Let’s say you are 30 now, and you’ve made the maximum contribution each year since graduating at age 21, and thus you have about $144,000 in the account. Let’s also assume your investments can grow at 5% after inflation. What will it be worth by the time you reach 60?
The answer is of course 144,000 x 1.05 to the power of 30 (years). This is about $622,000 inflation-adjusted dollars (i.e., in the year 2041, it will buy you just as much as $622k does today). Since this is more than the $600k we calculated above, it could be said that this person already has TOO MUCH in his 401k, and now he just needs some dough to get him between whenever he retires, and age 60.
Earlier in the post, MMM mentions the caveat of avoiding the 10% penalty for 401(k) withdrawals before 59.5. In some cases, I believe that MMM is wrong in focusing on avoiding the penalty. I’ll explain all of the juicy details, but first, we must address last week’s question when I asked what your financial goals were. Actually, before we even get to that, here is a gratuitous picture of a chihuahua wearing a jacket at a microbrewery:
Financial Goals for 2018
Here is what the readers had to say about financial goals for the new year:
Reader Dora is kicking ass (can I borrow some money, Dora? 🙂 ):
I’m maxed out on all retirement accounts (TSP, HSA, Roth IRA). My latest money goal is to diversify into long-term treasury bonds, commodities, and maybe corporate bonds. I have a good portion of my portfolio in stocks and it’s time to balance that with some less volatile investments.
Mrs. Live Simply Frugal wants to find balance, but maybe she doesn’t need to (Hint: Read the rest of my post below):
My biggest goal is to find a balance between investing in tax-advantaged accounted and our post-tax brokerage account. we’re hauling ass on our 401k’s today, but since we want to retire early we’ll need more post-tax investments to live off of before turning 59 1/2. I know there are workarounds to avoid paying early withdrawal penalties on your tax advantage accounts, but I want to avoid that as much as possible. It’s not as tax efficient as it could be, but I’m okay with that for now.
Congratulations Reader Dave! Come to Colorado and I’ll buy you multiple beers after you’re FIRE’d. Hell, I’ll do it before you’re FIRE’d. Any excuse, right?
Second off, my goal is to reach FI sometime in the second half of the year! After that, I’ll save up a cash pot of 1 yr living expenses and then peace out!
Reader Casey is another one worried about tax-deferred accounts. Again, the status of those accounts may not matter as much as he thinks (read on below):
Decide on an FI date (likely in about 5 years) and set action plans in place to ensure I reach that goal. Spouse wants to keep working, but I don’t! I think I currently have enough in tax-deferred accounts and just need to squirrel more away in taxable investments to get me through the five years before my Roth ladder money becomes available.
Finally, Reader Chuck’s comment puts everything in perspective:
Turning 41 this summer and have/had two goals this year. Consolidate and simplify investments (vanguard indexes) and pay off one of four rentals. I’m at 1.7m net worth, maxing out 401k and hsa, but now for the curve ball – my wife who I love very much is talking divorce.
Money is shit. Well, maybe not shit, but money doesn’t mean anything if you don’t have your health in order (bottom level of the pyramid) or human emotional needs (a step or two above the bottom level of that pyramid) together. If Mrs. 1500 came to me tomorrow and told me she was quitting our marriage, the big electronic pile of money that we have sitting in internet accounts would mean a whole lot less. It would probably also be gone in divorce court, but I digress…
I’m sorry that you have to go through this Chuck. Stay strong.
Reconsidering The 10% Early Withdrawal 401(k) Penalty
If you take money out of your 401(k) before age 59.5, you’re hit with a 10% penalty. So, if you withdraw $25,000, you pay $2,500. This is in addition to the taxes you’re hit with (ordinary income rate).
Even with the penalty, I believe that at least some early retirees will come out financially ahead by taking the 401(k) route. Note: There are strategies for accessing your 401(k) early and paying no penalties, but for the sake of this thought experiment, I’m going to assume the worst case scenario.
Here is a very simple example to illustrate my thinking:
- Contributions: Over the course of X years, you contribute $200,000 to your 401(k). Remember that these contributions are pre-tax.
- Income: You are single and make $70,000 per year
- Taxes: Income earned between $38,701 to $82,500 is taxed at 22%. There are a lot of moving parts to taxes including the standard deduction, but let’s assume that all of the money you contributed to the 401(k) would have been taxed at 22%.
Your 401(k) contributions reduce your taxable income in the highest bracket, so the money you’re saving would have been taxed at 22%. Your 401(k) contributions of $200,000 saved you $44,000 in taxes:
.22 * $200,000 = $44,000
But now, you’re 50 and times are tough. You quit your job a couple years ago, but you invested all of your post-tax savings in a cryptocurrency that went down in flames (1500Coin).
You need money to fund your Taco Bell Ultimate Cheesy Chalupa Supreme habit, so you take out $20,000 from your 401(k). Because you’re younger than 59.5, you pay a 10% penalty.
You’re also liable for taxes. However, since the standard deduction is $12,000, you’ll only pay taxes on $8,000 (10% tax rate), so you’ll pay $800 in taxes.
To summarize, you saved $4,400 when you initially put the $20,000 into the 401(k) and paid a $2,000 penalty plus $800 in taxes. You still came out $1,600 ahead.
**slightly less enthusiastic “Yippee!”**
This strategy works best if you make a lot of money at your job (high tax bracket), but plan on living in a lower tax bracket in retirement. This strategy is also a gamble since tax law will probably change. Taxes will probably need to go up to prevent the US from defaulting on its debt, but I suspect that lower tax brackets won’t be hit as hard if at all.
And even if you’re not in a high tax bracket, a 401(k) may still be a worthwhile option. If your employer matches part of your contributions, you’re flushing free money down the toilet if you’re not contributing enough to get the match.
What do you think?
Did I goof up anything?
Would you do it?
Do you have any other strategies for FIREy folks?
Do you love the 401(k) like I love the 401(k)?
Do you love the Taco Bell Ultimate Cheesy Chalupa Supreme like I love it?
Join the 10s who have signed up already!
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*Only if your life is pretty bad to begin with.