By Dr. James M. Dahle, WCI Founder
I've noticed a hesitancy to use retirement accounts among people aiming to reach financial independence and to retire early (FIRE) at a young age (like 30s-50s). There seems to be this idea floating around that you need a big old taxable account to live off of up until the time you hit 59 1/2. Some people aiming at FIRE actually purposely try to build a big taxable account at the expense of maxing out available retirement accounts. I think that is probably an error for most of them. Today, I'll explain why.
But first, let's look at why it probably doesn't matter anyway. If you want to retire really early, you generally have to save a large percentage of your income—like 50%+ of your net income. If you're doing that, chances are that you can both max out your retirement accounts and save a significant amount of money in a taxable account anyway.
You'll want to live off that taxable account first. Far better to let the compounding happen in an account that is protected from taxes. James Lange has done some great work demonstrating the value of spending taxable dollars first, and that's ignoring the estate planning and asset protection issues, which make retirement accounts look even better.
But if for some reason you won't build a taxable account large enough to last from retirement until you hit age 59 1/2, don't forego maxing out retirement accounts. Here are six reasons why.
6 Reasons Early Retirees Should Max Out Retirement Accounts
#1 You Can Avoid the Penalty
First, despite my debunking this myth years ago, there are still lots of otherwise smart people, including financial bloggers, who aren't aware that you can access retirement account money prior to age 59 1/2 penalty-free for lots of different reasons, including early retirement. That's right . . .
EARLY RETIREMENT IS AN EXCEPTION TO THE AGE 59 1/2 PENALTY.
I can't explain that any better. Is there a catch? Sure. You have to follow the SEPP rule—Substantially Equal Periodic Payments. That means you have to take money out every year until you turn 59 1/2 and for a minimum of five years. How much money? Oh, about what you should be taking out anyway if you actually plan to spend your nest egg in retirement. If you're 30, it's 3.3%. If you're 40, it's 3.7%. If you're 50, it's 4.3%. If you're 55, it's 4.7%. Those numbers look an awful lot like the 4% rule, don't they?
Not comfortable spending 4%+ in your 50s? OK, that's fine. You don't actually have to spend that money. You can take it out of the IRA, and . . . wait for it . . . reinvest it in a taxable account. Where it would have been anyway if you had never put it in the retirement account in the first place. Except that money enjoyed some tax-protected compounding in the meantime, and there probably was an arbitrage between your marginal tax rate at contribution and your marginal tax rate at withdrawal. And asset protection. And easier estate planning.
Need more money than 3%-5% a year? There are some other great exceptions to the rule that may allow you to take out even more penalty-free before age 59 1/2. These include medical expenses, disability, college for your kids, and even a house. Thanks to Secure Act 2.0, terminal illness and domestic abuse are two more reasons you can withdraw money before retirement without having to pay a 10% penalty.
Here's another cool trick—as long as you separate from your employer (i.e. retire), you can get to your 401(k) money at 55 without paying a penalty or SEPPing it. That's a good reason not to do an IRA conversion of those dollars, at least until age 59 1/2.
But even if you don't have one of those exceptions and need more than you can get via SEPP (also called 72(t)), you can always just pay the penalty. It's only 10%. Chances are you've gotten more than a 10% benefit given the years of tax-protected compounding and the arbitrage.
#2 Arbitrage
What do I mean by arbitrage? It's the difference between your marginal tax rate at the time you contributed the money into the retirement account (probably 22%-35% federal for most readers of this site) and your marginal tax rate at the time you pulled the money out in early retirement (likely 12%). That is a huge benefit, and it's one that you completely give up if you invest in taxable instead.
Just do the math. Say you've got $20,000. You can either invest it in a retirement account, or you can pay the taxes on it and invest what remains in taxable. Let's say your marginal tax rate is 44%.
Option A: Invest $20,000 at 8% for 15 years in a retirement account.
After 15 years, let's say you pay 15% at withdrawal. You're left with . . .
=FV(8%,15,0,-20000)*0.85 = $54,000
Option B: Invest $11,200 in taxable at 7.5% (don't forget taxes on the distributions).
After 15 years, let's say you pay 0% on the withdrawal. You're left with . . .
