Author Topic: Why max out your 401k?  (Read 17287 times)

aesojka

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Why max out your 401k?
« on: November 19, 2013, 06:21:16 PM »
Hello -

Apologies this is such a potentially obvious question ... I have been working on my anti-Mustachian habits for a month or so but my investing knowledge is still very basic.

Here is my question: why does MMM suggest you max out your 401k every year? I understand that it is before-tax income sent to a fund that earns interest and is matched by your employer. But I am 24. What if I can retire at 34, but all my money is in my 401k? Don't all deductions come with penalties until you turn 59.5?

Shouldn't I just invest up to my employer's maximum contribution and put the rest somewhere else, like index funds?

I guess I have another question too - my 401k is on autopilot for the "2050 retirement plan" or something. Obviously I no longer want to wait until 2050 to retire. What should I do with my 401k investments?

Thank you in advance for your help!

Frankies Girl

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Re: Why max out your 401k?
« Reply #1 on: November 19, 2013, 06:58:23 PM »
Two reasons right off the bat:

1) Reduce your taxable income (thereby potentially saving you big money on your tax return)
2) Pre-tax money is put to work. Your money technically goes farther and if your employer matches even a small amount, it's that much more money to work for you. The earlier you get this started and bumped to the max, the faster and easier it is to retire early.

And you can, once you quit your job - at any age - convert your 401K to an IRA, and then using a Roth IRA*, create a Roth Pipeline to convert that money over to money that you could technically pay no tax on - ever.

I just asked about the pipeline recently:
https://forum.mrmoneymustache.com/investor-alley/401k-to-ira-to-roth-and-effective-tax-rates/msg159676/#msg159676
and this post is a really great explanation
http://www.madfientist.com/traditional-ira-vs-roth-ira/

*Roth IRAs are currently something you can open and fund using after tax income up to $5,500 per year (as of 2013) and any contributions on this can be withdrawn without penalty. You can't take out the profit (dividends/growth) but the original amounts you put in are yours... do some reading on those as well as they are a very cool part of investing and saving that can help out in early retirement.
« Last Edit: November 19, 2013, 09:08:59 PM by Frankies Girl »

Bruised_Pepper

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Re: Why max out your 401k?
« Reply #2 on: November 19, 2013, 06:58:33 PM »
You can get to the money in your 401k before you're 59.5 without penalties.  There's a few workarounds such as the Roth pipeline and SEPP, but I'll let someone more knowledgeable explain those. 

The benefit of placing it in a 401k (which you then invest in index funds) is that it's pre-tax income, meaning that your tax liability decreases, meaning that more of your gross pay goes to you.  Less of it is "take-home", but including the $17,500 that you increase your net worth by, it's substantially more than if you had your whole paycheck taxed.  Another benefit of the 401k is that tax is deferred until you retire.  Since you'll make less money when you retire, you'll be in a lower tax bracket, and you'll pay less in taxes than if you paid taxes now.

chasesfish

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Re: Why max out your 401k?
« Reply #3 on: November 19, 2013, 06:59:39 PM »
Max your 401k because it is pre-tax investing and there are ways to get your money out before you are 59.5.  There's a MMM link that people smarter than me will post.

The theory is if you have very low expenses, then your taxable income will be much lower in retirement utilizing the ways to get the money out.  You also don't pay the taxes on income earned.

aesojka

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Re: Why max out your 401k?
« Reply #4 on: November 19, 2013, 07:36:42 PM »
Thank you everyone! I really appreciate your help!

StarryC

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Re: Why max out your 401k?
« Reply #5 on: November 19, 2013, 07:45:33 PM »
If you can retire at 34, then you'll have about 25 years to wait until you can get that money. From 59.5, you might hope to live about 25-30 more years, so you can expect to need money then as well.  Possibly more because as you age health care might get more expensive, you'll be dealing with inflation as well. As I understand it, you can only put income in a 401K while you are employed, not gains.  So after you retire, you can't add to your 401K through contributions, but if you do side gigs/ etc. you can still add to your taxable accounts. And there are annual limits to the 401K.  So if you really only plan to work for 10 years, the most you could put in the 401K is $175,000 (approximately).  So it won't be your only retirement fund, you will need plenty of money after 59.5, and you ONLY have your working years to contribute to this tax advantaged fund. 

