Author Topic: Early retirement... max out 401(k) or stick with outside brokerage accounts?  (Read 5264 times)

cheapass

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Hey everyone, long time listener first time caller.

I've been considering how I want to allocate my early retirement fund going forward. Currently I take advantage of my 401k up to the maximum employer match and that's it, the rest of my investing is done into Vanguard funds using after-tax dollars. For my projections I am assuming standard market indexes for both accounts, with expected real returns of 7%

Recently I've been thinking that maxing out the 401k with pre-tax dollars and allowing those dollars to compound for about 15-20 years would be a better course of action, even if I have to pay a 10% penalty on the back end. I am planning on being in a much lower tax bracket (0-15%) in retirement than I am now (28%)

A couple questions
1) Is it correct that the 401k is taxed on the full distribution amount whereas the Vanguard account is taxed only on the gain?
2) What are the tax bracket limits for investment income for a 401k and for a normal brokerage account? Are they the same?

Any other insight into this tax-advantaged vs. standard investment account decision would be appreciated!

MDM

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Recently I've been thinking that maxing out the 401k with pre-tax dollars and allowing those dollars to compound for about 15-20 years would be a better course of action, even if I have to pay a 10% penalty on the back end. I am planning on being in a much lower tax bracket (0-15%) in retirement than I am now (28%)
Don't understand why you would be paying any penalty...?

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A couple questions
1) Is it correct that the 401k is taxed on the full distribution amount whereas the Vanguard account is taxed only on the gain?
Yes, but the 401k contributions were not taxed at all, while you paid your current marginal rate before being able to contribute to Vanguard.

Quote
2) What are the tax bracket limits for investment income for a 401k and for a normal brokerage account? Are they the same?
Yes, although long term capital gains and qualified dividends in a taxable account have different brackets than ordinary income.

Quote
Any other insight into this tax-advantaged vs. standard investment account decision would be appreciated!
See http://forum.mrmoneymustache.com/investor-alley/using-a-high-fee-401k/msg670156/#msg670156 and links therefrom.

forummm

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Thanks for listening.

1) The 401k made with pre-tax contributions, requires distributions to be taxable at regular income tax rates. The post-tax Vanguard account is taxed, a) any dividends and capital gains distributions in the year you receive them, and b) capital gains taxes whenever you sell them
2) The marginal tax bracket for funds taken from your 401k is the regular income tax bracket you would be in based on adding the 401k distribution to all your income from that year. The same for a taxable brokerage account. There are different rules for earned income and long term capital gains and short term capital gains and dividend distributions.

In general, you would normally be better off maxing out your 401k and IRA and putting less in a taxable brokerage account.

DrF

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Looks like you need a strong dose of MadFIentist.

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

Then this: http://www.madfientist.com/guinea-pig-year-1/

Enjoy!

cheapass

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Thank you for the response.

Don't understand why you would be paying any penalty...?

I was under the impression that a 401k distribution before age 60 incurred a 10% early withdrawl penalty, no?

forummm

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Thank you for the response.

Don't understand why you would be paying any penalty...?

I was under the impression that a 401k distribution before age 60 incurred a 10% early withdrawl penalty, no?

The MadFIentists links will clear that up for you.

DrF

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55yo no penalty if you retire from the company where you ahve the 401k.

Also, roll over the 401k into your Roth IRA upon retirement, wait the alloted 5 years, and withdraw penalty/tax free. (Only convert an amount every year to stay below major tax thresholds).

Edit: you can add an additional step where you first roll your 401k (all of it) into a traditional IRA (not really necessary, but may give better investment options).
« Last Edit: May 22, 2015, 01:43:46 PM by DrFunk »

Cheddar Stacker

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I am planning on being in a much lower tax bracket (0-15%) in retirement than I am now (28%)

This is the key. If you can pull it off, then max every possible tax deferred account possible. Traditional 401k, traditional IRA (not likely in the 28% bracket though), HSA, etc.

Because as MDM points out:
.. the 401k contributions were not taxed at all, while you paid your current marginal rate before being able to contribute to Vanguard.

28% tax deduction today, 0-15% tax x years from now. That's a 13-28% return on investment.

And here's another often cited link, just for good measure:
https://seattlecyclone.com/accessing-your-retirement-accounts-early-yes-you-can/

cheapass

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55yo no penalty if you retire from the company where you ahve the 401k.

Also, roll over the 401k into your Roth IRA upon retirement, wait the alloted 5 years, and withdraw penalty/tax free. (Only roll enough over every year to stay below major tax thresholds).

Ah, thank you for clarifying. I am planning on retiring age 45-50 and I will most definitely not be working at this company at that time. I also have an IRA that is a rollover from a previous company.

Eric

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Edit: you can add an additional step where you first roll your 401k (all of it) into a traditional IRA (not really necessary, but may give better investment options).

Yes, it's absolutely necessary unless you want to pay taxes on your whole 401k in one tax year.

Cheddar Stacker

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Edit: you can add an additional step where you first roll your 401k (all of it) into a traditional IRA (not really necessary, but may give better investment options).

Yes, it's absolutely necessary unless you want to pay taxes on your whole 401k in one tax year.

+1. Don't skip that step or it defeats the entire purpose behind tax deferral. If you convert a $250K 401K directly into a Roth IRA the year you retire, you're going to pay 30%+ tax that year on the conversion. A slow drip allows you to remain in the 0-15% brackets.

DrF

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I think you guys didn't catch the part I had in ().

only convert a small amount to your Roth every year from your 401k to avoid excessive taxes.

Edit: woot! magnum!
« Last Edit: May 22, 2015, 02:17:06 PM by DrFunk »

jsternitzky

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Looks like you need a strong dose of MadFIentist.

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

Then this: http://www.madfientist.com/guinea-pig-year-1/

Enjoy!

From links inside these articles I just learned about Tax-Harvesting and tax free Traditional IRA to ROTH IRA conversion
#mindblown

Thank you so much!

forummm

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Looks like you need a strong dose of MadFIentist.

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

Then this: http://www.madfientist.com/guinea-pig-year-1/

Enjoy!

From links inside these articles I just learned about Tax-Harvesting and tax free Traditional IRA to ROTH IRA conversion
#mindblown

Thank you so much!

Pretty great right? Information is freedom.