=FV(7.5%,15,0,-11200) = $33,000
You get 64% more money by using that tax-deferred account. Make no mistake: if you're given the choice between tax-deferred and tax-free and you're the FIRE type, take that tax-deferred account. Your peak earnings years are far fewer than those of your peers, so take advantage while you can.
#3 Asset Protection
Just a quick note here. In almost every state in the country, retirement accounts get protection from your creditors in bankruptcy. If you are successfully sued for $10 million, far more than the policy limits on either a malpractice policy or an umbrella policy, you still get to keep your retirement accounts. Generally, 401(k)s get a little better protection than IRAs. But the point is that protection has some value—especially for a doc in a risky specialty like OB/GYN or neurosurgery—even though getting sued above policy limits is an exceedingly rare event for all docs.
#4 Estate Planning
What am I talking about here? I'm talking about the ability for your heirs to stretch a retirement account or simply withdraw money at a lower rate than you could. Or even just the ease of using beneficiary designations to avoid probate. It's far easier to estate plan with retirement accounts than with a taxable account.
#5 Roth Conversions
Here's another great benefit of maxing out tax-deferred accounts for FIRE types. After you quit working, you can do little Roth conversions every year between retirement and when you start getting Social Security. That might be 15-30 years worth of Roth conversions for a very early retiree who waits until 70 for Social Security. Sure, you generally want to pay for those conversions using taxable money, but as I mentioned above, you're probably going to have a taxable account anyway because you're a super saver.
#6 Lower Taxes = More Spending Money
Finally, let's not forget the main point of retirement accounts. The main reason we use them is that your after-tax return is higher inside a retirement account than in a taxable account. It might only be a 0.5% tax drag a year (if you are smart about how you invest in a taxable account), but that 0.5% adds up over decades. Over three decades, the difference between an investment compounding at 8% vs. at 7.5% is about 15% more money. Over six decades with an investment with a 1.5% tax drag, it is 130% more money!
The bottom line? Max out your retirement accounts, ESPECIALLY if you want to retire early. There are precious few good reasons not to max out your retirement accounts. I can really only think of three:
- You have an investment available to you that has such a high return that it is worth passing up those tax benefits in order to use it (and you can't invest in it in a retirement account).
- You have a particularly terrible 401(k) or a risky 457. We're talking exceptions like 2%+ expense ratios (ERs) on the mutual funds and a bunch of account fees. We're talking about a 457 offered by an employer that is teetering on bankruptcy.
- You will have a dramatically higher marginal tax rate in retirement compared to right now. There are a lot of people that think this applies to them, but it really applies to very few people. There just aren't a lot of people in the lower tax brackets during their earnings years who will be taking out all their retirement money at the top marginal tax rates. Even if tax rates climb, most people will still see far lower tax rates on those dollars in retirement. And even if you are one of those super savers worried about this, there is still a workaround—do as much Roth as you can, including Roth conversions, throughout your career.
What do you think? Do you know anybody not maxing out retirement accounts because they have early retirement plans? Did I convince you that it's foolish? Why or why not? Comment below!
[This updated post was originally published in 2018.]
Great post, WCI! I really like that information on 72(t) IRS rules for pulling money prior to age 59.5 years old. I knew about the other reasons you can pull money early from retirement accounts, but not the SEPP rules.
I will say that to point number 3 at the bottom (being in a high tax bracket even in retirement), if you feel that is one of your bigger reasons not to “max out” retirement accounts…another option is to use an employee Roth contribution into retirement accounts to avoid this issue as well (particularly if your employer provides a significant pre-tax match/contribution). Roth contributions will limit the amount of RMD’s you’ll have to take from standard (pre-tax) contributions in retirement accounts. This is certainly better than investing via a taxable account as well. I do agree with you, though, that the number of people fitting this situation is a very small number.
Bear in mind Roth 401(k)s do have an RMD requirement, although Roth IRAs do not.
Can you move a Roth 401k to a Roth IRA after you leave your company? (In order to avoid the RMD requirement.)
YES. easily done.
Yes.
