How Much is TOO MUCH in your 401(k)?
For all of its shortcomings, the traditional retire-at-65 system does have a few cushy benefits in the US. You get low-cost health insurance coverage through Medicare, a reasonable pension through Social Security, and you also get to start taking penalty-free withdrawals from your 401(k) plan.
This system was originally designed to accommodate people who would work through their entire adult life, and retire only when they had lost all ability to be productive, presumably to die just a few years later. In fact, the life expectancy of US males only reached age 65 around 1950. (Females reached that longevity in the mid 1940s, and both sexes only a hundred years earlier had expected lifespans of only 40 years!)
Books targeted at today’s Late Retirees (which I define as over 60) speak quite excitedly about the new idea that people get to live for twenty or more years in retirement, and thus the financial planning is much more complicated than it was just a generation ago. So as you can imagine, those of us planning a 50+ year period of retirement need to game the system even more.
This is one of the things about which I get the most email questions. People are asking,
Should I put money into my 401(k) if I’ll be retiring much younger than the standard age? Won’t I be hit with penalties if I try to use the money before then?
Let’s review the basics:
- Through most jobs, you can contribute to a 401(k) plan – currently $16,500 per year and rising. You might even get a partial or full employer match, depending on how fancy you are.
- If your employer doesn’t offer this option, you can still contribute up to $5,000 on your own to an IRA account.
- If you are self-employed, (which I highly recommend!), you can contribute up to $44,000 per year using the SEP-IRA or solo 401k options, and there’s a nice description of their differences here.
- The government lets you make any of these contributions out of your pre-tax income, so you pay no income tax on that cash, or any of its investment gains over the years. This gives you a big savings boost, which is the whole reason 401(k)s and IRAs are useful.
- You’ll still have to pay income tax on this money when you eventually withdraw it, but the idea is that you’ll be in a lower tax bracket then.. because you will have quit your job and your only taxable income will be your 401(k) withdrawals.
- If you try to withdraw the money earlier than age 59.5, you’ll pay the income tax mentioned above, PLUS a 10% penalty on top of it.
Assuming we want to avoid the 10% penalty, we early retirees have a few options.
Strategy 1: Treat the 401(k) as your “Old Man/Old Woman Money”
The idea with this strategy is to throw enough money into the fund, such that it becomes enough to live on for a good 30 years, from age 60 through 90. As a really quick calculation, say that you can live on $30,000 per year in today’s dollars. And assume that you can safely withdraw about 5% per year from your fund from a combination of its investment returns/dividends and a bit of its principal. You would then need $600,000 of today’s dollars, scaled up for inflation to whatever year you reach age 60, to meet that goal.
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.
This is a simple strategy, and it’s the one I took myself. Mrs. Money Mustache and I both let the 401k contributions run on autopilot when we were working, then promptly ignored them after we quit, where they have since continued automatically generating dividends which are reinvested in more shares every quarter. Besides the 401k contributions, we raked up some additional savings that went towards investments that provide for our current living expenses. Technically, this is sort of double-saving for retirement, but I like to think of it as a nice safety margin that allows you to loosen some of your other assumptions (like using a 5% withdrawal rate above instead of the 4% rule that serves as a general rule for sizing your retirement nest egg.
Strategy 2: Use the Roth IRA Escape Hatch Loophole
Don’t go google searching that term, because I just made it up. But here’s a trick I learned only recently from a fellow blogger named No Debt MBA:
- 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.
Strategy 3: Use the Section 72(t) Early Retirement Grocery Money Loophole
The government provides yet another complicated-but-still-useful way to draw a little penalty-free income from your 401(k). You can set up a stream of payments to yourself, called “Substantially Equal Periodic Payments (SEPP)”. The only hitch is that once you start them, you cannot stop them until you reach 59.5 years of age. To determine how much you can get, the government prescribes something called a “reasonable interest rate”, which right now happens to be 1.43%.
The 1.43% number then gets mixed and mashed with some other complicated stuff about principal withdrawals vs. life expectancy. But the bottom line is, for each hundred grand you have in your 401k, your SEPP payment will be about $2900 per year, according to this popular calculator on the subject: http://www.dinkytown.net/java/Retire72T.html. That’s some nice grocery money, but not a full lifestyle amount for most of us.
On the positive side, because you’ll be drawing the money out at such a low rate, the odds are it will grow faster than you use it, leaving you a larger amount to tap more freely once you reach 59.5.
Overall, any of these strategies will work, but the issue remains the same for early retirees – because of contribution limits, your 401k will probably not be large enough to retire on until you’ve made at least 20 years of maximum contributions and seen some investment gains as well. So while I still advise maxing out any tax-deferred savings accounts like the 401k, you’ll also need to invest elsewhere simultaneously. My own strategy was in Vanguard index funds, a paid-off house, and some rental properties, but you will surely find other places depending on your own interests.
Since I’m still over 22 years from 401k eligibility myself, I must admit that I haven’t done a huge amount of research into even more advanced strategies involving tax-deferred accounts. Some of you are masters of this subject, so if you see any errors or omissions, let me know in the comments, and I’ll continually integrate them into the article, so over time we will have a rather kickass “401k for early retirement” article.