Finally, if you do withdraw, as I understand it, the withdrawal is at your usual tax rate +10%. If you have a top tax rate of 28% right now, but after retirement you'll be in the 15% bracket, then you would STILL benefit from the tax deferment even after paying the penalty, even without a match! 
 
Imagine you are putting in $17,500.  Your employer is matching $5,000.  And you are avoiding having that money taxed at 28%.  Your pay will be reduced by $12,600 a year.  Your account gets $22,500.  Then, 10 years later, ignoring inflation and gains, you withdraw that money at 15% tax rate and 10% penalty.  You receive $17,000.  For an original cost to you of $12,600. 

No Name Guy

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Re: Why max out your 401k?
« Reply #6 on: November 20, 2013, 07:22:03 AM »
Actually StarryC, that isn't correct about having to wait for 59 1/2.

As Bruised Pepper mentioned, it's called SEPP, or 72(t).

SEPP stands for Substantially Equal Periodic Payments.  72(t) is the section of the tax code that deals with this and has provisions that allows one to pull money from a 401k / traditional IRA before 59 1/2 without the extra 10% penalty. 

Even if your employer doesn't do SEPP from your 401k after you quit / retire / FI, then you roll your 401k over into a traditional IRA and SEPP from that, or do the Roth conversions as noted below, or.....(insert other choices you find via research).  You can also roll a 401k into multiple traditional IRAs, and SEPP from only one of them, or several of them at various times, but you don't have to do all of them, all to optimize your income profile, depending on the details of your situation.

Aesojka - google "72(t) irs" and read the first link
http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments

This is straight from the IRS, but also do more research.  In that first link, read the exceptions part.  It says, in part:

Quote
If distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary, the 72(t) tax does not apply.

schimt

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Re: Why max out your 401k?
« Reply #7 on: November 20, 2013, 08:34:44 AM »
This last note in your comment No Name Guy, clarified a lot for me! Mainly the fact that you can create seperate IRA buckets and  SEPP from them to create a profile that fits your needs. This is extremely useful information because i assummed that if i wanted to use this strategy i would need to SEPP my entire retirement savings.

Thank you

StarryC

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Re: Why max out your 401k?
« Reply #8 on: November 20, 2013, 09:27:27 AM »
Right, you don't have to wait if you want to use other methods everyone mentioned.  What I meant was 1) Even if you do decide to wait, you will likely have plenty of time to use the limited money you can put in the 401K and 2) Even if you don't want to do any of the workarounds and just decide one day to withdraw it all (in an emergency, or a fit of bad decision making), there is still a benefit to having put it in the 401K. 

No Name Guy

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Re: Why max out your 401k?
« Reply #9 on: November 20, 2013, 09:42:44 AM »
Schimt:  I credit my financial planner for that tid bit.  I hadn't thought of that one and when I was talking SEPP-ing as part of ER she mentioned this as one possible strategy (e.g. multiple traditional IRA's, with appropriate fractions of the total in each, and SEPP-ing only from one, initially, then from the other(s) as necessary or using multiple IRAs as per a long term plan.)

More generally, look into the 3 formulas in the IRS rules and carefully consider which of them works right for you.  It may be found that using different rules on different IRAs your SEPP-ing from is the right way to go about it.

This is a topic to do your homework on before pulling the ER / FI trigger.

More generically - to the OP's question:  Max it out baby!  Shield all that you can from taxes today when you're making bank, since for most of us, our tax bracket will be a lot lower in retirement since we'll be in "poverty" with our frugal, MMM levels of income that we optimize via Badassity to a kick ass life.

