Why do we want to Max out 401k?

[jo552006]

I have been struggling with one concept for a very long time now.  Why exactly do we want to max out our tax advantaged accounts?

I know this is probably the most basic question I could ask, but I always see the recommendations to max out 401k (or TSP) then max out Roth IRA, then look to education funds if you have kids, then HSA? then...

I don't fully understand WHY we want to do this.  When we say "tax advantaged" don't we usually mean tax deferred?  Are we all making the basic assumption that we will earn less once we FIre than we currently do?  Is it implied in our recommendation that getting taxed now will be much worse than getting taxed later?  I can honestly see a possibility that when I'm old enough to take out money from tax advantaged accounts, I may be earning MORE than i currently do (between side hobbies and investments).  I can also see a possibility that the tax rate many years from now may be even higher than what we have come to know (like 50%) due to national debt.

Also,  what about retiring young?  Like 30-40 years old.  Other than backdoor roth (which I don't fully understand) we still need money to live from say 35 years old to when we can withdraw money from our retirement accounts.  Is the idea that once we have maxed out or tax advantaged accounts we invest what's left in normally taxed accounts and that we can live off of normal taxed investements and backdoor roth conversions until we are old enough to withdraw those other accounts?  Is the idea that even with the 10% penalty our withdrawals from 401k would be taxed less than our current tax rates due to a much lower income compared to our current jobs?

When we compute net worth for our FIre, it seems to me as though we add up all of our money, including money that we can't touch for many years without penalty, as though it's all the same, but aren't there implications to having reached your FIre number (let's say one million) when all of it is in 401k and you're 35?  At least as of right now, I feel like if I were offerred 1 million in my 401k or 800,000 (after tax) in my hands, that I'd be more inclined to choose the 800,000 (unless I calculated that after 10% penalty I'd still be better off with 1million in 401k).

For a lot of people invest in your retirement is great advice.  Also for a lot of people Dave Ramsey's advice is life changing.  For a Mustachian, after you receive any employer match, I don't understand why maxing retirement is always the first investment.

[jo552006]

*Last paragraph first sentence* Investing in retirement is always good advice, but for a mustachian is it always the best advice?

[begood]

MMM himself discusses this issue here:

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

From what I understand (and which more knowledgeable people can discuss in finer detail) is that there are ways around that 59.5 age minimum for accessing retirement accounts. It can be done.

[matchewed]

Because for many people it is mathematically superior.

http://www.madfientist.com/retire-even-earlier/

You can make all sorts of assumptions but consider your first scenario. You make X annually today but in FIRE you'll be spending Y and X>Y. So you can pay taxes on X now in order to invest it and pay the capital gains on Y later. Or you can pay income taxes on Y later. The problem is you actually would need to know the future and what X and Y are. You claim taxes will be higher in the future, they may be. But that also goes for capital gains taxes. People aren't saying only save in a tax deferred account but they are saying save in a variety of accounts so that you can use their different tax treatments to optimize for an uncertain future. Basically provide you with a set of tools to manage a situation. It just so happens that delaying income taxes today is sometimes mathematically superior to paying income taxes today when investing the money. There isn't blanket advice that works perfectly for every situation. It is why some of the advice you read has qualifiers such as generally or sometimes.

You're also not considering the various methods to get around the penalty; SEPP, Roth Pipeline, and minimized expenses.

Also no one has said maxing your retirement account as the "first" investment. I don't even know what that means. Generally the advice would go something like this depending on your income and particular FIRE plan*.

401k to match
Max Roth IRAs
Finish maxing 401k

*That being said it is your particular FIRE plan. Run the numbers. If you're stepping in and saying this won't work because I like something else then you're not really running the numbers and are shooting from the hip. Understand all the options you reasonably can then come swinging in the proverbial bat.
After tax investment

[jo552006]

Thanks all!

matchewed, for clarification, with regards to retirement being the first investment, I was counting 401k, Roth, and traditional IRA incorrectly as all part of the "retirment investment".  (aka. all the items you listed as the general advice were retirement accounts which I had lumped together).

Also, I hope I don't give the impression that I am saying the general advice won't work for me... I just wanted to know WHY this is the general advice.  I am just about to turn the corner between paying off student loans and beginning to invest and was looking for insight from the forum.    I really like the idea that I don't know what the future will bring, but having a set of tools to manage it will help.

I had read both those articles suggested (though admittedly it has been a while since I read that MMM article).  I with I had re-read the MMM article prior to posting.  Thanks for the help!

[Gimesalot]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

[Cheddar Stacker]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

+1.

And if you have kids you get more deductions and credits.

And your investment income that you mentioned in the OP is not necessarily taxed either, depending on many factors.

And the last sentence above from Gimesalot. You have a lot of 0%, 10%, then 15% tax on the money you withdraw or convert later on. Right now you likely are paying 15% or 25% on the money that you don't defer (it's taxed at whatever % your last dollar is taxed at).

Keep reading madfientist tax avoidance posts. Read gocurrycracker as well. And rootofgood. All have great posts about this topic.

[GreenPen]

I have been struggling with one concept for a very long time now.  Why exactly do we want to max out our tax advantaged accounts?

This is a good question. And here's one way to picture it. With a tax advantaged account, you only need to pay taxes at one point rather than two.