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Mr. Money Mustache is a family man living in the United States who retired from work, relatively wealthy, at about age 30. After several years of retirement, he noticed that his still-working peers were envious of his lifestyle. They were making more money than he ever had, yet they were somehow still broke. So he decided to write this blog to educate the world on how it is done.
This is an interesting topic. I’m personally not planning on retiring too early (my personal goal is 55). So in the meantime, including employer match, I’m saving around 19% of my gross income in my 401k (which is a Roth option) and maxing out a Roth IRA.
I’ve been considering lately to reduce the amount I’m personally setting aside since of the 19% being put into the 401k 10 is from me and 9 is from my employer. The idea would be to start long-term investing for home or an even earlier retirement.
But I do really think that for “super savers” this is a good question. Is ≈ 30% of your income being set aside for retirement too much at the age of 30? Should a larger percentage of that be diverted to non-retirement investing?
Do you think there’s a reasonable probability that tax rates will rise enough by the time I want to retire, that I’d actually have been better off just paying tax on the money up front? Given government debt problems, it seems that something has to change radically. I am of course, still contributing to my RRSPs personally. Just musing.
The top income tax brackets here in Canada are somewhere in the 40 – 45% range.
Come retirement, Mustachians will find themselves in the $30k income range, where taxes are much lower.
We’ll still have basic exemptions of (inflation adjusted) $10k or so, which will protect half to a third of your necessary withdrawals from your RRSP (twice that if you’re making sure that half your RRSPs are in a spouse’s name).
Unless the tax rate on the remaining income, in the lowest bracket, goes to 80% or so, we should all come out ahead.
Thanks Mr. Toque! I fully agree with your analysis.
Heather’s point is a great one for the traditional idea of a big-spending retiree, like the people who plan a retirement budget of $120,000 per year. In this case, their retirement income might be just as high as their working income. I do believe that the tax rates on higher income brackets are probably going to rise in the coming decades. And maybe somewhat on the middle and even lower income brackets too.
Another interesting point, however, is that you are both in Canada, which has less than half of the US level of government debt, both on a debt-to-GDP ratio and a debt-per-person basis.
Part of Canada’s success and the US failure has been caused by rising oil prices and the fact that Canada is a massive net oil exporter while the US is a net importer. If these things continue (which I also expect to happen), Canada’s government will continue to have lots of income and the US will continue to have a disadvantage in the oil-based revenue department.
Which means you lucky people will take less of a tax hit, because your social programs will be paid for by the polar bears and the ice caps instead of the taxpayers ;-)
You might want to touch on (or maybe you already have elsewhere) the fact that employee matching in a 401(k) is FREE MONEY! We always like that.
I work here in Longmont (at an unnamed Turkey plant) and the plan they offer isn’t great, but if you put in a minimum of 5% of your salary, they will contribute a maximum of 4%. So by putting in the 5% I will get a 9% total into my 401(k).
If I contribute 10%, I would have a total of 14%, and my 10% is pre-tax, so I effectively LOWER my taxable income by that much. This may not mean much to most people, but if that’s enough to drop you into a lower tax bracket, you get a double benefit! Or is it triple?
1, Lower effective income
2, Lower tax bracket
3, Free money (the company match)
In common urban vernacular: I lurvs me some free monies!
I also echo the sentiment of encouraging people to at least make contributions up to the match.
This is stache territory though, I think he assumes we will be doing this already. In fact he actively encourages us to be “maxing out any tax-deferred savings accounts like the 401k”. So I think his bases are covered there.
That contribution doesn’t drop you into a lower tax bracket because tax rates are marginal meaning the first 15,000 is at 0% the next 10,000 is at 15% and so on (don’t know the exact rates). It doesn’t matter what the tax rate on what you put into your 401k would have been because it’s 0% now. It could help you in the way of not phasing out of certain tax credits though if you keep your taxable income low enough. That’s about it.
Great article! But you’ve got the maximum withdrawal per year from the 72(t) wrong.
Use the java calculator in the source you linked to. With a 1.43% reasonable interest rate and $100k in the 401k and an age of 35, you can withdraw up to $2,873/yr (2.87%) if you choose the fixed amortization calculation method.
Here’s a screenshot I took of the calculator results: http://akratic.com/ERE/72t.png
Isn’t that what I said? “About $3000 per year”? .. or is my figure not precise enough for you? ;-)
Either way, I am glad you are trying out the calculator since that’s the goal here – to get people to poke around on the Internet and figure out the details of these potential strategies if they are interested.
My bad. Reading comprehension failure. I saw the 1.43% in your post and assumed that was the withdrawal rate, which is actually closer to ~3% right now, as you correctly pointed out.
Vanguard Index Funds are great. Vanguard ETFs may be even better. These are ETF versions of your favorite Vanguard mutual funds, only cheaper. They carry lower fees and if you have your brokerage at Vanguard, you can buy / sell them for $0 in commission. So if you’re into the dollar-cost averaging thing then you can now execute an extreme version of that strategy at Vanguard, buying just a couple of shares every month commission-free. This sounds like a GREAT way for a new investor to start building assets.
You might also think about rolling any 401k assets into a rollover IRA at Vanguard and investing that into Vanguard ETFs as well. You may be paying unreasonably high account fees in your 401k (these fees seem to be, shall we say, less than transparent), and for passive strategies a few basis points worth of fees every year for 30 years can add up to real money.
