I was talking to Miss Mazuma a couple of weeks ago at Camp FI about 401(k)s. At one point, she mentioned this post from MMM. In the post, MMM states that you can have too much in your 401(k):
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
Yippee!
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.
You?
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!
Subscribing will improve your life in incredible ways*.
*Only if your life is pretty bad to begin with.
Mr. Tako says
Interesting plan. If you store too much in the 401k, RMD’s will hit you and force you into a higher tax bracket too. I have relatives going through this right now and they’re spitting mad about it.
I think there might be better options however…
For example: Our assets are split about 60/40 in taxable and tax free (until withdrawal) accounts. For now, we have enough in the taxable accounts to live until we’re well into our 70’s.
At that point we can draw down our 401k’s… this is of course assuming we don’t start a roth IRA ladder, which is technically more tax efficient but requires more patience to get the money.
Either way we won’t pay penalties. Seems like it’s worth the extra effort.
Mr. Tako recently posted…Going Completely To Cash
Dividend Growth Investor says
We are in a similar boat to the Takos, though we are perhaps 60:40 tax-deferred/taxable. I have to weigh the impact of pre-tax 401 (K) plans on taxability of social security income and medical benefits. Plus, I do not want to be the person paying through the nose for RMDs if ( when) my investments are uber successful 30 – 40 years from now.
In fact, I see the point where it may be worth it to just use taxable accounts for investments, since paying RMD from a $200 Million 401K or IRA in 30- 40 years will likely push us into the highest of brackets.
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Mr. 1500 Days says
$200,000,000? Whoah, you dream big DGI!
Cubert says
Good stuff! I’m glad people like YOU do all of the mental heavy lifting for us lazy readers out there. Thank you!
I’m quite familiar with that golden oldie MMM post from years back. A similar post he did on a case study of a family similar to ours led me to ratchet back my 401K contributions to just the company match.
It’s clear to me know (from your post) how much tax avoidance I can credit to my 401k contributions. Hopefully we’ll avoid tax hits galore in our 60s by moving to low-tax, high times Colorado.
Accidental FIRE says
This is why I have a significant portion of my net worth in taxable accounts. I still max out my tax-free stuff every year including back-door Roth, but I save tons extra and hopefully I won’t have to worry about this.
But your math experiment looks pretty solid to me. I never thought of it that way. You’ve already benefited from the 401k way more than the penalty itself, so though it’s not ideal, it’s not nearly as bad as it seems on the surface.
Great post!
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Mike @ Balanced Dividends says
Related to Accidental Fire’s comments above, we’re focusing in 2018 and beyond to build up taxable accounts. About 97% of our net worth is currently in retirement accounts. So there is very little between now and retirement that we could access penalty free.
Overall, your details seem accurate. On your other questions, I would not access our retirement accounts prior to retirement age. The only exception would maybe be Roth Contributions, which can be accessed for certain reasons. But even then I’m tempted to not touch it.
Thanks for the post. – Mike
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Jay says
Depends on how you view 401(k) money. I view it as “my old age” money, meaning my plan is not to touch it until we’re required to take a distribution – sort of a forced annuity managed and controlled by me. Unfortunately, I realized too late that the RMD will put us in the same 33% tax bracket we’re in today. Once realized this, I immediately reduced the 401(k) contribution to the company match – but even without any future contributions, we’ve already done the damage. So, of the hundred plus grand we save/invest each year, only 10% of that is put into tax deferred accounts.
Mr. 1500 Days says
Whoah, that is a hefty RMD hit. On the other hand, this is a good problem to have.
Jason@WinningPersonalFinance says
It may not be perfect for everybody 100% of the time but it’s very hard to pass on the tax benefits of a traditional 401(k). As you pointed out, you may need to pay a 10% penalty to get the money out but if you are in a significantly lower marginal tax bracket, that’s still a win. Best case is you do a Roth conversion, wait 5 years and don’t pay any penalty. Don’t you love complicated IRS rules?
