Say no to 401K, and yes to other investments ??

[tiredMike]

Hi there,  I've read just about everything on the MMM site, and one thought keeps coming to mind when I think of the advice given on how to retire early: 

Except for the matching contributions by the employer,  why should anyone who wants to retire early,  and I mean real early, like around 40,  put money into a 401K, when you cannot withdraw the money until you are 55 or older without real penalty ?  Why not just invest in something like the Vanguard Total Stock Market Index fund MMM recommends, or the Lending Club, or something else like this?  Where, once you build up the amount you need to retire (using the MMM formula for the amount needed for retirement), you can retire immediately, instead of having to wait to the required age to start drawing on your 401K funds?

I can think of two possible answers to this:

1. The amount of the employer's matching contributions has a such a large impact on the growth of the nestegg being saved, that it would be foolish to turn it down.  Plus, it is pre-tax money you are saving, which is less painful to say goodbye to.

 OR
2.  One can actually get at the 401K money at any point in time if one is willing to take the 10% penalty on the withdrawal (and pay income tax on the net amount actually withdrawn).

Can anyone shed any more light on this? ... cause its been bugging me since I discovered the MMM site.

I am 49, and want to retire as early as possible, but feel that I cannot get to my 401K money before age 59.5.  Actually, I think I can start getting at 401K money as early as age 55 if I use IRS Rule 72t, which allows me to use "substantially equal periodic payments" to avoid the early withdrawal penalty, but then I have to take these payments for the rest of my life or something. 

Anyway,  please shed some light on this if you can.  Thanks!

-- tiredMike

[footenote]

Mike - All points are correct to the best of my knowledge.

One additional selling points for 401k's (or any other "qualified" retirement investment) is that you are saving money pre-tax when your earnings are higher and withdrawing / paying the taxes when your income is lower. So assuming you are in a lower bracket during retirement, you save on taxes both in the present (lower your current year tax burden) and over time (lower rate when you draw down). (And if you live like a Mustachian in retirement, you should be able to get your income tax bracket really low.)

Yes, you can always get the money and sustain a 10% penalty. And, yes, you can 72t over time. But you give up a fair amount of flexibility because the government spreads those SEPPs evenly over your theoretical lifetime.

IMO, if you want to retire substantially earlier than 59.5, you should save in both pre-tax and post-tax vehicles. This also gives you the flexibility to make investments with the post-tax money (landlording, startups, buy an existing small business) after you've hung up the corporate gig. But you still get some tax relief today and in future.

[matchewed]

Actually you can access your investments prior to 59.5 using a Roth pipeline. You can roll over money from tax deferred accounts into your Roth account. At that roll over you will pay income tax. Five years later you withdraw from the Roth with no taxes. None of this incurs a penalty.

All you would need is enough money outside of tax deferred investments to last you for five years.

Alternatively you mentioned 72(t). Which is another viable option for those closer to traditional retirement age. I'm not up to snuff on it as I don't consider it in my plan currently.

[Eric]

I am 49, and want to retire as early as possible, but feel that I cannot get to my 401K money before age 59.5.  Actually, I think I can start getting at 401K money as early as age 55 if I use IRS Rule 72t, which allows me to use "substantially equal periodic payments" to avoid the early withdrawal penalty, but then I have to take these payments for the rest of my life or something. 

Rule 72(t) can be used to access your 401k/IRA funds at any age.  However, once the distributions start, they need to continue until you reach age 59.5, or for 5 years, whichever is longer.  After age 59.5 (or 5 years), you can stop the SEPPs and withdrawal any amount penalty free.  (but of course these are taxed as income)

This is a pretty simple explanation:

http://www.obliviousinvestor.com/72t-distribution-rules/

[NumberCruncher]

MMM goes over the standard options here: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

The option not covered here yet is the Roth pipeline

Build up your 401k and any other savings, then quit your job to begin retirement – hooray!
You are now in a low tax bracket – you can actually roll over a chunk of your 401k into a Roth IRA account and pay income taxes on it at this point.
Then you let it sit in the Roth IRA for a minimum of 5 years
At this point, you can withdraw all of the principal (but not the gains yet, no big deal), penalty-free!