Yeah, I have recently switched to buying ETFs for all future purchases as well. Because Vanguard’s regular funds have an annoying habit of delaying your purchase to the end of the trading day, or even the end of the following day. They say they do this to discourage market-timers, but in today’s volatile stock market, I AM somewhat of a market timer. When there is a huge drop like the one on October 3rd, I wake up and make a big transfer out of any cash I have around and into stocks. During my earlier investing years from 1997-2008, drops like this and the subsequent recovery seemed much less common.
For automatic payroll deductions, you don’t care about this advantage. But even so, if the management expense ratio is even lower with ETFs, I don’t see any disadvantages.
This is a good topic especially for folks that are aggressively saving for retirement. The strategy is different depending on your goals, job, benefits, etc. I think Carl’s point about always taking the 401k match is a good one. Even if you pay the taxes and take the 10% withdrawal hit down the road you will still be in the black because you doubled (or nearly doubled) your money when you made the contribution.
Also, for those now planning to use money from an IRA before retirement age right now is a good time to convert some of your money to a Roth IRA. First, you can split the amount converted between two years so you aren’t hit quite so hard on the taxes. For instance, if you convert $50,000 you can pay taxes on $25,000 in 2011 and $25,000 in 2012. Remember that this amount is added to your taxable income so plan accordingly. Here is an article on that: http://articles.moneycentral.msn.com/RetirementandWills/InvestForRetirement/best-time-to-convert-to-a-roth-ira.aspx.
To Heather’s point about paying the taxes upfront instead of when you withdraw it I really think it depends on how much the person is earning now versus how much they plan to earn/withdraw during retirement. If they are earning a high salary now and plan to withdraw small amounts during retirement it would probably be better to pay the taxes later. However, who knows what the tax situation will be in 20 or 30 years. Personally, I contribute to both tax deferred (401k) and taxable accounts (Roth IRA) which equals to a pay some now and pay some later situation.
Timely post!
I’m going through my numbers, trying to figure out if I’ve amassed enough in my Qualified accounts to stop contributing and focus on my young person retirement plan (though I might keep putting some into my 401k to get the employer match, like Carl mentioned above).
The current parameters on my spreadsheet are:
1. 7% return until 60, then dropping to 6%
2. 1.5-2% inflation of my current expenses (taking into account major changes in the future, eg home paid off in 15yr and no more daycare in ~4 yrs)
I’m not sure how to deal with the tax changes at this point, so they are included in my current expense figure. But they’d likely go down as we’d be bringing in much less income by then.
Am I missing anything else?
We are maxing out our 401ks as part of our FI plan. Part of the reason for that is taxes – we are making much more now than we plan to spend in retirement. But the other important part of that decision is the protections that retirement accounts have – no one can take that money even if we get sued and even if we go bankrupt. We don’t plan on getting sued or going bankrupt, but those things happen and it is an additional layer of security and piece of mind that I wouldn’t have if I put the money into taxable accounts.
Oops, I meant PEACE of mind, not piece of mind ;)
I think if you have maxed out your other savings and don’t qualify (income to high) for a tax deductible IRA than a Roth is a great place to save. Then once you quit working you can pull out the principal if you want.
Also worth noting another vehicle you can use to save is and HSA.
Good point made by Carl above. For every 1k I can shelter I can save $300 in taxes. That’s a pretty good chunk of savings.
Yes, an HSA is another neat place to sock money away. For a family, you can put up to $6250/year tax free AND social security AND medicare free. Unlike 401ks and IRAs where you have to pay social security/medicare upfront before putting money away, HSAs allow you to save tax free, SS free, medicare free.
The trick is to save enough (and no more) to cover for medical expenses you think you’ll have from retirement until age 59.5. You can take the money out before age 59.5 for medical expenses, and then at age 59.5, it becomes just like a 401k/ira.
Also, if in true mustachian fashion, you choose to get your healthcare across the border, I *believe* you can take money out of your HSA to pay for transportation to that country. Assuming it’s a legitimate medical expense, and it’s going to be at most what you’d reasonably pay in the US. Tax free vacation!
I’m not 100% sure, but I read the entire IRS rules on HSA last year, and the section on travel was vague enough to allow for travel to medical care– even in another country. Especially, if it’ll be cumulatively cheaper than having the procedure done locally.
WOW!! Those are all things I did not know about the Health Savings Account. I will have to incorporate your wisdom into the article too, Gypsy.
While we are on a roll here, are there any limitations on how we can invest our savings in the HSA? Can I buy Tobacco and Whiskey company stocks? (haha).
The investment variety in an HSA plan lie solely in the plan administrator’s options. For example, my plan does not allow any investment other than money market/CDs until I save at least $10,000. I suppose it’s a way to keep stupid people from investing all their HSA into volatile funds.
Then after 10,000, you can choose amongst a variety of index mutual funds or bond funds. Although you should probably keep at least your year’s deductible (or max out-of-pocket amount) in a highly liquid format (money market?).
It depends on the plan. Ideally you want a plan with lots of options.
It would be interesting to know if HSA plans can be transferred to another provider. I know that after I quit my job, I would like someone like Vanguard to administer it. BTW, I don’t know if Vanguard actually administers HSA’s.