Many people forget, or never knew, about the SEPP rule option. Personally we have about half our investments in retirement accounts and half in taxable accounts. We always maxed retirement accounts and tried to match that taxable when possible. It worked out well in helping us achieve FIRE in our 40s.
I was not on the FIRE path from age 30-45, just putting in the max in tax deferred accounts and feeling like that was a big accomplishment. It never occurred to me to put away more than 10-15% of my income.
Since age 45, I took on a side gig and maxed out a SEP on this (for 2018, this will be a solo 401). This has allowed me to put away $50,000 to $70,000 the past few years. Talk about “catchup contributions”…
In comparison to some here, I’ve been spending like the federal government: Big house, nice cars, lots of vacations, inadequate college savings. I don’t regret the vacations, but the big house was a mistake.
Happy that I found your book, your blog, and your website/partner websites. I tell all young docs I meet to read the book, subscribe to the blog, and consider your financial course.
I am making up for poor decisions in my youth (and since) but it’s always good advice here.
I am in this situation now: trying to finish up early but invested no money outside of retirement accounts. I am solving it by downsizing and will work part time from 56 to 59.5. No big deal. If I get to drop to half time at age 56, it’s still a win for me. It’s hard to get burned out working 8-4 T/W/TH and having long weekends for three years.
My small pension for working at a hospital for 11 years, kicks in at age 60 (it’s worth $24,000 a year but is not inflation adjusted).
I’ll only need about $100,000 a year to live in my downsized life with no mortgage. I think I can make that easily with my half time plans. I no longer need a big house or to drive a new car. Luckily, I am in excellent health due to triathlons.
One thing I’ve learned here is that everyone is different in what they want and how they make it happen.
Thank you! Great post!
Great article, there are many paths to fire. The most common seems to be reducing expenses, and invest until you get at least 25x. Once you retire, keeping your expenses the same (very low) will qualify you for a ton of opportunities and benefits. You can tax gain harvest, roth conversions, qualify for health insurance subsidy, and perhaps even qualifying for FAFSA to help send children to college. Our society rewards low income, even if you have great wealth and a low income. Simply knowing the rules and using it as an advantage. I find it very interesting, and certainly if this is a path you are considering it would make the most sense to take advantage of tax deferred retirement plans now, and roth convert them in your retirement.
Interesting post today. My advice to all young docs is do it all. Save aggressively in your 30s and early forties. Max out all tax protected space (a no brainer really). Then put the excess into a taxable account. The power of compounding will allow you to retire early or cut back to part time when you want. This plan will allow you relax about money in your 40s because you know you will be ok. When to retire becomes on your terms. I followed this plan and worked with less stress and will be retiring at 61. Read my first blog post about my journey https://wp.me/p9CTec-H.
Dear Hatton1, Cool to see you jump in. Love the purple border- are you going to keep the color scheme?
I am still playing with the appearance
Excellent!
Keep up the good work!
thanks
put your first dollars of the year into your ret plans for addl compounding
Careful. If I contribute early, I miss out on the match. Sucks.
Many companies do a “true-up” in December so you don’t lose the match, but best to ask before maxing it out in January!
Yes, mine did a true-up the following February.
I did ask before front-loading, was falsely told the match would continue to be granted, and was quite miffed when that information turned out to be incorrect.
Fortunately, I did get the match eventually, but I had to wait about a year for it to hit my account, at least partially negating the usual benefit one might expect from maxing out the 401(k) early in the year.
Best,
-PoF
We are allowed to contribute up to 6% of our salary to a 401k, which the company will match. The rest has to go in a 403b (same fund options, I should add). The only way to front load is to put a larger amount in the 403b, leaving less to put in a 401k. It’s devious and crappy, and a way to avoid giving people the full match if they leave before the end of the year, no matter how many hours someone worked. Then you don’t even receive the match until the following March!
I got caught in this the first couple of years as I was misadvised. It’s terrible.
Of course, our 457 is terrible too.
Interesting. You’re the second person I’ve talked to in 24 hours whose employer offers both a 401(k) and a 403(b). I don’t think new plans can do that, but I guess some people were grandfathered in.