Mr. 1500 Days says
Ha ha, they are complicated, but it’s nice to know these options are there!
Rounding the Bend says
Leaving aside strategies for penalty-free withdrawals from 401(k)s, here’s my take: Once the tax-advantaged accounts are “full enough,” speed up savings into regular taxable accounts and kill off any remaining debt such as a mortgage. It’s also possible to move costs from the future to the present by repairing everything in your house that might need repairing and making other large purchases earlier.
Then when you reach FI and stop (or slow down) working, your expenses will be lower, so withdrawals can be lower, and taxes will be as low as possible.
Mr. 1500 Days says
Interesting thoughts! While there isn’t a right or wrong answer, I’m keeping my mortgage because I think rates will go up. We may even do a cash-out refi to take advantage of sub 4% rates.
I like what you said about doing expensive stuff while you’re still working. That’s pretty much what we did with our home remodel.
Rounding the Bend says
I still push for mortgage reduction. Financially, the mortgage interest rate is lower than average returns from an S&P 500 index funds, so the debt looks good. But you still need to make the standard mortgage payment every month or you lose your home. Job loss and market corrections tend to come together — limiting choices at the crunch time. When you pay down the mortgage instead of investing, you lose a little return, but you remove a lot of risk from your future. I closed out the mortgage last year and the newfound freedom is much more powerful than I expected.
Mr. 1500 Days says
This is a topic I think a lot about. A paid off mortgage would give me a sense of peace, but I also want to keep the powder keg available to buy another property. I’m reasonably confident that I can make more than 3.25% over the next 10 years. I also wouldn’t be surprised if my internet bank account is paying more than 3.25% within 10 years (currently 1.25%).
But, personal finance is personal. To each his own. As long as we’re making these decisions mindfully, I won’t argue. And when you get to a certain point, it just doesn’t matter much.
Danny the Pizza Guy says
Very interesting questions, and I’ve seen others make the argument to just take the 10% penalty, since it’s really no big deal at the end of the day. When I first found the FIRE community, I was lucky enough to stumble onto Mad Fientist’s Roth Conversion Ladder strategy which was a complete game changer for me, and which I think was after the MMM article you linked above (?). I’ve gone with this strategy of still putting into my 401k and having a taxable account outside of it as a bridge. Actually, my VERY lofty goal this year is to get our taxable account to $100k before we meet again (I’ll probably be very close, but likely unsuccessful). Anyway, I guess the simple answer to your question is, yes, I’ll definitely be accessing my 401k early, but in a slightly different way than you’re suggesting 🙂
Mr. 1500 Days says
Oooh, a $100,000 goal before the next pizza party! I like it!
I love the Roth conversion strategy. I go back and forth every day about whether to do it or not. For now, we have enough in post-tax accounts, so we’re holding off. Maybe someday.
Danny the Pizza Guy says
Yeah, I’m trying Haha! After today I’ll be at $80k (bonus is coming in today…hooray!). But that will be the last big hit I’ll get for a long time.
In your case, I agree. With Mrs. 1500’s income, investment income and the blog income, there seems like very little need for you all to do the Roth conversion strategy at this point in time.
Dave @ Married with Money says
I think at some point we’ll scale back our 401(k) contributions and kick up taxable. But honestly what I’d REALLY like to do is get to a point that we can max out our 401(k)’s and save adequately in a taxable account as well. I’m using the desire to not touch my 401(k) money until I’m an old man to help drive some income growth in my young years now.
Hopefully I don’t have to decide. 🙂
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Joe says
I think the main problem with the example is taking out $20,000 per year to fund your Taco Bell lifestyle. It sounds like this dude is living on around $40k/year before losing his job. It’s going to be tough to cut back 50%.
We have over a million dollars in our 401k and we still have 15 years until we’re 59. That’s probably a bit too much. I plan to go with the Roth conversion at some point.