OK, I have double checked. In my plan with Chase, you need at least $2000 before you are eligible to invest in anything non-cash, so it’s not too bad.
There are of course fees, so buyer beware. My Chase HSA charges $2.50/month fo INVESTMENT balances less than $10,000. There is no such fee for keeping the money in cash. You have to do the math and see if it’s cheaper to take the $2.50/month hit if you’re getting more than that in investment returns…until your balance grows to more than $10,000. In my case, I’m stuck with stupid fees, but after the 2nd year I should have $12,000 which should be enough to bypass the $2.50/month fee.
Assuming mine is a typical HSA, here are typical HSA investment options:
JPMorgan Prime Money Market Fund – Morgan Shares
Federated Government Ultrashort Duration Fund
American Century Diversified Bond Fund
Russell LIfePoints Conservative Strategy Fund
Russell LIfePoints Moderate Strategy Fund
Russell LIfePoints Growth Strategy Fund
JPMorgan Equity Index Fund
Royce Premier Fund – Investment Shares
BlackRock Small Cap Growth Equity Fund
BlackRock Capital Appreciation Fund
DWS Global Thematic Fund
Thornburg International Value Fund
Unfortunately, most employers do not have options as to who administers your HSA. As you can see, my options suck. Perhaps the equity index fund is the best option.
OK, so it sounds like it is partially controlled by your employer? When I look it up on Vanguard, I see that they do have HSA eligible accounts: https://personal.vanguard.com/us/whatweoffer/overview/healthsavings — but do I understand correctly that not just anyone in any job can open one independently?
Year late after the fact response… :) I’m just anyone in any job and I opened an HSA. I don’t have health coverage through work so I signed up for a HDHP on my own and set up an HSA.
I think of it as a retirement savings account that also happens to allow early withdrawals if I have medical needs.
Since it is not through my employer I only get to deduct for Federal/State Income Taxes, not FICA/Medicare as it is not really pretax, it’s an above the line 1040 deduction
What I really like is using http://www.hsaadministrators.info/ as mentioned on the Vanguard page as well. They allow investment in Vanguard funds and the fees have been reasonable (not that there is competition since I can’t find anywhere else that offers Vanguard fund investments for an HSA). I just put everything into the total market stock market index, get my tax deduction and stay healthy. Rinse and repeat yearly
That is my understanding, but I’m also new to HSA’s. This is our first year.
Your employer must provide a high-deductible plan. My employer provides either a high-deductible plan or a traditional plan. Most employers will sweeten the pot by throwing additional money your way to motivate you to switch to the cheaper high-deductible plan. If you are relatively healthy, this make sense: let’s say $20/month instead of $100/month, and the employer throws $800/year into your HSA.
So yeah, I *think* the HSA provider is completely controller by your employer. It would be interesting to find out if you can transfer it to Vanguard when you retire. I don’t see why not.
First, the maximum contribution limit for a solo-401k or SEP-IRA is now 49k, not 44k.
Second, another benefit to keeping as much as is reasonably possible in your 401k is lawsuit protection. 401k’s are protected from bankruptcy and lawsuits in all states. The money you roll over to a ROTH-IRA has no such protection. If you plan on doing part-time work in retirement in a field that has high liabilities, keeping the money in your traditional 401k may make sense. Yet another reason not to own a car– less chance of getting sued in an accident!
Third, for folks in high tax brackets (33% and 35%), it may make sense to put the maximum money in 401ks, regardless of if you have enough in it already. If you are in a 33% bracket during your work years, but will drop to the 10% bracket in retirement (*), even with a 10% early withdrawal penalty, you can withdraw money at 10% bracket + 10% = 20%. Twenty per cent is a lot better than 33%!
This all assumes no state income taxes (there are 7 states that have none). Adjust accordingly for your state.
I’d love to hear any other tricks. This is all I can think of off the top of my head. Anyone, feel free to correct me if I got the details wrong.
(*) It is very reasonable to drop to the lowest bracket (10%) in retirement for married couples, because the standard deduction/exemption for couples is about $19,000, and the top of the 10% bracket is $16,700 for a total of $35,700/year. And even junior mustachians can live on $35,700 a year!
Google “IRS Substantially equal periodic payment”
First link from the results.
3rd question in the FAQ for the 3 methods. 5th question in the FAQ for the tables. Question 7 for how the payments are determined under the 3 methods.
MMM: There is also the “required minimum distribution” method that does not require the use of an interest rate. It’s based solely on the account value and your age.
An example: If the 401k is worth 100k and you’re 35, your life expectancy is 61.4 years. Divide 100k balance by 61.4 = $1,629 required min distribution. Of course, you can take more. For the same 100k for someone who is 55, the life expectancy is 41.6, so the RMD = 100k / 41.6 = $2,404. You use both the current account balance and the current life expectancy each year for the calculation. For the frugal FI / ERE / MMM types, this one (the RMD method) might prove to be the better way to do things – calculate it out for all 3 methods and cherry pick the one that matches your needs / wants / goals the best.
Also – heck yeah to 401k – my current wage payer matches 75% for the first 8% – which, since I max out, is 6% of the gross pay. Wuhoo! “Free” money (although in reality, it’s simply part of the total compensation package).