Your example illustrates the importance of reading your plan document and understanding how your plan works, including how to get the full match. It’s a little easier for me in our three 401(k)s- none of them offer a match so we’ve already maxed them out for the year.
Interesting. I thought the 403b thing had to do with the partial tax-exempt status of te company, but I admit I haven’t researched it fully. Interesting to hear it may (not) be allowed now.
It’s extraordinarily annoying to have to contribute all year long, so I celebrate New Year’s with a backdoor Roth. Perhaps my annual emails complaining about the 1% expense ratios on their funds have not fallen on deaf ears- we are now up to for Vanguard index funds.
Our tax sheltered account rules are slightly different in Canada, but the principles that you have described here still apply. We also have some tax deferral using a CCPC (professional corporation), but that is about to be severely limited with an annual passive investment income cap by our government. Previously, most of us just kept everything in our CCPCs since it was basically equivalent (although more tax deferral than shelter), simple, more flexible, and had unlimited room. I have always used a mixture of CCPC, RRSPs, TFSAs, and spousal taxable accounts to diversify my tax risk (and government rule changing risk). These tax sheltered accounts will likely make a come-back with our new (Canadian) tax law changes, but the same idea of maximizing your tax shelter/deferral first will make sense.
Great article!! What if you have a total of 100k debt for cars and student loans at an average interest rate of 3.5%?Better to contribute up to company match and spend the rest paying down debt? Or contribute the annual max and keep the 3.5% debt? Or is it a toss up depending on a person’s mindset about debt?
Mathematically, it’s almost certainly preferable to max out tax-deferred accounts before paying down a 3.5% debt, especially for someone in the higher tax brackets. For most of those folks who are financially minded, maxing out tax-deferred accounts shouldn’t interfere much with also paying down $100k of debt.
It depends as discussed here: https://www.whitecoatinvestor.com/pay-off-debt-or-invest/
Great post! It’s worth mentioning as well that a good 457 plan (i.e. one that is ‘safe’ and has good investment options with relatively low expense ratios) is probably the ultimate tax-advantaged account for FIRE since you can take withdrawals at any age after you’ve separated from the employer. There are also some exceptions allowed by the IRS to take withdrawals while you’re still in service with the employer.
Between my 457, 401k (required and voluntary contributions), IRAs, and an HSA, we have almost $73k of tax-advantaged space annually, which eliminates the need for any taxable accounts. I should have enough in my 457 to make it until 59.5, but if I don’t, I’ll just use the SEPP rule to make early withdrawals from my 401k or our IRAs.
One other characteristic of a good 457 plan is good distribution options. Many of them are not that good. For example, they require you to take all your money out in the year you retire.
True, but even with this restriction the 457(b) seems to make sense given some reasonable assumptions.
Eg, my side gig provides a non-governmental 457(b). It does have the lump sum distribution requirement, but slightly better since I get to choose any year for distribution within 10 years of quitting that gig. Suppose I max out contributions at ~$20K/y for 10y, so now it’s worth $200–300K with returns. Then I take that $200–300K out all in one lump sum in the year that I FIRE, so minimal other income for that year. Assuming my wife still works and joint filing and TCJA tax cuts are repealed by then, that puts us in the 28% or 33% bracket. *But* assuming reasonable doctor numbers we were likely in 32% bracket the year before anyway. Or very worst case for the 457(b), TCJA ends the year before I FIRE and we were in 24% bracket that year.
Even assuming the very worst case, we still had tax-free compounding of that money for all 10 years I contributed. So 457(b) should still beat Roth or taxable compounding. (Of course, I will have been maxing out my 401(k), CBP, and Roth IRA along the way as well.)
Agree that if your 457(b) has terrible investment options or if your employer might go under before you cash it out, it’s worth a second thought, but otherwise what’s not to love about even this worst-case-scenario 457(b) scheme?
Imagine you retire in October after earning $400K that year. Then the 457 requires you to take your entire $600K 457 out that same year. Now it’s all being taxed at quite a high rate and you may be coming out behind for using it even with years of tax-protected growth when compared to a taxable account.
I’m just saying pay attention to the distribution options. If they work for you and the 457 is otherwise fine, then great. But I can’t think of lots of situations where they wouldn’t work very well. The less flexible they are, they less valuable the 457 is.