To be extra fancy, you could just roll over enough to cover your annual spending (say, $30,000) once per year into the Roth account, and pay the minimal income taxes. This would build a 5-year pipeline so that you would be able to withdraw an equal amount from the Roth account each year once you got the pipeline filled out. Of course, you also have to set aside money (or do some part-time work, or pay some 401k early withdrawal penalties) to get you through the first five years while you are waiting for the first batch to finish “fermenting”. But it is still a definite loophole that can help you spring out your 401k money penalty-free.

[tomsang]

72(t) as many have brought up can occur at any age. 

Why I max out my 401k relates to tax rates.  Currently, my marginal federal tax rate is 39.6%.  I expect my marginal tax rate to be 15% when I retire.  Maybe lower if I can generate tax preference items with rentals and others.  Therefore, every dollar that I put into my 401k saves me 24.6% over what I will end up paying in retirement.  The other significant benefit is that the deferral of taxes allows the compounding of returns to be on a large amount.

Example:

$10,000 after tax is equal to $16,556 gross (IE 16,556 x .396=$6,556 of tax).

$10,000 at 8% grows to be $14,693 after 10 years
$16,556 at 8% grows to be $24,326 after 10 years

If both investments were cashed out in 10 years and tax paid at 15% you would have x left over.

$10,000 = $14,693 - (15% x $4,693) = $13,989 (note only the gain is taxed)
$16,556 = $24,326 - (15% x $24,326) = $20,677 (note all of it is taxed.

Under this scenario I am better off by $6,688 by putting the money into my 401k vs. after tax.

If your marginal tax rate is low, then the difference is less. 

Good luck!

[TSR Capital]

The investment limitations of 401Ks bother me.  My current employer uses Vanguard, which is decent, but it still has a very limited array of options.  Individual stock picking is out, can't use specialized ETFs, etc.

The more I look at 401Ks, the more it seems like a quasi-monopoly to funnel investors into the funds of big investment firms.  Why does your investing for retirement need to be tied to your employer?

[tomsang]

The investment limitations of 401Ks bother me.  My current employer uses Vanguard, which is decent, but it still has a very limited array of options.  Individual stock picking is out, can't use specialized ETFs, etc.

The more I look at 401Ks, the more it seems like a quasi-monopoly to funnel investors into the funds of big investment firms.  Why does your investing for retirement need to be tied to your employer?

Retirement is suppose to be safe.  They don't want idiots buying the latest penny stock with their future.  As a fiduciary, they are held responsible if you do stupid things.  Therefore, they don't allow you to invest in anything to exotic.  In fact, they are risk adverse, so they pick plans that probably aren't in your best interest risk adjusted.  I personnally don't want people to have complete control over their 401k plan, as most people are not educated in finance and will blow their future trying to score a huge windfall and we will have to support them when it does not work.

[pbkmaine]

If you separate from service in or after the year you turn 55, you can take distributions from your 401(k) or 403(b) without penalty. And not just in substantially equal payments. Any way you like. Do not roll this money into an IRA until 59.5, though. For IRAs, it's 59.5.

[GreenGuava]

The other thing with "normal" retirement accounts is that they're great for money post-59.5, even if you don't use rule 72(t) or anything else.  My goal is to be sure I have enough in my tax advantaged accounts so that, with reasonable growth assumptions, I'll have enough in just those accounts for life post-60.  It also makes figuring out how much I need in taxable much easier:  I only have to account for the years until then.

[matchewed]

The other thing with "normal" retirement accounts is that they're great for money post-59.5, even if you don't use rule 72(t) or anything else.  My goal is to be sure I have enough in my tax advantaged accounts so that, with reasonable growth assumptions, I'll have enough in just those accounts for life post-60.  It also makes figuring out how much I need in taxable much easier:  I only have to account for the years until then.

But it is mathematically suboptimal to go that route. Assuming FIRE is your goal and you want that goal faster, using and maxing tax deferred accounts is going to be a superior method all things being equal such as investments and returns.