MrsPete

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Re: Why max out your 401k?
« Reply #10 on: November 20, 2013, 09:50:43 AM »
You've already received good responses, and you understand that flexibility is the cost of the tax saving for a 401K.  I'll add one more thing:

Most people who retire at a young age aren't living off their savings.  Rather, most -- or at least quite a few -- are going to work at something else: likely something less stressful, likely part-time or seasonal.  Everyone has a different plan, but a typical plan might be something like this:  Once I have X amount in savings and a paid-for house (so that expenses are lower), with frugal ways I can afford to give up my stressful, full-time job and work part-time 'til I'm able to draw up on my 401K money. 

bUU

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Re: Why max out your 401k?
« Reply #11 on: November 20, 2013, 09:57:44 AM »
The benefit of placing it in a 401k (which you then invest in index funds) is that it's pre-tax income, meaning that your tax liability decreases, meaning that more of your gross pay goes to you.
Just a small clarification here: The more money you tax defer, the less tax you pay, meaning that you can invest that money (the money you would have paid in taxes too) and earn money on that money as well. You'll eventually pay tax on the income you defer and on all the gains - true - but the one bit of "found money" in this is what you earn on the money that you would have been taxed on, between the year you defer the taxes until the year you pay the tax (i.e., when it comes out of the 401k).

the fixer

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Re: Why max out your 401k?
« Reply #12 on: November 20, 2013, 11:50:03 AM »
Just a small clarification here: The more money you tax defer, the less tax you pay, meaning that you can invest that money (the money you would have paid in taxes too) and earn money on that money as well. You'll eventually pay tax on the income you defer and on all the gains - true - but the one bit of "found money" in this is what you earn on the money that you would have been taxed on, between the year you defer the taxes until the year you pay the tax (i.e., when it comes out of the 401k).
That's close, but not mathematically correct. The commutative property of multiplication keeps you from "finding money" in the principal contribution, because all the compounded gains get taxed too.

Suppose I have a 401(k) and a taxable account. Both accounts invest in the same index fund with the same expenses. My tax bracket stays at 25% throughout the scenario. I have $20000 of excess income I can invest in a given year. I put $10000 into the 401(k). The remaining $10000 I pay income taxes on, and after taxes I have $7500 to invest in a taxable account. For simplicity, let's assume the investment I use does not throw off dividends and there is no return of cost basis (sheltering of tax-inefficient assets is an undisputed benefit of tax-deferred accounts).

After 10 years, the average annual return on my investment in both accounts is 10%. The ending balances are: $25937 in the 401(k), and $19453 in the taxable account (principal * (1 + 10%) ^ 10 years). It looks like I have more money in the 401(k), but do I? If I did a penalty-free withdrawal from the 401(k) of the entire sum, it would get taxed at 25% and I'd have: $19453. Exactly the same balance in the taxable account.

The 401(k) is still better off than the taxable account, though, because I haven't revealed what would happen if I sold the taxable asset. If I did that, I'd be subject to capital gains taxes on $11953 of gains. My takeaway would only be $17660 at a 15% capital gains rate. So it's actually the capital gains tax being compounded with ordinary income tax on investment principal that makes tax-deferred accounts better, so long as everything else is equal.

An interesting variation: if I assume that the fund I choose in the 401(k) has the same underlying investment performance but charges an extra 1% per annum in expenses (so 9% return), after 10 years the 401(k) is still the better investment but only by $95. I essentially break even.

bUU

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Re: Why max out your 401k?
« Reply #13 on: November 20, 2013, 12:03:41 PM »
So it's actually the capital gains tax being compounded with ordinary income tax on investment principal that makes tax-deferred accounts better, so long as everything else is equal.
Precisely.

Zelda01

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Re: Why max out your 401k?
« Reply #14 on: November 20, 2013, 04:25:28 PM »
... a typical plan might be something like this:  Once I have X amount in savings and a paid-for house (so that expenses are lower), with frugal ways I can afford to give up my stressful, full-time job and work part-time 'til I'm able to draw up on my 401K money.
I never thought of it that way.  Have all the retirement in place, then a person can just work to support themselves in the present time.  What a concept!