Agreed on the negatives of 457s, not to mention the availability to creditors and the concerning ease with which companies can change the rules partway through the game. I have avoided my company’s.
Totally agree with this – max tax deferred while working especially if you are in a relatively high tax bracket (most reading these threads will be). However, you will need a “large” taxable accounts to bridge the gap between your early retirement date and the date upon which you start RMD’s and SS (for most this should be age 70). Large taxable account will also allow good sized annual Roth coversions between early retirement age and age 70.
FWIW, I early retired at 53 and am doing precisely this.
Great article as it articulates and objectively explains the opportunity cost of sacrificing tax advantaged accounts during FIRE journey. I also agree with MikeG as I am doing the same. When I started my RE journey, I noted that most that FIRE do it through the large taxable account. That did not sit right with me, until I realized that, I could invest in both tax advantaged and taxable accounts.
I am a 33 year old FP working in urgent care with plans for retirement at age 45.
My plan from from age 30-45
1) Taxable investment accounts goal 1M. Save enough yearly from age 30-45.
2 ) Tax advantaged accounts goal 2-3M. From age 30-45, Max out 401k (54k), backdoor roth ira (5.5k), HSA (3450) = 62950 annually. Compounded at 5 percent from age 30-59.5= 2.8M.
With retiring at 45, I can live off taxable investments from 45-59.5. Then live off of tax advantaged accounts from 59.5 on. With this plan there is bonus/safety net that we get access to the SEPP rules. Actually, leaving money in tax advantaged accounts allows more for compounding anyway, so I will try not to use SEPP rules.
I really appreciated this article, partly because it validates what I am doing, but also because of its comprehensive argument for the tax advantaged accounts with FIRE. I especially appreciated the illustrative arbitrage example.
What are you planning for in terms of annual withdrawals? Back-of-the-envelope math makes me wonder about a discrepancy between your pre- and post-59.5 income when inflation is considered. Remember that 25-years of 3% inflation cuts your purchasing power in half. (Or are you assuming 5% returns net of inflation?) Add to that the taxes that will be due on the withdrawals and the lower withdrawal rate to make that $2.8M last 30 years vs making the first $1M last 15 years. Not trying to criticize, just wondering what annual spending rate you think will work. I think these long-term projections are a real challenge for early retirement planning.
No you don’t. You can SEPP it up until Age 59 1/2 and then the penalty goes away anyway. No need for a taxable account if you can meet your savings goals in tax protected accounts. Read the post again, you missed the main point.
OK Jim, fair enough. You don’t “need” a large taxable account to bridge the gap between your early retirement date and the date you begin drawing SS and taking your RMD’s.
However, I would still submit it is much better if you do (provided you max your tax deferred accounts while you are working too). The reason being you can better manage your effective tax rate in retirement if you have different buckets from which to create your cash flow (taxable, tax deferred and tax free). As an example, my effective Federal tax rate is in my second full year of retirement the mid single digits.
My point was that generally speaking people should max their tax deferred accounts while working while at the same saving considerable funds in taxable accounts. This should be very doable for the audience who read your blogs.
Depends. I mean, some people have massive amounts of tax-deferred accounts available to them. For example, between WCI and my partnerships we’ve got 3 401(k)/PSPs ($165K), a DB/CB plan ($30K) plus Roth IRAs and an HSA. We have to save more than $200K a year before we even think about taxable. Lots of docs don’t save that much.
WCI- Great post. This brings up a topic that I know has been discussed before at length but I think worth further discussion. That is, whether to contribute post-tax (Roth) or pre-tax. I know you favor pre-tax and I am beginning to be swayed into your camp on this one. However, in considering a 401k with a Roth option, something that I feel gets lost in a lot of the discussion on this is if you can afford to max the Roth contribution ($18.5K), you are effectively getting more money into the 401k to grow tax free. Most of the comparisons (and calculators) that I have seen assume you contribute an equivalent amount to either the pre-tax or post-tax side (for example, $18.5K pre-tax and a number less than that, maybe $14K to the post-tax side). What do you think about this as a reason to maximize any Roth contributions that you can make?