With a ROTH account, you pay taxes when you put the money IN. With a traditional account, you pay taxes when you take the money OUT. But when you invest in an taxable account, you pay taxes at BOTH points, when you put the money in and when you take it out.

That's why it's important to start maxing out your retirement accounts as soon as you can.

[DoctorOctagon]

Maxing out IRA, roth, 401(k) makes no sense if you retire early because of the withdrawal penalties.  Smarter decision would be to allocate any money EXCESS of your early retirement requirements in the IRA/roth/etc.  You should be investing for early retirement in a taxable individual investment account for stocks or in a business system involved in real estate (either you own a property management company, rentals, etc).

[Cheddar Stacker]

I have been struggling with one concept for a very long time now.  Why exactly do we want to max out our tax advantaged accounts?

This is a good question. And here's one way to picture it. With a tax advantaged account, you only need to pay taxes at one point rather than two.

With a ROTH account, you pay taxes when you put the money IN. With a traditional account, you pay taxes when you take the money OUT. But when you invest in an taxable account, you pay taxes at BOTH points, when you put the money in and when you take it out.

That's why it's important to start maxing out your retirement accounts as soon as you can.

If you invest in a taxable account you don't pay any taxes on the principal you invested, you only pay taxes on earnings, and if you do it right you won't pay taxes on those either. If you are in the 15% bracket or lower there is no tax on most investment income.

[Cheddar Stacker]

Maxing out IRA, roth, 401(k) makes no sense if you retire early because of the withdrawal penalties.  Smarter decision would be to allocate any money EXCESS of your early retirement requirements in the IRA/roth/etc.  You should be investing for early retirement in a taxable individual investment account for stocks or in a business system involved in real estate (either you own a property management company, rentals, etc).

There are many ways around the early withdrawal penalties. Go read the madfientist link matchewed provided and read all the stuff he links in there. This is not an issue. Max out if you can, invest the excess in taxable accounts. It's not for everyone, but it should be the best advice for most.

[rpr]

Maxing out IRA, roth, 401(k) makes no sense if you retire early because of the withdrawal penalties.  Smarter decision would be to allocate any money EXCESS of your early retirement requirements in the IRA/roth/etc.  You should be investing for early retirement in a taxable individual investment account for stocks or in a business system involved in real estate (either you own a property management company, rentals, etc).

There are lots of ways of getting at the money in tax deferred accounts without penalties. Have you read the articles listed in this very thread?  SEPP 72t, Roth Conversion ladder, etc.

[sirdoug007]

Maxing out your 401(k) is almost always the way to go because of the difference in how the money is taxed going in and going out.

Going in, your 401(k) contribution avoids your marginal tax rate of your last dollar earned because you are subtracting it from your total earnings. 

Going out, your 401(k) distributions are taxed at your OVERALL tax rate with standard deductions, personal exemptions, child tax credits etc. applied. 

Go look at your tax return from last year.  In my case my marginal tax rate was 25% and my overall tax rate was a bit over 16%.  So even at some point in retirement if I take out the same amount I made this year (which I won't since I won't be paying a mortgage any more or contributing to taxable savings) my tax rate will mean I saved 9% of my income from federal income tax.  If I take out less than I earned, which is likely since I'll only be taking out an amount equal to my spending, then the tax savings is even more.

There are plenty of ways to access your money and avoid the 10% penalty before 59.5 as described by the mad fientist.

[frugaliknowit]

You should not max out your 401K.  Everyone needs "tax diversification", a fancy term for "buckets" of money:  Taxable, Non-Taxable, and Capital Gain Taxable.  No one knows future tax rates, nor future tax situations.  That's why you need to have "buckets", so you can maneuver and be strategic.  Another point:  "RMD's" (required minimum distributions).  Once you hit 70 1/2, the IRS requires that you take IRA distributions each year (a taxable event).

[davef]

Maxing out your 401(k) is almost always the way to go because of the difference in how the money is taxed going in and going out.

Going in, your 401(k) contribution avoids your marginal tax rate of your last dollar earned because you are subtracting it from your total earnings. 

Going out, your 401(k) distributions are taxed at your OVERALL tax rate with standard deductions, personal exemptions, child tax credits etc. applied. 

Go look at your tax return from last year.  In my case my marginal tax rate was 25% and my overall tax rate was a bit over 16%.  So even at some point in retirement if I take out the same amount I made this year (which I won't since I won't be paying a mortgage any more or contributing to taxable savings) my tax rate will mean I saved 9% of my income from federal income tax.  If I take out less than I earned, which is likely since I'll only be taking out an amount equal to my spending, then the tax savings is even more.

It may be taxed at the marginal rate initially, but in the end (once you have filed your taxes) everything is taxed at the overall rate. The overall rate considers ALL federal taxes paid for the the year. And your overall rate is calculated after all deductions.

Imagine you make 100,000 a year and you put nothing in 401k. You are taxed at the marginal rate of (25% filing jointly or 28% single) on the money from 90k to 100k, but after you add your deductions and whittle it down to 70k or so your overall rate is computed and you will get a refund (assuming your claimed exemptions is correct) so none of the money was really ever taxed at 25%.

