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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.

 

  • Scott March 1, 2015, 9:04 am

    So my previous employer wanted me to close out my portion of a defined benefit plan he had for me. Financially it was agood time to make the withdrawl despite the tax hit. I owed some back taxes and we are getting debt free by doing it. Problem is MetLife cut the check to the business and didn’t take out the 20% taxes right off the bat. I know I’ll need to pay an additional 10% later but may be able to avoid that with other things. Anyway, my employer won’t release the check because of the first tax issue and MetLife refuses to take it back and pay the taxes. So my money has been in limbo for 12 weeks and I’m getting frustrated. Is there anyway I can pay the 20% tax myself? Is there a form I can show my previous employer that so he can release the check to me?

    Reply
  • des999 March 13, 2015, 7:06 pm

    here is my plan.

    currently 35 yo, balance of 135k in 401k, maxing out. also maxing out roth. I plan to use the sepp withdraw at age 46, which should calculate to 19k / year till 59.5, at which point (assuming 7%) will leave my balance at 900+k :)

    to help during the 13 years of only getting 19k I hope to be able to withdraw 11k / year of my roth contributions. With a paid for a house and no other debt, I feel good about living off of 30k/year.

    Also, this is 30k / year tax free!

    Reply
  • Mackenzie April 23, 2015, 9:56 am

    From what I understand, those old life expectancies are based on mass numbers of men dying at age 18 in wars. The military pretty much completely covers the life expectancy gap between men and women. If you look only at people who survived into their 30s, the life expectancy was only a few years lower than today.

    Reply
  • Ishabaka September 3, 2015, 1:43 pm

    In case no one has mentioned it – in the USA you can withdraw money from tax deferred pension plans – 401k and IRA – penalty free beginning at age 59 1/2, not age 65. You can begin collective Social Security at age 62, although, unless you really need the money or have a short life expectancy, it is better to wait until age 70. Medicare comes into effect at age 65 – and requires monthly premium payment. Best book I have found on Social Security is “Get What’s Yours” by Lawrence Kotlikoff.

    Reply
  • Gregory October 17, 2015, 4:59 am

    MMM,

    MMM,
    My wife and I have been following your advice for about two years. We are in our mid-30’s, maxing out our Roth IRAs in a low-fee Vanguard account, saving in a Vanguard taxable account with ETFs and index funds, contributing to our kid’s 529 plan, and only have about 6 months left on our mortgage. My wife is contributing up to her employer’s match for her 401k and I am contributing some (about $4,000 per year) in my non-annuity 403b . We would love to contribute more to each of the these retirement plans but the fees are ridiculous! Between the up-front load fees of 5.75%, and internal fees over 1%, I cringe knowing there are better options but our employers won’t even consider lower cost providers. We are both stuck with high fee, pre-tax options. Should we just contribute more to the 401k and 403b knowing the fees are eating into the returns or keep our levels the same and add more money to our taxable vanguard account?

    Reply
  • Josh March 31, 2016, 1:45 am

    MMM,

    First off, I found this blog about a month ago and absolutely love it. I have always been frugal and saved and never even realized that it was possible to retire early. I am 26 and have dreaded having to work (for someone other than myself) for another 30+ years! Seeing other people with this thought-process and talking about ways to do it is awesome.

    I know this is a very old post, but I recently found out about (and am still investigating) a tax loop-hole that allows you to contribute more to your Roth IRA. It is well-known that the 401(k) elective deferral limit is $18,000, but less known that the total contribution limit is $53,000. Basically, after putting in your $18,00 and hopefully an employer match of ~$5,000, you can still contribute up to the rest ($30,000) after-tax to your 401(k). This seems pointless, except that some accounts allow in-service withdrawals of rollovers and for this case, after-tax contributions. You can then roll over the $30,000 directly to your Roth IRA.

    Am I missing something, or does this sound much better than investing in a taxable account, since you would only be taxed on one end and could still take from your contributions at any time or age? I have seen it in several places online and need to look into it more before committing.

    Reply
  • Pedro April 26, 2016, 9:23 am

    Could you clarify the statement below:

    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.