I understand not touching the principal on post-tax investments during retirement (because we’re all so bad-ass that we’ll live to 100-plus), but is it the same for tax-deferred investments? I know in Canada, if you die with money still in your RRIF/RRSP, your estate gets taxed on that money all at once… almost certainly at a higher rate than when you contributed. This is why the Shark people (http://www.milliondollarjourney.com/book-review-why-swim-with-the-sharks.htm) recommend you plan to die broke… mustachians, of course, will also have another reliable income source carrying them through.
In this case, you’d want an annuity or something to winkle the money out of that account in a reasonable manner… or pick a year or two early into retirement where you earn very little elsewhere, and you pull out a crapload of the principal, just under the amount that pushes you into a higher tax bracket.
I like the idea of dying broke in principle – just because I’m not a big proponent of leaving a large estate to your children and denying them of the pleasure of having to make their own way in life. But on the other hand, there’s no shame in not having spent all your money either. Even if your estate gets taxed, that money is still (mostly) going to support your own society, so it’s just another form of giving your money away to help your fellow citizens.
I was gonna say, “Well then, why not just save outside the tax-deferred instrument in the first place, and pay taxes now?” But I think I get your point — this way we make sure we have enough loot to carry ourselves through, and then contribute to society when we don’t need the money any more (due to the whole “being dead” thing).
Right! .. and to complicate the picture with even more options, I ALSO like the idea of using one’s estate to go directly to the most effective causes, if you happen to be smarter than your own government. For example, about 20% my taxes in the US get wasted on things like unnecessary fighter jet contracts and Iraq. I like my taxes to be spent on education and environmental protection. So I can get a tax deduction for creating a foundation which only gives scholarships and grants to schools, and does something about pollution. Then I can accomplish more social good with the same amount of money. But I also want the government itself to get smarter, so I try to do my part by voting, paying taxes, and maybe even writing this blog, if it helps to influence the votes of other people ;-)
The issue I have with dying broke is that I don’t know how long i’m going to live. My grandmother planned that she would finish her biography, take care of one or two last things, and kick off. She finished her book, took care of that last one or two things, and proceeded to live for ten more years.
Where would I be if I did all my retirement planning based around burning through the last of my retirement by 90, then managed to live to be 108? In a bit of a pickle, that’s for sure.
I’d rather just have my principal lined up to go to the causes I believe in, and be ready in case they come up with a miracle longevity treatment while i’m in my old age.
I need to get more Mustachian badassity going on in my life, so I can contribute this 401k money to the early retirement fund. Sigh.
What are your thoughts on medical expenses (which increase as you age)?
I’m on the fence about this. In the long run it definitely makes sense for me to contribute the max to 401k while I’m working and in the 25% bracket. However, at the same time I’m trying to build assets for short term (<10 year) goals – eg buying a house. 16k in the 401k means 12k less for the house down payment each year, which means waiting a lot longer to buy.
If I were a paragon of badassity, I’d say you should be saving double your 401k!
As I’m not, I’ll just say that we’ve been saving for a few years… and in the meantime, we have someone else to fix things in the apartment we live in, so we can concentrate on saving in other areas. We’re looking at a house in another few years perhaps…
TLV, I actually had the same dilemma in 1999. I really wanted to buy my first house, and the prices were appreciating in my area so I felt like I wanted to lock in before they rose further. So I paused contributions to my 401K until I got the 20% downpayment raked together.
Looking back, it paid off, because I DID get the house relatively cheap, and later sold it after capturing lots of early-2000s appreciation. Plus, I avoided buying into the 1999-2000 dot-com market peak just before the crash.
In today’s environment, houses are again really cheap, and will probably start appreciating again after a few more years of the foreclosure hangover. And the stock market is relatively expensive right now as well, meaning you’re not getting a particular bargain with extra 401k investments at the moment.
Depending on your rent vs. price ratio, the house could actually be a good choice right now. Especially if you lean towards do-it-yourself maintenance instead of expensive outsourcing. Fixing up your own house is actually a second source income, if you eventually sell it and get the profits and repeat the process.
Thanks for the great ideas. So far, I’ve been maxing out my Roth and 401k, but I’ve been at a loss for where to put money for early retirement.
I just recently started maxing out my HSA, which I’m sure will be helpful. I also have a Roth 401k through work, since I’d rather pay the taxes now than during retirement. Of course, the risk is that the tax rate I’m paying now will be higher than during retirement, but then again, taxes will likely go up, too. With a Roth IRA rollover, I can still withdraw these contributions tax free.
I’d love to get started in rental properties, but the process is a litle intimidating to me. Maybe a few more of your articles will give me courage to jump in.
I’m happy to see someone else prefers to think about 401ks as “set it and forget it.”
I contribute 10% of my salary annually. This is enough to get my full employer match and then some, but not to max out my contributions. I then forget about the 401k except to calculate my net worth. I don’t include it in my income, savings rate, etc for monthly statistics.
Furthermore I don’t even want to think about it until I’m 60 years old. So I ignore it when examining theoretical dividend income, my “early retirement savings” and so forth. My expenses should be sustainable, indefinitely, without dipping into this fund.
For me, it is purely a ‘safety factor’ for old age – particularly since I don’t know what my health will be like at that point. 60 years old is so far away, and there are so many variables it’s difficult to calculate what I’ll require. But knowing there’s a few hundred thousand hidden away somewhere will make me feel more comfortable.