If you made 100k and put 10,000 in 401k, true, you are only taxed at the marginal rate on 90k, and after exemptions you would be down to 60k (assuming the same exemptions) Then when you figure your overall rate, off of 60k and get your refund the only difference in taxes paid at the end of the year (after refund) is the difference in the overall rate between 60k and 70k. NOT that marginal rate.

Using last years total tax charts 60,000 in income for a joint filer was $8,111 in taxes. 70k was 9,611. If your statatement was correct the difference would be 25%. It is not. it is 18% the Overall rate in this case. 

I am 99% sure on this but somone please explain in detail if I am wrong.

Jo like you I expect to have income from a business I own when I retire, and to be in a higher tax bracket than I am now.

I use the same stratagy matchewed advocated.

401k to match
Max Roth IRAs

Afte that I invest in real estate, rental properties, and am considering buing a Jimmy Johns Franchise next year.

[Eric]

You should not max out your 401K.  Everyone needs "tax diversification", a fancy term for "buckets" of money:  Taxable, Non-Taxable, and Capital Gain Taxable. 

These ideas are not mutually exclusive.  You absolutely SHOULD max your 401k.  You should also invest in other buckets.

[Cheddar Stacker]

Ok, I'm just going to leave this now:

http://forum.mrmoneymustache.com/ask-a-mustachian/questioning-the-advice-to-max-the-401k/
http://forum.mrmoneymustache.com/investor-alley/roth-or-traditional-ira401k457/msg334648/#msg334648
http://forum.mrmoneymustache.com/ask-a-mustachian/standard-401k-question-roth-or-traditional/msg333388/#msg333388
http://forum.mrmoneymustache.com/ask-a-mustachian/confused-about-401k-withdrawals/msg343905/#msg343905
http://forum.mrmoneymustache.com/investor-alley/how-should-i-be-investing-my-$$/msg347819/#msg347819

This is literally asked here at least 3-4 times/week. Read through all those links for more discussion. Very few people think maxing your 401k is a bad idea.

To each their own.
YMMV.
/ shrug

[Cheddar Stacker]

Using last years total tax charts 60,000 in income for a joint filer was $8,111 in taxes. 70k was 9,611. If your statatement was correct the difference would be 25%. It is not. it is 18% the Overall rate in this case. 

I am 99% sure on this but somone please explain in detail if I am wrong.

Davef, this part of your statement is incorrect. The difference in income is $10K, and the difference in tax is $1,500, which is exactly 15%. This is because a joint filer at that income level is in the 15% bracket.

Every single dollar you defer reduces your tax by the marginal tax rate.

Definition of 'Marginal Tax Rate'
The amount of tax paid on an additional dollar of income.

This is the "bracket" you are in. You defer $100, you save $15 if you are in the 15% bracket. You defer $100, you save $25 if you are in the 25% bracket.

[PathtoFIRE]

I am 99% sure on this but somone please explain in detail if I am wrong.

I think your mistake is that you are looking at the gross income to decide what bracket your hypothetical MFJ family is in, rather than the adjusted gross income, which determines the true "bracket" or marginal tax rate of each additional dollar.

[beltim]

I am 99% sure on this but somone please explain in detail if I am wrong.

You've got the idea right, but you're looking at a case where the marginal rate is not 25%, but instead 15%.

And now I see you've gotten 2 responses showing your error.  You probably don't need a third.

[Jack]

With a ROTH account, you pay taxes when you put the money IN. With a traditional account, you pay taxes when you take the money OUT. But when you invest in an taxable account, you pay taxes at BOTH points, when you put the money in and when you take it out.

And with the taxable account you pay each year in between on the dividends!

[catccc]

Maxing out IRA, roth, 401(k) makes no sense if you retire early because of the withdrawal penalties.  Smarter decision would be to allocate any money EXCESS of your early retirement requirements in the IRA/roth/etc.  You should be investing for early retirement in a taxable individual investment account for stocks or in a business system involved in real estate (either you own a property management company, rentals, etc).

There are lots of ways of getting at the money in tax deferred accounts without penalties. Have you read the articles listed in this very thread?  SEPP 72t, Roth Conversion ladder, etc.

This seems to come up a lot on this forum.  I wonder if a stickied topic would help mitigate the number of times this is covered...

To add to the general why-max-out-the-401K conversation:  Sometimes using 401K contributions to reduce your taxable income to fall below a certain threshold can make a respectable difference in your tax bill.  I am harvesting about 12K in taxable capital gains this year, moving the taxable investments that didn't fit into my 401K from American Funds to Vanguard.  Maxing out my 401K puts me nicely in the 15% tax bracket for ordinary income, which means that my capital gains rate is going to be 0%.  If I did not max out my 401K, it would put me over the edge and I'd be in the 25% tax bracket for ordinary income, and my capital gains rate on that 12K would be 15% instead of zero.  That's $1,800 I will not have to hand over to the IRS by staying in the 15% tax bracket for ordinary income, if I'm understanding this all correctly.  The same argument can probably be made about a host of other tax gimmes that require your AGI to be under a certain amount.