    Please correct me if I am wrong, but I understand the rolling over to a Roth IRA does not create a tax event. Therefore you pay NO income taxes on that amount, unless you later withdraw from the Roth IRA account.

    Reply
  • KDubz May 4, 2016, 3:30 pm

    Hi Mr. MMM!
    I agree that $144,000 @ 5% over 30 years will net ~$622,000, but that is only if the interest is compounded annually. I think in most savings/investment situations, interest would be compounded more often that that, perhaps monthly? I found that $144,000 @ 5% compounded monthly over 30 years is actually even more- $643,000! This is even more encouraging~ I don’t need nearly as much in a 401(k) as many retirement calculators would lead you to believe. Thanks for the outstanding article!

    Reply
  • David June 1, 2016, 12:21 am

    I love the calculator. I am about to graduate college and expect to make about 50k starting out when I graduate. Saving in a tax deferred account would definitely help me to put away more money but still have enough income left to save for a down payment on a house. I was worried that I would have trouble accessing enough of the money though to retire early. I plan to retire at 45 and according to the SEPP calculator that should be about half of what I need. I think I should be able to save enough in taxable accounts as I get raises to make up the other half. I think I will even put another 5000 in the IRA and take advantage of those tax savings since when I’m retired I expect to be in a much lower tax bracket.

    Reply
  • MarredCheese June 30, 2016, 6:16 am

    I am very interested in “Strategy 2: Use the Roth IRA Escape Hatch Loophole,” but I cannot find any mention of it anywhere else (with regard to 401k’s rather than IRA’s, that is). Anyone know a source confirming it, or at least another website mentioning it? Has anyone actually pulled it off?

    Reply
  • Nick July 28, 2016, 8:28 pm

    Awesome comments guys and gals! Can I ask for some advice?

    My wife and I are setting up our retirement accounts, and are wondering if there is any benefit of setting up a Roth IRA for one of us and a traditional IRA for the other? The idea is that when we would withdrawl in the future we could decide which makes more sense to draw from in a given year.

    We are just growing our mustaches, thankfully mine is coming in quite a bit thicker than hers..:)

    Aloha

    Reply
  • kindoflost August 11, 2016, 8:31 pm

    I’ve been waiting for this post (I am still 5 years behind). But it looks like the only advantage of the 72t over the Roth conversion is that you get the money right away. From what I read at 72t.net it is complicated and risky. The Roth conversion is more flexible (you can essentially decide what bracket you will be). MMM lead me to ERE and ERE to Go Curry Cracker who seems to be an expert at the Roth ladder and all kinds of tax matters.

    Reply
  • Ruth September 4, 2016, 8:51 pm

    Mad Fientist has some GREAT articles on his website about how to use HSAs to the max. Also lots of other great hacks like Roth Conversion ladder.

    Reply
  • hashbrowns March 25, 2017, 5:30 pm

    Reply
  • Brian G August 21, 2017, 9:47 am

    This article talks a lot about how taking the penalty hit can still be a valid strategy. In that case never stop contributing
    http://www.madfientist.com/how-to-access-retirement-funds-early/

    Reply
    • Jwheeland October 5, 2017, 12:45 pm

      Thanks, Brian G.

      I just read this post via the MMM “Random” button and I was like! Shit. Madfientist has got this covered. A case of the master becoming the student, I’d say!

      Reply
  • Reuven Kishon October 2, 2018, 4:19 pm

    Hey MMM,

    I wonder if you read responses to your old posts? Love your site, been living what I thought was a frugal life until I saw what you do. Got some work to do but it’s totally doable.

    What I’m wondering is what inflation rate you use for your expenses? I go with either 4-5% given that I think we are in for some higher inflation years due to our debt issues.

    I’m also wondering if you factor in the fact that from now till you die your expenses will inflate at the inflation rate each and every year. That’s at least my assumption. This sort of persistent inflation can turn a 30K cost of living style into something much more dramatic the longer you live.

    Taking the above into consideration, if you have stashed away whatever sum you feel will get you returns to pay for your 30k cost of living, that return will no longer suffice the longer you live, as your 30k cost of living will be significantly higher as time goes on.

    If I’m not missing anything, then I am wondering how you account for this?

    Reply

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