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Mr. 1500 Days says
Yeah, there are a lot of moving parts to the equation. What I really wanted to show is that it’s not a black and white situation.
In my example, the guy could have taken out a bit more before breaking even.
Done by Forty says
I read a post talking about a similar strategy (maybe from the Mad Fientist) showing that just taking the 10% penalty is almost identical in results to doing a complicated 5 year Roth conversion ladder. I was shocked to see how well that approach performed.
Only perhaps 20% of our nest egg is likely to be in 401k/Traditional IRAs, so we have some options of the best way to use those funds. I guess that’s the silver lining from finding out about the benefits of tax deferral so late in the game!
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James says
If you’re able to find that post I’d love to read it! I looked back through Mad Fientist but couldn’t find that one.
Anything to make my life less complicated would be greatly appreciated and knowing the 10% penalty comes out roughly the same would remove a lot of hassle.
James says
I think I found it under the Pay the Penalty section here: https://www.madfientist.com/how-to-access-retirement-funds-early/
Mr. 1500 Days says
Yep, that’s it! Make sure that you listen to the Joshua Sheets podcast too that MF mentions.
Gwen @ Fiery Millennials says
This is one of those places where my partner and I are very compatible. He focused more on buying property, paying it down, and paying off debt; whereas I focused more on maxing everything out. I have almost $130k in my 401k right now, which will be our “tomorrow money”. I’m 27.5 years old, so that account will grow to $619k by 59.5. That’s a lot of money to get us through old age! This year for the few months I have access to my 401k I’ve reduced my contributions to the match. I’m considering rolling it over into a self directed 401k and using a bit of it to invest in some property now, but it makes me nervous to dip into that tomorrow money.
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snowcanyon says
To each her own, but I have to say that one of my biggest regrets looking back from the advanced age of 45 is not having maxed out my 401k every year in my twenties/early thirties. As your earnings grow over time, it’s easy to save a ton in taxable, but as an employee you are restricted to the same small 401k space until you hit fifty and it really, really helps to have maxed it out. I will have $1.5 million at 60 in non-inflation adjusted dollars in my 401k, and it just seem less and less. 619k seems tiny.
My guess is you will be a successful entrepreneur and these issues won’t affect you, but from my advanced and wizened age not maxing out the 401k twenty years ago is my biggest regret. YMMV, of course. But why NOT do it?
Brian @ The Graying Saver says
I guess this is one “advantage” of getting a later start on our journey to FI. We’ll only need to bridge about a 5-year gap between our FI-ish date and when I turn 59.5.
Thank you for the chihuahua in jacket picture. Inspiring.
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freddy smidlap says
i am lucky that big brother company (my employer) has the option for 401k and roth 401k’s. until last year i was in the traditional pre-tax one only but mid-year i split it more evenly, just in case i wanted to access that money earlier. in my humble opiinion, roth money is the gold standard of money and the more you can afford to get characterized that way the better. i think many of the people of this community are going to have a lot more dough in their golden years than they thought and tax free withdrawal on those big assed gains sounds sweet to me. sure is a first world problem worrying about being in a high tax bracket at age 70.
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Mrs. LSF says
I agree Freddy. I also have my contributions split between roth and traditional, for that same reason. Since we can’t predict life or the economy, its hard to know how much you’ll have in your retirement accounts later in life. Investing in both roth and traditional 401k’s seems like a good way to level off your tax burden later.
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Adam says
It’s all going pre-tax. Every penny. My wife and I put some into Roth IRAs a year or two ago after a small inheritance windfall, but from a tax perspective it makes more sense for us to max our 401(k) plans. We’ll hit our goals faster and more efficiently.
Our married-filing-jointly MAGI slips under the limit for full deduction of IRA contributions, so that’s where we’ll dump anything we have left over (just waiting on her W-2 to show up so I can calculate 2017’s ideal IRA contribution).