[okashira]

Ok, I'm just going to leave this now:

http://forum.mrmoneymustache.com/ask-a-mustachian/questioning-the-advice-to-max-the-401k/
http://forum.mrmoneymustache.com/investor-alley/roth-or-traditional-ira401k457/msg334648/#msg334648
http://forum.mrmoneymustache.com/ask-a-mustachian/standard-401k-question-roth-or-traditional/msg333388/#msg333388
http://forum.mrmoneymustache.com/ask-a-mustachian/confused-about-401k-withdrawals/msg343905/#msg343905
http://forum.mrmoneymustache.com/investor-alley/how-should-i-be-investing-my-$$/msg347819/#msg347819

This is literally asked here at least 3-4 times/week. Read through all those links for more discussion. Very few people think maxing your 401k is a bad idea.

To each their own.
YMMV.
/ shrug

Agreed. People keep bring it up because deep down, they don't want to max it. It makes people uncomfortable because the money "disappears," in their mind. It can't be taken out easily.
I can sense it in every one of these threads. The folks can't produce a logical or mathematical reason to not max it, just feelings.

[sirdoug007]

Agreed. People keep bring it up because deep down, they don't want to max it. It makes people uncomfortable because the money "disappears," in their mind. It can't be taken out easily.
I can sense it in every one of these threads. The folks can't produce a logical or mathematical reason to not max it, just feelings.

^This!  The ironic thing is this is a strategy to KEEP more of your money away from Uncle Sam!  People have a hard time getting past the feeling that the money is locked away until you are a gray haired oldster.  The reality that you can work the system to access your money doesn't seem to totally remove this feeling of disconnectedness from the money.

[jo552006]

Wow, so many responses in a short time!

I'd like to point out that I had read most of the threads linked.  I'm sure a sticky would help to put all the information in one place (and I think it's a good idea), but I did look and find most of the information before.  It just didn't answer my initial questions at least not in a way that clicked for me.

With regards to being uncomfortable about fully funding my 401k... at least for me this isn't true in the least.  I know my net worth goes up when I save, regardless of where.  I also know that worst case scenario I could always withdraw my money pay taxes and penalty, and still be better off than a lot of my peers.  In the case of a true emergency, I'd probably be able to withdraw without penalty.  I DO plan to fully fund my 401k as well as other investments.

The REASON why the threads/articles linked didn't fully answer my question is due to expected future income.  I think most of my questions boil down to one basic question.  Though I believe that I have the answer, I'll ask my question in a more succint form at least so people know what I was getting at.

1. Are we (and the linked articles) all making the basic assumption that we will earn less once we FIre than we currently do? (Or as matchewed stated "You make X annually today but in FIRE you'll be spending Y and X>Y.")  I just wanted to clarify if this is a common but unstated assumption.

Matchewed, thanks again for your response, as I can't know the future, I plan to build up my tools to take advantage of whatever situation presents itself in the future.

[beltim]

1. Are we (and the linked articles) all making the basic assumption that we will earn less once we FIre than we currently do? (Or as matchewed stated "You make X annually today but in FIRE you'll be spending Y and X>Y.")  I just wanted to clarify if this is a common but unstated assumption.

Yes.  If this isn't the case (which is certainly the case for some people here), there may be other vehicles that are better suited to savings (particularly the Roth IRA).  It can get more complicated in the case of people starting out with low salaries who know (or reasonably expect) that their income will be much higher in a few years.

[GreenPen]

I have been struggling with one concept for a very long time now.  Why exactly do we want to max out our tax advantaged accounts?

[]... I always see the recommendations to max out 401k (or TSP) then max out Roth IRA, then look to education funds if you have kids, then HSA? then...

I don't fully understand WHY we want to do this.  When we say "tax advantaged" don't we usually mean tax deferred?  Are we all making the basic assumption that we will earn less once we FIre than we currently do?  Is it implied in our recommendation that getting taxed now will be much worse than getting taxed later?

You are getting two different types of answers on this thread because your original question is still ambiguous. You are asking whether certain advice carries the assumption that you mention. Is that advice to a) Max out your tax-advantaged accounts prior to investing in a taxable account, or b) Invest in tax-deferred accounts rather than Roth?

[Cheddar Stacker]

1. Are we (and the linked articles) all making the basic assumption that we will earn less once we FIre than we currently do? (Or as matchewed stated "You make X annually today but in FIRE you'll be spending Y and X>Y.")  I just wanted to clarify if this is a common but unstated assumption.

Yes.

You can't know what the future will bring for sure, but if you're nearly certain you will have more income later on (i.e.-you are a doctor and you plan to practice until you're 70, or you are a business owner and plan to grow it exponentially and don't intend to sell) then this strategy might not work. You can still come out ahead though considering potential changes in future tax rates/laws.

If you have slightly more income later it can really still benefit you a lot. If your future income is from investments it's taxed at lower rates than earned income. Plus the factor that you're deferring at your marginal rate and in the future you are potentially taxed based on average rates (See sirdoug007's post above for further discussion).

For most people though, you'll end up with SocSec income, some investment income, and withdrawals/rollovers from your IRA, and this will likely be substantially lower than your wages during the highest earning years of your career.

[sirdoug007]

1. Are we (and the linked articles) all making the basic assumption that we will earn less once we FIre than we currently do? (Or as matchewed stated "You make X annually today but in FIRE you'll be spending Y and X>Y.")  I just wanted to clarify if this is a common but unstated assumption.