Your first line indicates you get free healthcare. But in the US, Medicare is not free healthcare. You pay a premium for the coverage, and it is basically a 80/20 plan. If you have any medical conditions this could really add up.
http://www.medicare.gov/cost/
check it out to see what the monthly premiums are. Not free.
Thanks, I appreciate the correction.
It looks like part A, which is the hospital insurance, is “free” because of the premiums you paid throughout your working career. Part B is $99.90 per month and it covers 80% of standard doctor bills and 100% of some other things. So it’s not as good as the Canadian healthcare system, and you are right that of course the costs for an extended medical condition could add up. It’s one of the reasons I advocate a nice safety margin in your retirement savings, and also a reason I recommend staying skinny and healthy through your whole life, to drastically cut down on the risk and cost of health problems later in life.
thank you. Your blog is widely read and everyone should carefully check for themselves what medicare covers, what you would owe if you were hospitalized or had a medical condition before they reach age 65. Even those who take meticulous care of themselves can have an accident or be diagnosed with cancer so it is imperative to make informed decisions.
I might be the only one here not contributing to their 401K. In the late 90s, I contributed to my 401K so I could get an employee match. I think I socked away about 15K in a few years. Unfortunately I also led a very high spending lifestyle which was greater than my income. When the shit hit the fan in 2002, I had to cash out my 401K for living expenses and got hit with the extra penalty fees.
Fast forward to today when I am just starting to work into a Mustachian life plan. My immediate goals are 1) payoff my 30 year mortgage 23 years early. This could be in ~4 years at my current prepayment rate 2) maintain a 1 year liquid cash fund in case I lose my job 3) prepare to quit working by selectively investing
I figure the mortgage payoff will provide me with a lot of freedom. I save 6% in interest which is an immediate return. I can sell the house easier if I decide to. And my basic fixed housing costs drop from $2300/month to about $700/month not including all the extras like maintenance and utilities.
While I hate keeping a wad of cash in a savings account that pays so low an interest rate that it angers me (.1% are you f***ing kidding me?), I’ve had some bad patches in my life and want the security of a year’s living expenses should I need it. I’ll forgo the income potential from the investments for a few more years to avoid the risk that comes with higher potential returns.
I think I might need to revisit the 401K though. I might be stupid for not contributing to get the employee match.
Steve – sounds like you’re on the right track. I’ve been mulling over paying my mortgage early, but right now I am about $30 underwater on my mine (house worth $170, I owe $196K) so I am loath to put more money in it if something happens that requires money – when the mortgage is closer to break even, then I’ll start throwing more ‘stash in it. :)
The second reason is that I am making far more money in the stock market than the 5% interest rate, so for right now, I am letting it ride.
As for having liquid cash, have you thought of something relatively safe like short-term CDs or something? YOu might earn a little more interest. Every dollar counts.
Not wanting to advertise, but ING Direct and some other online banks are offering around 1% interest on savings, I think it is slightly higher for checking with large balances. I think it is at .9% right now, if I recall correctly. It still isn’t the 6% it was a few years ago, but it is far better than .1%.
>> Let’s also assume your investments can grow at 5% after inflation.
That seems very optimistic. Investments that grow faster than GDP are considered “alpha”, and most people will be lucky to even track inflation, after taxes and fees. An ETF like SPY can grow faster than GDP on a temporary basis, due to P/E expansion (optimism). But given the headwinds of inverted demographics, debt saturation, and peak (conventional) oil, odds are we won’t see SPY continue to throw off huge amounts of free money.
So this means, if you have $300k in your 401k today, and your burn rate is $30k/year, then that 401k would last 10 years. If decades from now, the 401k “grows” to $1m, chances are, it will still only last 10 years. That is, your future burn rate will be $100k/year. This is not inconceivable if gasoline is $12/gallon, organic cheese is $30/pound, and property taxes are $15k/year.
I agree with your conservative opinion on stock appreciation – except that you’re forgetting DIVIDENDS – your share of earnings, which is the true underlying reason stocks are worth anything. The average “real” (meaning inflation-adjusted) return of the stock market over a long period is equal to real GDP growth (which could be estimated at 3%), plus the dividend yield at the time of purchase. Right now the yield is 2% – not great, but still not to be ignored, since it is 40% of your total expected return!
Alpha is the term given to the amount by which an investment outperforms the broader index of its asset type, or the overall stock market. Not the amount by which it outperforms GDP.
As for the headwinds you mentioned – there is certainly a case to be made for slower GDP growth over the coming decades – the standard bear argument. But there’s also an opposing case that the bullish investors like to make. This has been true throughout stock market history, and the battle between these two camps determines the P/E multiple.
I am not forgetting dividends. I don’t think a company ROI is any higher just because it pays dividends. Paying dividends just ensures that the company throws off real cash, which keeps management a bit more honest, compared to their pure capital gains competition.
I haven’t done the math, but I am not sure that companies have been able to grow ROI faster than inflation in the past in the aggregate. If it seems that way, its likely that this was fueled by both P/E expansion, debt growth, cheap energy, favorable demographics. and ever increasing division of labor. All of those things are not in our future.