“if you can afford to max the Roth contribution ($18.5K), you are effectively getting more money into the 401k to grow tax free.”
Remember that you don’t get to deduct this $18.5K in the current year. So even though you are “maxing” your tax-free space, you ended up paying tax on that money upfront at your marginal rate.
If your marginal tax rate at retirement is lower than your current tax rate (true for majority of docs), you will come out ahead maximizing your regular PRE-tax contribution.
You missed the point of the statement. If you are going to save $18K in after-tax dollars and have a 33% marginal rate, you can either put $18K into a Roth 401(k) or you can put $18K into a tax-deferred 401(k) plus another $6K into a taxable account. In the future, the taxable account investments have a tax drag on them whereas those in the 401(k) do not. So by doing Roth, you are getting more money into a tax-protected account even though you’re saving the same amount of money on an after-tax basis.
There is a nice effect there such that if your tax rate now and your tax rate later are the same, you’re better off with Roth than tax-deferred plus taxable. But for most people reading this forum, the tax rates will be so different that the arbitrage will overcome that effect.
Let’s say you have a pension (forced contribution of around 10k a year) and you do backdoor Roths but you don’t have other tax shelters or matching type contributions available. Would you opt for normal investment accounts so that you can attempt to make gains for early retirement at the long term capital gains rate as well?
In general, what would be your recommendation for early retirement (number) if you are out of debt, mid to late 30s? Just throw something out there — age 45? Age 55? A million? Or will you have to focus more on semi-retirement. The idea would be to spend a lot of time in another country as well, with a much lower cost of living.
Thanks.
Its not clear to me what you’re asking. If you’ve maxed out your available retirement accounts and need/want to save more for retirement, then yes, do it in a regular normal non-qualified taxable investment account and then invest tax-efficiently there to take advantage of tax laws like the LTCG rates.
As far as how much you need to retire at 45, I would aim for a number that is at least 25 times what you spend in a year. So if you spend $40K a year, then $1 Million. $100K a year? $2.5M.
If you’re just talking about going part-time, then you can do it with less. If your retirement expenses will be dramatically reduced by moving to another country, then you can do it with less.
Wow, just voted in the umbrella insurance poll at the bottom of this post. Looks like you need to do another post on the subject.
How come? You don’t like the old one? I’m not sure there’s much new to say about it.
Buy it. It’s cheap. Get it from the same company as your car and home insurance. Get $1-5M. It’s tough to come up with a very long post about umbrella policies.
Could you clarify why getting umbrella insurance thru same company as home/auto is important. We were not able to do that because our local rental property (our 1st home) insurance is thru a different company (in area of CA where wild fire risk makes getting property insurance near canyons tricky). Our umbrella insurance is thru an affiliate of our medical liability trust company. I’ve wondered if having it thru a separate company could be problematic and so your comment concerns me. Thank you.
I guess it’s not mandatory, but it seems weird to have to deal with two companies when defending against/paying a large judgment. I wouldn’t worry about it too much though. Just realize your first $300K is paid by one company and the next $700K (or whatever) is paid by another.
I have to add the obvious- this is doubly important for employed docs, who have very little 401k space to play with. Max it out, even beyond your match (if you have one) and use the backdoor Roth. You are going to be saving a ton in taxable in addition, but just make sure to maximize your tax-advantaged space.
One of my biggest regrets was only contributing to a Roth in residency and foregoing a 401k. In retrospect, I would have worked hard to use that early, tax-advantaged space.
I’m impressed with any resident who can max out both a Roth IRA and a 401(k) during residency. No way could we have one that. We were doing well to max out two Roth IRAs on our $37K income.
Agreed. Too bad the Match deflates salaries. But I wish I had saved at least a bit in a 401k during residency.
It probably deflates some and inflates others. What a crazy game it would be if they weren’t mostly uniform. You’d have to choose between making $100K at a crummy residency or $25K at a good one.
I also wish I would have maxed out my Roth IRA in residency. Instead I spent the money on vacations, bikes, and backcountry ski gear. I didn’t discover the white coat investor until 2013, the last year of my residency. Better late than never.