The math works out if X=Y but not necessarily if Y>>X.

For example, lets say Joe is single and make $75k/year.  Joe's marginal tax rate is 25%.

Joe can save up to the 401(k) max ($17.5k/yr) and wants to spend the remainder.  Maxing the 401(k) drops his taxable income to $57.5k/year.  Joe will pay $5,738 in payroll taxes and $7,810 in income tax or $13,548 total.  I'll ignore state tax.  That means Joe's spending is about $44k/year.  By maxing out the 401(k), Joe avoided $4,375 (25% of the $17.5k) in income tax that he would have paid otherwise. 

Now Joe retires and wants to spend the same $44k/year after tax.  His marginal tax rate is still 25%. 

Since Joe is drawing down his 401(k) and not contributing to his 401(k) his income needs will be less.  So he needs to withdrawal about $50k/year (paying about $6k in income tax, no payroll tax) to get the same $44k/year after tax to support his spending.

Looking at his retirement taxation, he is being taxed $6k on $50k to support his annual spending.  That is 12%. 

So even with constant spending, the effects of reducing the top part of your working income while paying tax on the whole of your retirement spending mean you are paying 12% income tax on your money rather than 25%.  This is a HUGE advantage.  I would much rather pay <15% on my 401(k) than 25% to put the money in a Roth or taxable account.

You can run income tax numbers easily using this tool: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/

Edit: Just for kicks, how much would Joe have to withdrawal to match the 25% he would have given Uncle Sam during his working years?  $240,000!  Then his income tax would be $60k or 25% of his withdrawal amount.

[Ynari]

If you really think overall tax will be higher in retirement than your marginal tax now (a scenario I happen to be in, since I'm nearly tax-free right now), first check if there's a Roth 401k before abandoning 401ks.  My employer offers one, and it only ties up my money for the Roth IRA conversion process.

[rpr]

jo552006 -- You've had some good responses.

You had two concerns in your OP:
1. Penalties when withdrawing early
2. Tax rates in withdrawal higher than tax rates when contributing

From your most recent post, you only raise Concern 2. Can we assume that you are satisfied that Concern 1 is addressed and that other posters have shown that it is indeed possible to get at these tax deferred savings without paying any penalties.

Regarding Concern 2, you are indeed very fortunate if you have other sources of income that will put you in a high tax bracket in retirement. That is indeed a good problem to have. I'd be willing to bet that most of us will not be in that category.

If you indeed retire early, then it is possible that you can control your tax circumstances quite well and that withdrawals and Roth conversions can be made judiciously in order to minimize the taxes to a large extent.

[jo552006]

I think both concerns are answered by the same assumption.  If X>Y in you should be able to get access to some of your money early with no penalties/lower tax.  If Y>>X you'll probably have a much more difficult time accessing your money with no penalty/low interest.  Also, you'll probably pay higher tax rates.  Having said that, you'd also be making much more than you do now, so it probably wouldn't matter (and you may not even need/want any money from your retirement accounts).

-Side note.  I don't neccessarily EXPECT to Y>>X. I just like to know WHY before I do something.  I know why paying off debt is good.  I know why investing is good.  I didn't know why it makes sense to max 401k, IRA, before investing in taxable accounts but now I think I have a good handle on it.

[boarder42]

This is beyond an easy decision. You max the 401k. I get taxed at 28.5%. I'm not going to be in that bracket when I retire.  I'll be around 15% unless I move to Florida or az. Then I'd be around 9%. Math is easy. 35000*.135 =4725 a year MORE than saving any other way just due to taxes. 

Statements made about not knowing what will happen to taxes. Yes you DONT know so build wealth off what you DO. know.

Its a simple common philosophy. I'll retire by 35. And have access to all the money. The more complicated decision is figuring out how to make the bridge work if you haven't been saving in a non tax advantaged account. But I'm 3 years away from seeing if I need to pull back tax ad and just go taxable.

I'll then post my finances here and ask the mathematicians their philosophy. THATS HARD MATH

[davef]

This is beyond an easy decision. You max the 401k. I get taxed at 28.5%. I'm not going to be in that bracket when I retire.  I'll be around 15% unless I move to Florida or az. Then I'd be around 9%. Math is easy. 35000*.135 =4725 a year MORE than saving any other way just due to taxes. 

Statements made about not knowing what will happen to taxes. Yes you DONT know so build wealth off what you DO. know.

Its a simple common philosophy. I'll retire by 35. And have access to all the money. The more complicated decision is figuring out how to make the bridge work if you haven't been saving in a non tax advantaged account. But I'm 3 years away from seeing if I need to pull back tax ad and just go taxable.

I'll then post my finances here and ask the mathematicians their philosophy. THATS HARD MATH

Agreed, unless you are a business owner or expect to have a significant income after retiring maxing the 401k is the way to go.
I am a business owner and dont ever expect to fully retire. I'll just spend less and less time at the office and hire more people to makge the place for me. However, I'll likely still be drawing a nice salary. So I went the Roth IRA route as priority, but am still contributing the excess funds to 401k.