On the energy front, in the old days, ROI for liquid fossil fuel was 100. Now its more like 10. And the trend is down. Big Oil gets excited about polar oil, ultra-deep oil, oil sands, shale oil, and corn oil. This implies the supply side is stuck. At the same time, everyone in Asia is getting excited about trading in their bicycle for a Mercedes with a V8 engine. They may have to settle for a Corolla with a 4-cyclinder, but the advancing demand curve is predicable.
In the world of macro-economics, what happens when a stuck supply curve meets a rapidly advancing demand curve?
The price goes up, leading to the equally important macroeconomic concept of “substitution”!
My own call for the next 100 years of economic growth is all of us spending our efforts harvesting the ridiculous amount of free solar energy that is showered on us every day. And converting from an extraction-based economy to a reuse-based one. But I don’t claim to be a better forecaster than anyone else (although I do know more about solar energy than most peak oil doomsayers), so I guess we’ll just have to wait it out and see.
Note that the comment I made on “stock returns = dividends plus GDP growth” is more or less a studied and accepted economic truth when you are talking about the stock index as a whole. It is because even without ANY economic growth, a chunk of capital has a certain return value when put into use. There is a nice explanation of this math in A Random Walk Down Wall Street.
I do agree that any stock appreciation beyond this value is due to P/E multiple expansion, and I also agree that this is why the stock market did better than GDP from 1950-2000 (http://www.multpl.com/) – and it’s also why our stock prices have gone down even as earnings have gone up since 2000.
Also, why am I having this conversation with someone who doesn’t even have a name!? Make up a cool username for yourself, dude, and add a nice Gravatar picture too. Mr. Money Mustache is a sociable place! We’re all drinking beer while we’re writing these comments!
I’ve read that the reason stocks return more than GDP growth is that only half of the US economy is represented by public companies. Apparently, the public companies average out the less profitable small businesses and households.
I contribute only enough to get the employer match (5%/4%). At 27 I have no idea what kind of tax bracket I will be in when I am in my 60s so it is hard to say if additional contributions will result in a lesser tax liability in the long run. What I do know is I can get immediate return on paying down student loans faster or pushing the money into rental properties. Given all of the management fees in my 401k I think I can get a better return investing the money myself (rental properties).
On the other hand…
Speaking of employer contributions: These do no count against the $16,500 limit but the total of all employee contributions, employer match, profit sharing cannot exceed $49,000 in 2011 (assuming your compensation is greater than this amount). Obviously this far exceeds typical matches on normal income levels. Has anyone investigated if it would be worthwhile for both the employee and employer to adjust the compensation package for a year or two to total boost 401k contributions?
For instance, on a $100,000 normal salary could one have their employer change their standard salary to $80,000 + $20,000 401k contribution?
I haven’t looked into this at all. What are the advantages / disadvantages?
I work for a non profit that doesn’t offer a 401K, the hubs and I are planning on maxing out each roth IRA for the year,but is there a way to set up a 401k by myself?
I am not an expert, but it is my understanding that setting up a solo 401k is only for the self employed. When I set one up, I had to do so by getting an employer social security number. So, unless you are getting paid as an independent contractor through a 1099, you have to depend on your employer.
Again, this is my understanding.
That is what I thought. Thanks!
MMM, your reference to life expectancy in the 19th century is accurate…but misleading, especially for the purposes of discussing retirement needs.
Yes, a new born white boy in 1850 in the USA had a life expectancy of just under 40 – but likely wasn’t thinking too much of retirement yet.
If he made it to 10 years of age alive, his life expectancy was 58+ – and he probably still hadn’t considered retirement.
If he lived to 40, then he could expect to be alive until his late sixties.
Of course back then, his retirement planning took place in the marital bed, and so his ‘retirement net worth statement’ read: 5 boys, 3 girls :-)
Hmm, must talk to my wife again about retirement…
See: http://www.infoplease.com/ipa/A0005140.html
ok, It looks to me that the calculation in Strategy 1 is way off mark. Since nobody has commented on this, it might also be that I’m not thinking about this clearly enough. Anyway, here it is:
Now, the deal is, if someone needs 30k a year to live comfortably and they have 600k in their account already, only then can we say that they have enough.
Having only $144000 right now sets them up to have $622,000 30 years later, which is obviously not enough.
So am I right with this calculation or am I missing something glaringly obvious?
Yes, it is supposed to be glaringly obvious, but maybe it still was not. You just need to research and understand the term “inflation adjusted” that I repeated throughout the article, and it will make sense.
MMM, I don’t understand how you arrived at the $600,000 figure in your example. Your parameters were:
1) Money needs to last 30 years
2) You withdraw 5% per year
3) You need $30,000 per year to live
Can you explain the math behind arriving at $600,000? It would seem that $600,000 would last you 20 years, not 30.
The $600k is generating RETURNS of 5% per year (after inflation) in that example. So it gives you that cashflow FOREVER, and you will never even need to touch the principal. This is what assets do for you – you don’t have to use up the asset itself, you just live off of its cashflow!
Okay I see. So the “money needs to last 30 years” parameter is pretty much meaningless in that example. If the assumption is that you will live only on the returns on your $600,000 (and we’ve conveniently set the return rate and the withdrawal rate both at 5%), then theoretically you can live an infinite number of years on that $600,000.
