tax rate than you would have paid if you had failed to max the 401k while working.  This is why it is virtually always better to max out your 401k.  Even the "penalty" is really just an extra tax, which comes out to be a lower tax rate anyway.  People just hate it because it's called a "penalty".
Title: Re: Very NOOB question about the 4% rule
Post by: Jeremy E. on May 08, 2016, 07:08:33 PM
Title: Re: Very NOOB question about the 4% rule
Post by: RavensBrew on May 09, 2016, 11:02:23 AM
Thank you Sol and Jeremy! This is extremely helpful and will help me get a start on researching this stuff! I really appreciate it!