Come thirteen years from now when we pull that FIRE trigger, our needs will be low enough and our accounts likely large enough that 72t withdrawals shouldn’t be too big a deal. She or I might still work part-time (and/or in less stressful jobs) just to keep health insurance, and that may be more than enough to cover spending even without setting up withdrawals. Worst-case, we sell the house; that would provide most of a decade of living expenses for us to set up shop in Spain, or Ecuador, or someplace warm and friendly and way more chill than inside the DC Beltway.
Mr. 1500 Days says
Your thoughts are really similar to mine, right down to the “get the heck out of America” backup plan. Maybe we can buy a duplex near the beach in Ecuador? 🙂
Adam says
I love this plan! I’m excited to be a part of it! 😉
Mr. 1500 Days says
Yippee!
Sharing a property somewhere in the world with the right person/ group of people is something that I’d totally consider. It could be something in Ecuador, a house near a lake in the Midwest or maybe a cabin in the mountains.
I’d build it with efficiency in mind and rent it out when we’re not there.
Ideas? I’m all ears over here!
Adam says
My wife and I are looking out to 2050 for actually making these dreams happen rather than just saving up toward them, but we figure on travelling an awful lot… so proximity to either an international airport or public transit to get there is a big deal. We’ve also discovered we’re huge fans of an urban setting. We’ve spent time in places like Cape Cod and small-town Wyoming; the peace is nice for a day or two, but we enjoy massive walkability and vibrance.
Ecuador is still on the table. We just need to pay it a visit first!
Adam says
ugh, 2030, not 2050. 2050 is what we’re trying to AVOID.
Mr. 1500 Days says
2030 is a lot better than 2050!
“We’ve also discovered we’re huge fans of an urban setting.”
Yes! We spent time in Edinburgh and NYC last year. One of the things I enjoyed most was never driving. It was so pleasant to have stores, parks and other activities all within walking distance. It seems to me that you may need a town of about 100,000 to get the right mix.
snowcanyon says
How do you save enough in just pre-tax? Are you self-employed and able to do 54k each?
Divnomics says
Quite interesting to see all the thoughts from others. I have the luck (?) that we don’t have any of these 401k accounts, but one simple pension fund where I don’t have to add in anything myself. In the NL we do have to possibility to save additionally into an account with tax advantages, but I never saw any value in it. Mostly because of my young age (30) and I know I will need that money sooner than I can touch it (around 55). It’s a whole different world there up in The States.
snowcanyon says
NL? Netherlands? Can you keep your pension if you switch jobs?
JoeHx says
I don’t think I’ll touch my 401k until after the prescribed time. If I need to hit my retirement accounts before that, I’ll go after my Roth IRA first.
chris says
Maybe I just don’t see it the same as some others, but my plan is to max pre tax 401k and based on the new tax law pay my house off instead of investing post tax.. In your example your single person was taking the 12,000 credit which would mean the person isn’t itemizing. I normally itemize but won’t in 2018. It’s close but since I am married looks like standard deduction will be slightly more and the gap will widen each year as I have left interest. If I don’t itemize than my 4% loan is a real 4% and a more guaranteed return than even a nice bond fund.
So if I pay off the house in 5-7 years I could always tap some equity before I retire if I need a bridge. Seems better than income tax + 10%. In all likely hood I get bored easily and will always work on something, so if expenses are low and I work part time, a $10,000 home equity loan for a few years won’t hurt me and I would only take if I actually need it.
All that said I enjoy reading everyone’s comments on the topic.
Mrs. LSF says
Thanks for sharing my goal! This post is definitely a good reminder to always do the math.