For a 90% confidence rate of not living with your grand-kids:
3.8% / 50 years (aka forever)
4.3% / 30 years
5.0% / 20 years
http://firecalc.com/
However, 90% is not 100% percent. All facets of your life should come close to 90% for all of this to work out. See the MMM article on Safety Margin.
I am currently investigating my options for sheltering money. My wife works for one of the local school districts and i was just reading about her options. They offer both a 401k and a 457. You should consider adding a small section on the advantages 457 plans. They are pretty sweet.
My strategy is to withdrawal everything out of my 401k, move to the Cayman Islands and just not file taxes ever again in the US. They’ll probably put a warrant out for me but they won’t catch me.
I retired at 47 in 2008. I keep my expenses low so I’m in the zero percent tax bracket. I take money out of my 401K each year to offset my medical expenses, which are fairly high. My health insurance is over $500/month because of pre-existing conditions and I have a high $2000 deductible. So I take out $7 – 10K each year from my 401K to cover those expenses. By filing form 5329 I can offset all but 7.5% off my medical costs from the withdrawl. Since I can’t be completly precise on the numbers I usually owe a small 10% early withdrawl penalty of less than $100. But that’s my total tax for the year. So I think it’s a good deal.
I want to start withdrawing some of the money from the 401K now, when I only have to pay 10% than when I’m forced to withdraw and I might be making SS putting me a higher tax bracket, plus who knows what gov’t might be charging by then. I’d rather pay 10% now, than 20 – 30% or more later.
excellent post! i ran my numbers and i am only 5 years away from stashing my old woman money. this is such a motivator. :)
I skimmed but I didn’t notice anyone else mention that retirement accounts don’t count towards the parents’ assets when you’re filling out a FAFSA so that’s another point in favor of stashing in a retirement account.
Just an additional note on 401k’s: If you sever from your job after you turn 55, or even during the year you turn 55, you are freed from the 10% penalty on distributions. This could be helpful for some who didn’t get as early a start as the triple M.
Mr. MM, keep up the great work. Internet anal guy here. Large life expectancy differences between the time social security was created and now is a myth! mostly held low by the infant mortality rate and high youth death rate. If you made it to 25 odds are you would live a very long life, not unlike today. And since the ones that die young rarely contribute substantially to social security, it didn’t make much of a difference in that regard!
http://krugman.blogs.nytimes.com/2013/03/05/the-life-expectancy-zombie/
Nothing positive to say, just enjoy being an all around internet know-it-all. Carry on
Thanks Austin – I’ve learned that from a few other sources since this post was written, too. Dang, it was a fun factoid while it lasted.
But at least the overall message remains valid: you can withdraw money from 401(k) at any age :-)
Great Blog MMM, you and I could be brothers the way we have approached our financial lives, we even made some of the same mistakes (ie, timing of RE purchases). I’ve got about 3 years on ya tho!
Anyway, with regards to 401ks, here’s the approach I plan on using.
I save a sh*tload of an income slightly over $100k/year (saving about 70%) which seems to be your target audience. If you are doing this, then saving that $17,500 in the 401k saves you paying taxes on this money at the 28% federal rate. Since you will almost surely be in a lower tax bracket (likely 15%) when you retire, this is the only way to go. Obviously the match is nice too, if you get one, but not necessary to make the math work.
Then, you should still have a sh*tload of money to put in after tax investments. First should be a ROTH IRA. Now, I’m single and with my income I can’t do a direct ROTH IRA, I need to do a backdoor Roth. Same thing, a couple extra steps. Google it or better yet go over to bogleheads for their explanation. As a side note, this is another good reason to have a solo 401k and not to have any deductible IRAs. You’ll see why when you do your homework on the backdoor ROTH.
After this, you should STILL have a crapload of money to invest (after all, we are liviing on like 25-30k/year, right?). This get’s invested in taxable funds at Vanguard.
Now, I structure my investments such that Stocks and muni bonds are in taxable funds (and nothing else). This is due to tax treatment of these vehicles at my tax rate and it lets me keep a sh*tload more of my hard earned $$ instead of giving it to Uncle Sam. My Taxable bonds are all in the 401k(s) that I have. I personally use my backdoor ROTH for REIT fund investing, but you can put anything here that does (or will) benefit from tax free treatment.
NOW, after all that sh*t, the important part. If you are saving enough to have at least HALF of your stash (stache?) in after tax investments (and that should be easy) you can effectively draw from your 401k any time you want! How you ask? Just draw from your taxable funds as needed and if you need to sell some shares in taxable, you can re-balance in your 401ks and re-buy the same (or similar) funds without tax consequences. This really helps if you sell funds at a loss in your taxable accounts then re-buy similar (not the same or wash rules apply) in your 401k. Remember, you can write off some of your taxable losses against your income ($3000/year I think?) This lets you further reduce your taxes.
Also, if you only want to spend only dividends, you can look at what your 401k has produced in dividends, and sell the same $$ amount in taxable to get at that income.
People usually view taxable, tax deferred, and tax free as separate accounts, this can cost you money. They should be used for what gives us the greatest advantage, ie, to keep the most of our ‘stash’ from the ‘gubmint’.
The key to making this work is to have lots and lots of money after tax (at least as much, hopefully alot more) than you have in tax-deferred, which should be the case for us ‘Mustachians’.
Anyway, hope this makes sense!
(sorry, that was more of an article than a post, lol!)