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

It's cool if that's not your plan and you're comfortable with that. I can understand the risk of the unknown, as in "What if they change the rules?" or "What if they close the Roth pipeline loophole?" But those risks of the unknown don't go away with other strategies... they just change a bit. So why not shoot for a mathematically optimal situation?

[BlueMR2]

I kept waffling on this for awhile.  I've always taken the max match.  However, when Obama came into power I dropped from maxing my 401k to just taking the match as there was a lot of talk about his plans to do a money grab from 401k to prop up the new programs he was planning on.  I did pretty well out on my own during that time, but when we got to Obama term 2 and the supposed 401k money grab doesn't look like it stands a chance, I decided to jump back into 401k whole hog again.

As far as how it impacts my plans/outlook.  Well, it actually makes me feel *better* about early retirement to load up the 401k...  Even if there are some hard times between now and "official" retirement age, I can look forward to being in great shape.  Worst case, I just scrape by for the next 2 decades, and then I'm golden (assuming nothing statistically improbable happens of course, nothing's a guarantee ever!).  :-)

[tomsang]

I kept waffling on this for awhile.  I've always taken the max match.  However, when Obama came into power I dropped from maxing my 401k to just taking the match as there was a lot of talk about his plans to do a money grab from 401k to prop up the new programs he was planning on.  I did pretty well out on my own during that time, but when we got to Obama term 2 and the supposed 401k money grab doesn't look like it stands a chance, I decided to jump back into 401k whole hog again.

As far as how it impacts my plans/outlook.  Well, it actually makes me feel *better* about early retirement to load up the 401k...  Even if there are some hard times between now and "official" retirement age, I can look forward to being in great shape.  Worst case, I just scrape by for the next 2 decades, and then I'm golden (assuming nothing statistically improbable happens of course, nothing's a guarantee ever!).  :-)

As MMM says, cut the cable. Seriously stop watching FOX. If the fear that they are spewing is causing you to cut your 401k, it is not healthy for your financial well being. Hopefully you did not divert capital into guns and gold.

[FlorenceMcGillicutty]

I kept waffling on this for awhile.  I've always taken the max match.  However, when Obama came into power I dropped from maxing my 401k to just taking the match as there was a lot of talk about his plans to do a money grab from 401k to prop up the new programs he was planning on.  I did pretty well out on my own during that time, but when we got to Obama term 2 and the supposed 401k money grab doesn't look like it stands a chance, I decided to jump back into 401k whole hog again.

Huh? I never saw that Obama wanted to mess with the 401k. Democrats, Republicans, and Obama all support it as a way to continue securing retirement. The issue has been whether or not it's regressive (which it is), and since pensions are pretty much a thing of the past, they need to do something for low-wage earners.

I did the calculations and plan to max out my 401k for 5 more years. After that, I'll just do the max for the match. I could never leave free money on the table!

[GreenGuava]

It's cool if that's not your plan and you're comfortable with that. I can understand the risk of the unknown, as in "What if they change the rules?" or "What if they close the Roth pipeline loophole?" But those risks of the unknown don't go away with other strategies... they just change a bit. So why not shoot for a mathematically optimal situation?

Sorry if it wasn't clear:  I do max tax-advantaged accounts first.  But when I find myself with enough to retire pre-60, I won't do it unless the state of my finances is such that my tax-advantaged accounts alone would be sufficient after 60.

I'm not worried about them changing the rules.  Fact of the matter is, I don't think that would happen, and if it does, it won't be to a large degree.

[matchewed]

It's cool if that's not your plan and you're comfortable with that. I can understand the risk of the unknown, as in "What if they change the rules?" or "What if they close the Roth pipeline loophole?" But those risks of the unknown don't go away with other strategies... they just change a bit. So why not shoot for a mathematically optimal situation?

Sorry if it wasn't clear:  I do max tax-advantaged accounts first.  But when I find myself with enough to retire pre-60, I won't do it unless the state of my finances is such that my tax-advantaged accounts alone would be sufficient after 60.