Part of my motivation to balance where we’re investing is to help diversify our portfolio. Today we utilize both roth and traditional retirement investments, invest in taxable accounts, pay a smidge extra on our mortgage, and keep a healthy emergency fund around. Since we are still in our 20’s, we thankfully have a good amount of time left to adjust our strategy, for better or for worse. With FI at least 10+ years away, we’re still not sure what our life is going to look like, and what our expenses will be down the road. We’re still deciding if we want to have a kid – which I know doesn’t have to break the bank, but undoubtedly is more expensive than not having a kid. There are also unfortunate unforeseen life events that come up, like developing a chronic illness or injury that raises your annual medical expenses. Or maybe tax laws will change. Or healthcare could change. I don’t want to be overly pessimistic, but the younger you are, the more time life has to knock you around and throw you curve balls. We view our taxable brokerage account as a “retirement account” – untouchable until we stop working. I feel like I can be most agile with our finances with our money smartly spread around.
Ideally, In a few years, we’ll be able to max out our 401k’s, IRAs, and have enough surplus income to really fund taxed accounts, and this whole question will become irrelevant.
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Jason says
I might actually take some of the 401k early, but I think it would be to pay off the mortgage or something. If I could use it to free up some other cash flow then I can then plow money into another account to make up for the 401k. And I prefer the Cravings box at Taco Bell. Only $5 and works well after lots of beer. Coming out…well that is a different story. :).
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Jamie V says
If I saved too much, perhaps I’d withdraw early, since RMD’s are a thing. I think my plan might be changing slightly. Before, I was thinking, I’d max out the pre-tax accounts, then save any extra leftover, if there is any, in my taxable account.. BUT I also don’t want to draw down the 401k before it’s time, because then what will I live on in my older years? And I simply do not make enough to save $24,000/year both in my pre-tax account while also saving the same amount in my taxable to live off of before 59.5 years.. So I am wondering if maybe I should contribute like crazy to my pre-tax until I have enough to grow on its own to what I need at age 60. When I get to that point, say in 5 years, then stop contributing so much to pre-tax and start putting the majority in my taxable. I’d still contribute pre-tax to stay low in taxes, but the rest..taxable account. I think this may be where I’m leaning. Not sure. I’m still paying off debt so I’ve got time to ponder.
Acastus says
For me, this is a no brainer. I plan to use the age 55 rule to spend my 401k early. That plus some taxable accounts act as a bridge to age 60. Spending from both accounts will let me choose a taxable income and spending level that are semi-independent of each other.
Ping says
The one thing I find odd about the idea of saving for retirement is that I will have all this money when I am older and not as vibrant or energetic to enjoy it. While of course it makes sense to have a nest egg, don’t you also want to enjoy your money while you can?
Mr. 1500 Days says
Yep, but I can’t think of anything I could buy that would lead to more happiness. I have all of the gadgets I need including 3 (!) expensive bicycles and even a classic sports car (Acura NSX). I don’t want a bigger home or any more cars. There is a lot of joy in simple living.
The one thing we do enjoy is travel, but we use credit card points to fund much of that.
So, I spend money when I think it will improve my happiness. There just isn’t much else that I want.
Ping says
Totally. I am a minimalist..I hate stuff and most of my money is spent on “experiential” things like travel or a nice meal.
snowcanyon says
I have to say I wish I had saved more in my 401k when I was younger!
I have maxed it out every year for the last eight years, and also have saved 100k or so a year in taxable, but nothing beats those tax-deferred, lawsuit-protected, bankruptcy-proof early savings. Biggest regret is not maxing it out every year. Super easy to get a huge taxable account as your income increases, but you can never get the time and tax savings of the 401k back because the space is so limited.
Remember that if you end up with a large taxable account, it will throw off huge taxable dividends every year well before you turn 70. Early savers should check out Millionaire Interview 26 for regrets on not maxing out a 401k early: https://esimoney.com/category/millionaires/page/2/.
Nikos Alepidis says
I think 59 years old is not the best age to start enjoying your life. I would like to spend the money more often while I’m young. I’m not saying 59 you are old but why to spend the money at 59 while you can do it at your 30-40?
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