[okashira]

Ok, I'm just going to leave this now:

http://forum.mrmoneymustache.com/ask-a-mustachian/questioning-the-advice-to-max-the-401k/
http://forum.mrmoneymustache.com/investor-alley/roth-or-traditional-ira401k457/msg334648/#msg334648
http://forum.mrmoneymustache.com/ask-a-mustachian/standard-401k-question-roth-or-traditional/msg333388/#msg333388
http://forum.mrmoneymustache.com/ask-a-mustachian/confused-about-401k-withdrawals/msg343905/#msg343905
http://forum.mrmoneymustache.com/investor-alley/how-should-i-be-investing-my-$$/msg347819/#msg347819

This is literally asked here at least 3-4 times/week. Read through all those links for more discussion. Very few people think maxing your 401k is a bad idea.

To each their own.
YMMV.
/ shrug

Agreed. People keep bring it up because deep down, they don't want to max it. It makes people uncomfortable because the money "disappears," in their mind. It can't be taken out easily.
I can sense it in every one of these threads. The folks can't produce a logical or mathematical reason to not max it, just feelings.

BUT once you do max it you are done and every raise you get after that can go elsewhere which is a pretty good feeling.  That is until the gub'mint raises the max again.

It is amazing how quickly you get used to things- just max it out and you get used to the smaller paycheck. My order was to contribute up to the match on my 401k first, then max my roth, then max my 401k, and now I am doing a combination of paying off the mortgage and taxable investing.

Yup, I have had the exact same experience. It was hard to finally max it out. Once done, I have all but forgotten about it.

[Scandium]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

Is the 10% penalty added in all cases (before 59.5)? So before then we could withdraw the $20k and pay no tax, but have to pay 10% penalty? Which is a pretty low tax rate so I might be ok with that. And then 20% on a portion if we want $38k.

I think I understand the Roth conversion ladder. Is it correct that it will only provide about $9,000 per year? (the conversion max). That's something, but not enough to live off fin ER for me.

[matchewed]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

Is the 10% penalty added in all cases (before 59.5)? So before then we could withdraw the $20k and pay no tax, but have to pay 10% penalty? Which is a pretty low tax rate so I might be ok with that. And then 20% on a portion if we want $38k.

I think I understand the Roth conversion ladder. Is it correct that it will only provide about $9,000 per year? (the conversion max). That's something, but not enough to live off fin ER for me.

You're mixing up contribution max ($5.5k for IRA per person) with conversions. There is no conversion max, you can convert as much as you want but will have to pay income taxes on the amount converted.

[Gin1984]

Ok, I'm just going to leave this now:

http://forum.mrmoneymustache.com/ask-a-mustachian/questioning-the-advice-to-max-the-401k/
http://forum.mrmoneymustache.com/investor-alley/roth-or-traditional-ira401k457/msg334648/#msg334648
http://forum.mrmoneymustache.com/ask-a-mustachian/standard-401k-question-roth-or-traditional/msg333388/#msg333388
http://forum.mrmoneymustache.com/ask-a-mustachian/confused-about-401k-withdrawals/msg343905/#msg343905
http://forum.mrmoneymustache.com/investor-alley/how-should-i-be-investing-my-$$/msg347819/#msg347819

This is literally asked here at least 3-4 times/week. Read through all those links for more discussion. Very few people think maxing your 401k is a bad idea.

To each their own.
YMMV.
/ shrug

Agreed. People keep bring it up because deep down, they don't want to max it. It makes people uncomfortable because the money "disappears," in their mind. It can't be taken out easily.
I can sense it in every one of these threads. The folks can't produce a logical or mathematical reason to not max it, just feelings.

BUT once you do max it you are done and every raise you get after that can go elsewhere which is a pretty good feeling.  That is until the gub'mint raises the max again.

It is amazing how quickly you get used to things- just max it out and you get used to the smaller paycheck. My order was to contribute up to the match on my 401k first, then max my roth, then max my 401k, and now I am doing a combination of paying off the mortgage and taxable investing.

Yup, I have had the exact same experience. It was hard to finally max it out. Once done, I have all but forgotten about it.

Funny enough, I was fine with putting 20% for retirement and 5% in taxable until you folks corrupted me.  :). Now I can't wait to max out, put still working on it.

[gobius]

I don't know if anyone has mentioned that your money will grow faster in the 401(k) as well.  If you are in the 15% tax bracket and put $17,500 into a 401(k), you are saving about $2,500 (15% of $17,500) in taxes.  In other words, $2,500 MORE is working for you as an investment.  Granted, if you are FIRE'ing only a year or so later it won't have as much time to compound, but if it's growing at 8%, that difference becomes about $2,700 after a year, $2,900 after 2 years, and $5,400 after 10 years.

As you seemed to have guessed, most people here are assuming that they will need a lot less money in retirement than they are making now (myself included), and will only withdraw enough to cover those needs, so their retirement incomes will be lower.  Many don't intend to work until they have enough investment income to cover 3-4x their future expenses even though they could be making 3-4x their expenses now.  Even if they do intend to make that much, they will not be withdrawing 3-4x their expenses each year.