I'm not worried about them changing the rules.  Fact of the matter is, I don't think that would happen, and if it does, it won't be to a large degree.

Ah gotcha. I'm mostly responding to a trend of threads which seem to be promoting a concept that investing solely outside of tax advantaged accounts is more effective due to mental boogie men. I personally invest in both tax advantage accounts and standard taxable.

[Blindsquirrel]

As MMM says, cut the cable. Seriously stop watching FOX. If the fear that they are spewing is causing you to cut your 401k, it is not healthy for your financial well being. Hopefully you did not divert capital into guns and gold.

  I am all for unplugging but AR15 or AK47 type rifles are up about 175-250% in price year over year, as is .223 ammo and 7.62. It would have been world beating investment return. Sturm, Ruger Co-   RGR has been a great stock for me the last 3 yrs.

http://investing.money.msn.com/investments/charts?symbol=RGR&config={%22zRange%22:%227%22}

[tomsang]

Fear and misinformation is not an investment policy. If you have guns, stock in gun companies, gold, ammo then logic would show that it is time to dump them. The fear mongering will be shown to be a bad joke as the economy continues to improve, unemployment decreases, stocks gain, and all the end of the world predictions prove false.

FOX and the GOP have created a number of bubbles based on the fear that they have created. Capitalize on emotions based on facts.

[MrsPete]

So you have enough to live comfortably in retirement, but you can't access it for roughly another decade? 

How about this as a different plan: 

Retire at 50.
Work part-time at a job that's completely different from your current job.
Live frugally. 
You don't really need to save for retirement since you have it in your 401K.
Quit the part-time job when you're old enough to begin deducting from the 401K without penalty.

[Mike]

Ah gotcha. I'm mostly responding to a trend of threads which seem to be promoting a concept that investing solely outside of tax advantaged accounts is more effective due to mental boogie men. I personally invest in both tax advantage accounts and standard taxable.

It adds a layer of complexity to the proceedings (converting/waiting to use the money), so I can see that dissuading at least some people from using this strategy.  However, after I followed the link and read the various articles about it, I've been convinced.  In the meantime, it's not as though I've lost much ground - my approach to this point has been pretty balanced between funding the 401(k), the Roth, and the taxable accounts.  Now it will simply switch from funding a Roth to funding a traditional IRA, and funding the 401(k) more heavily and the taxable accounts less (their balances are now high enough to fund five years of retirement on their own, which is the key threshold for the Roth pipeline approach anyway).

Oh, and thanks for that link - it was very informative.

[matchewed]

:)

Just remember to stay flexible as FIRE nears, revisit the rules and taxes governing your various account types. Given what you're saying about your various accounts you probably have that flexibility built in.

[Mike]

Well, I suppose the worst thing that could happen policy-wise is for the government to shut down Roth conversions right after I retire.  I really don't see that as being particularly likely, nor do I see it as making much sense, though.  A more likely tweaking of the system would be for the IRS to require a minimum conversion amount each time so that people converting their IRA's have to pay some tax on it.  If they go with that second approach, it would still be more efficient in all likelihood than paying my current 25% marginal rate and funding a Roth.

As far as the nightmare scenario of an ill-timed total shutdown is concerned, the next best option would be to simply go with some combination of working an extra year or so / 72(t) / moving to a cheaper place + renting/selling my existing place.

[ender]

The way I'm dealing with this potential problem as a 25 year old:

• Contributing to a 401k pretax (34% marginal tax rate)
• Contributing max to a Roth IRA

If I decide to aim for super early retirement, I probably will shift some of those 401k contributions towards a mortgage payoff/taxable investments in order to either lower my expenses in the "gap" or increase my income.

Also by filling a Roth IRA early (2012 and 2013 both will hit max) I have a fair bit of flexibility since even if the limit doesn't increase I'll have close to 100k principle in there by the time I am 45. I understand I probably should prioritize maxing pre-tax 401k before this but the flexibility is pretty helpful. The difference would let me max the 401k and still do some for the Roth IRA, but the flexibility is helpful.