Even for folks who can't manage the five-year pipeline method for getting 401k money out penalty free at any age, the usual 10% penalty is still a good deal for folks whose effective tax rate will drop more than 10% as they transition to retirement.
I'm having a hard time thinking of anyone who is more than about five years from retirement who shouldn't be maxing their 401k plan before investing anything in taxable accounts.
Just looking at this in a little more detail for myself, we're currently at an effective tax rate of 20%. Therefore, assuming the 10% penalty during early retirement, we'd need a rate of 10% or less. This equates to a taxable income of $17,000 or less at 2011 rates (calculated here
http://www.moneychimp.com/features/tax_brackets.htm).
Is that a reasonable income level to assume? MMM's comfortable living expenses were right around $27,000 (2 adult + 1 child, no mortgage). With appropriate deductions, it looks like any expense level below $40,000 would work in our case:
$17,000 taxable income
+ $11,600 standard deduction (married, joint)
+ $11,100 exemptions (2 adult + 1 child)
-----------
= $39,700 total income
Any other early retirees with kids able to comment on their taxable income levels?
Another big factor to consider is the tax rate on capital gains and dividends versus distributions from a 401k. Until 2013, you get a pretty sweet 0% tax rate on long term capital gains and qualified dividends, if you're in the bottom two brackets (10/15%). Whereas all distributions from a 401k (pre-tax contributions + gains) are taxed as regular income. Definitely a better deal to have the taxable account in place with a steady stream of dividend payments, in that case.
Again, after 2013 the rates change, but that's always a big unknown with this analysis...none of us know how tax rates or early withdrawal penalties might change in the future, for better or worse. I'd rather have my money freely available to use and invest, with similar justification as MMM describes in his post. It's a personal choice, similar to the decision to pay off a mortgage vs. invest.