As for income tax rates being higher, we don't necessarily know that it will happen.  It depends on how you intend to FIRE.  If you intend to FIRE and live off $20K/year for 2 people, that is considered a low income and I doubt the government would increase income taxes on that level of income.  If you intend to retire at the same income as what you make now, for example $70K/year for one person, then you may need to worry about it more.  Even in that case, though, by deferring taxes now you are allowing a bigger amount to grow and you can control how much you withdraw (to a certain degree, anyway).

[beltim]

I don't know if anyone has mentioned that your money will grow faster in the 401(k) as well.  If you are in the 15% tax bracket and put $17,500 into a 401(k), you are saving about $2,500 (15% of $17,500) in taxes.  In other words, $2,500 MORE is working for you as an investment.  Granted, if you are FIRE'ing only a year or so later it won't have as much time to compound, but if it's growing at 8%, that difference becomes about $2,700 after a year, $2,900 after 2 years, and $5,400 after 10 years.

This isn't really true.  If your tax rate in retirement is the same as your tax rate now, then it doesn't matter when the taxes are withdrawn – you wind up with the same amount after tax.  If the tax rates aren't the same, then the savings come from the difference in tax rates.

[Scandium]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

Is the 10% penalty added in all cases (before 59.5)? So before then we could withdraw the $20k and pay no tax, but have to pay 10% penalty? Which is a pretty low tax rate so I might be ok with that. And then 20% on a portion if we want $38k.

I think I understand the Roth conversion ladder. Is it correct that it will only provide about $9,000 per year? (the conversion max). That's something, but not enough to live off fin ER for me.

You're mixing up contribution max ($5.5k for IRA per person) with conversions. There is no conversion max, you can convert as much as you want but will have to pay income taxes on the amount converted.

Ok, I see. Yeah I meant the tax-free limit. But a 401k distribution would be considered income right? So you can either do $10k roth conversion, or $20k in 401k distribution (with 10% penalty, 0% tax) per year?

The concepts are all interesting and mostly understandable in isolation, but I would like to see an overall strategy for getting say $30-40K per year from a combination of taxable, tax-deferred and tax-free accounts. What is the best way to go about it?

For example, something like this?
401k - $500,000 - 4% SWR = $20,000 (-10% penalty)
Taxable = $300,000 - 5% SWR = $15,000 (0% capital gains)

Giving $33,000 per year, a comfortable amount. With relatively high safety. Or am I way off?

In any case I'm still just working on getting that combined $800k portfolio so still have some time to figure this out:D

[matchewed]

One thing to keep in mind is that you don't necessarily pay taxes on money withdrawn from your 401k.  My understanding is below (someone please correct me if I am wrong):

For example, if you were retired this year you could withdraw $6200 per person as the standard deduction and $3950 per person of personal exemption.  Therefore, if you are married, you can withdraw $20300 from your401k, without paying federal income taxes on the money.  On any additional money withdrawn from your 401k, the standard tax brackets apply (for example 10% federal income tax on up to $18150 over the $20300).

Is the 10% penalty added in all cases (before 59.5)? So before then we could withdraw the $20k and pay no tax, but have to pay 10% penalty? Which is a pretty low tax rate so I might be ok with that. And then 20% on a portion if we want $38k.

I think I understand the Roth conversion ladder. Is it correct that it will only provide about $9,000 per year? (the conversion max). That's something, but not enough to live off fin ER for me.

You're mixing up contribution max ($5.5k for IRA per person) with conversions. There is no conversion max, you can convert as much as you want but will have to pay income taxes on the amount converted.

Ok, I see. Yeah I meant the tax-free limit. But a 401k distribution would be considered income right? So you can either do $10k roth conversion, or $20k in 401k distribution (with 10% penalty, 0% tax) per year?

The concepts are all interesting and mostly understandable in isolation, but I would like to see an overall strategy for getting say $30-40K per year from a combination of taxable, tax-deferred and tax-free accounts. What is the best way to go about it?

For example, something like this?
401k - $500,000 - 4% SWR = $20,000 (-10% penalty)
Taxable = $300,000 - 5% SWR = $15,000 (0% capital gains)

Giving $33,000 per year, a comfortable amount. With relatively high safety. Or am I way off?

In any case I'm still just working on getting that combined $800k portfolio so still have some time to figure this out:D

An example of someone doing similar to what you're talking about - http://www.gocurrycracker.com/never-pay-taxes-again/

Yes the idea is about minimization of taxes. The best way is by minimizing your expenses so you need less income. Then kind of how you're saying you just use various tax treated investment vehicles and minimize your taxes through tax loss harvesting and a combination of various distributions and conversions.

I'd try to run the numbers with a bit more than back of the napkin math if you're really curious on how to do it. Literally pull the forms from the IRS site and run the numbers.

[Cromacster]

Ok, I see. Yeah I meant the tax-free limit. But a 401k distribution would be considered income right? So you can either do $10k roth conversion, or $20k in 401k distribution (with 10% penalty, 0% tax) per year?

The concepts are all interesting and mostly understandable in isolation, but I would like to see an overall strategy for getting say $30-40K per year from a combination of taxable, tax-deferred and tax-free accounts. What is the best way to go about it?

For example, something like this?
401k - $500,000 - 4% SWR = $20,000 (-10% penalty)
Taxable = $300,000 - 5% SWR = $15,000 (0% capital gains)

Giving $33,000 per year, a comfortable amount. With relatively high safety. Or am I way off?

In any case I'm still just working on getting that combined $800k portfolio so still have some time to figure this out:D

You will never pay the 10% penalty....401(k) is rolled over to IRA.  Then converted to Roth IRA in small chunks.  Wait 5 years and withdraw money from Roth, no fees.

[Scandium]

Ok, I see. Yeah I meant the tax-free limit. But a 401k distribution would be considered income right? So you can either do $10k roth conversion, or $20k in 401k distribution (with 10% penalty, 0% tax) per year?

The concepts are all interesting and mostly understandable in isolation, but I would like to see an overall strategy for getting say $30-40K per year from a combination of taxable, tax-deferred and tax-free accounts. What is the best way to go about it?

For example, something like this?
401k - $500,000 - 4% SWR = $20,000 (-10% penalty)
Taxable = $300,000 - 5% SWR = $15,000 (0% capital gains)

Giving $33,000 per year, a comfortable amount. With relatively high safety. Or am I way off?

In any case I'm still just working on getting that combined $800k portfolio so still have some time to figure this out:D

You will never pay the 10% penalty....401(k) is rolled over to IRA.  Then converted to Roth IRA in small chunks.  Wait 5 years and withdraw money from Roth, no fees.

Yes, but only about $10K per year, unless you pay income tax. And Roth contributions in addition, which say you work 20 years is less than $120K. It's a good strategy, but I would need a way to get more out of my 401k than that.

[Cheddar Stacker]

Scandium, this is not limited to $10k and you shouldn't have to pay penalties. You will pay tax on anything > $10k if you don't have other deductions. But you will be paying some tax at 10% and some at 15% at worst.

[Cromacster]

Scandium, this is not limited to $10k and you shouldn't have to pay penalties. You will pay tax on anything > $10k if you don't have other deductions. But you will be paying some tax at 10% and some at 15% at worst.

If I have a million in my 401(k) I could rollover to my IRA, then convert to a Roth the same year if I wanted (paying taxes the whole way X.x).  No limit on how much you can convert.

[MooseOutFront]

The tax reasons, as mentioned in this thread make the 401k max a no-brainer in most scenarios.  I'll just add that also in most cases an extreme early retiree will need to be saving more than the typical employee maximum of $17,500 401k plus $5,500 IRA each year to reach their goals anyway. 

Now, in my case by the time you throw in an HSA, a 457b, and a mandatory .gov pension contribution, the tax adv space gets up to $72,000+.  I'm not there yet, but am getting closer all the time and the goal is to max it.  Then I'll go taxable.  The main effect for me is that I'll never have much in taxable which helps me decide on contributing to a Roth IRA over a traditional IRA at my 15% marginal rate, just so that I can access those $100k+ worth of Roth contributions during the 1st 5 years of retirement while I start with the Roth rollovers and or get alternative sources of income up.

For example.

And deep down, I fully expect to generate a nice income during retirement, but I also expect to be able to keep from paying a bunch of taxes on it.  Like, for example by deferring retirement income for my sole proprietorship at that time into a solo 401k to keep income taxes low while living off of dividends, capital gains, seasoned roth rollovers, and roth principal contributions.  All of which spend just like earned income but are not taxed as such.

[Scandium]

Scandium, this is not limited to $10k and you shouldn't have to pay penalties. You will pay tax on anything > $10k if you don't have other deductions. But you will be paying some tax at 10% and some at 15% at worst.

eh ok. I may be more confused now than before. Need to do some more reading on this. Good thing I'm 20 years away from implementing this.. 

- There's a limit on tax-free roth conversion, correct? That what I meant by limit. This is the standard deductions/credits. So about $20k for couple? The $10k number mad fientist uses is for an individual?
- Above this limit conversions are taxed at regular income tax rates? So <15% up to $70k for a couple.

So from this it looks like with some foresight there is no reason to do a direct 401k distribution, even with just the 10% penalty (which is from the 1st dollar), since it's always better to convert to roth first, even if you have to pay 10% or 15% tax? Only disadvantage is the 5 year wait.

[MooseOutFront]

exactly Scandium.

[beltim]

Scandium, this is not limited to $10k and you shouldn't have to pay penalties. You will pay tax on anything > $10k if you don't have other deductions. But you will be paying some tax at 10% and some at 15% at worst.

eh ok. I may be more confused now than before. Need to do some more reading on this. Good thing I'm 20 years away from implementing this.. 

- There's a limit on tax-free roth conversion, correct? That what I meant by limit. This is the standard deductions/credits. So about $20k for couple? The $10k number mad fientist uses is for an individual?
- Above this limit conversions are taxed at regular income tax rates? So <15% up to $70k for a couple.

So from this it looks like with some foresight there is no reason to do a direct 401k distribution, even with just the 10% penalty, since it's always better to convert to roth first, even if you have to pay 10% or 15% tax? Only disadvantage is the 5 year wait.

If you commit to regular distributions, you can withdraw nearly 4% (it depends on current interest rates, but a 45 year old person could withdraw 3.85% annually) from a 401k without bothering with the Roth pipeline and corresponding 5 year wait.  http://www.bankrate.com/calculators/retirement/72-t-distribution-calculator.aspx