Sounds like “I spent all my money on partying, booze, and women and the rest I just wasted.”
Differentiate between governmental 457s and the NGOs! The governmental ones are a good deal and should not be discouraged.
Agreed. Government ones are great. They can be rolled into IRAs- best possible distribution option.
I was going to ask about this. My wife is a teacher and has been maxing out her 457 for years. From the statements they send us, it “seems” to be real money that is invested in real investments. The statements in the post and comments are alarming, re: creditworthiness of the employer, but I guess those don’t apply to governmental 457s?
Governmental 457s are generally fine. Do read the plan document of course.
Please explain this in the post: “……Generally, 401(k)s get a little better protection than IRAs, ……”. Thanks.
In some states, 401(k)s get better asset protection than IRAs. Meaning it is easier for a creditor to get your IRA money than your 401(k) money.
IRAs are governed by state law:
https://www.thetaxadviser.com/content/dam/tta/issues/2014/jan/stateirachart.pdf. Once again, avoid California unless you are a union worker. Since 2005, IRAs have been protected in bankruptcy at the federal level up to $1,283,025 (as of 2016).
There is a federal statute for 401ks, but I believe there is an exception for solo 401ks.
Care to elaborate? Post?
The problem with doing a post on it is that it varies by state, so it is hard to give very definitive information and the second I did, it would be wrong and I’d spend the next 10 years keeping the post up to date.
Bottom line: Know what is protected in your state. In my state, it’s 401(k)s, IRAs, whole life insurance, and $40K of home equity.
Utah should do better with home equity. Insane.
I just looked it up. It’s up to $30K/$60K now! Woohoo! I also discovered that one shotgun, one handgun, and one rifle is exempt from my creditors along with a year’s worth of food. You can’t make this stuff up.
Just to clarify, aren’t cash balance / defined benefit plans also protected in Utah?
Yes, should be.
http://www.irafinancialgroup.com/solo401kassetprotection.php
I read this article three times and settled for seeing “YES” in the “State Solo 401(k) Plan Exemption from Creditors” column for my state. The site’s content has always been accurate, but I wouldn’t call most of it straightforward.
Great post, and I agree completely. I take advantage of every tax-deferred and tax-advantage account that’s offered to me.
One additional point to add is that a SEPP / 72(t) isn’t the only way to access your 401(k) before 59.5 or 55 without a penalty.
If you start doing Roth conversions early (after rolling the 401(k) over to IRA), each conversion is available to be withdrawn tax and penalty-free after a 5-year “seasoning” period. It’s actually closer to four years if you convert late in the year, and withdraw early in the 5th year after the conversion. Annual conversions will set up a “Roth Ladder” of money available to be spent annually after the 4 to 5 year waiting period.
Cheers!
-PoF
Oooohhh…..tricky. Just have to think ahead a few years to do that one.
Yes, the 5 year trick is a good one. Although, I have not seen anyone use it yet. I have one client that might have to for extraordinary circumstances, though. Appreciate the article. Yet another post I can send people to on a regular basis. I have not seen this written about much for some reason in other places. I am amazed how many people have money sitting in a taxable account to live on, yet don’t fund their 401k. They teach you calculus in high school, but they don’t teach you about a 401k and basic personal finance.
How do you avoid taxes on the rollover?
Direct rollover to a regular (pre tax) IRA. Then Roth convert as much and when you wish.
Very good points. I cut my salary in half this year going part time but am still maxing out my government TSP, which they raised to $18,500 this year. It’s a lot harder, but I’m already FI and the reduce take home pay doesn’t concern me too much. The benefits and low cost of the TSP are too good to not max out.
If you only had $53k/yr to invest and you had the Mega Backdoor Roth available, would you put $18k in pre-tax 401(k) and the remaining $35k in an after-tax 401(k) (rolled then into a Roth 401(k) if your employer allowed)?
I’m struggling with this as I have ZERO taxable investments accounts. I have my pre-tax 401(k) and then I have my Roth 401(k) (from doing Mega Backdoor). I’m not likely to be able to save more than $53k/yr, but I feel like I’m doing something wrong by not having taxable accounts.
Sure, why not? Unless you have something better to do with it. I certainly wouldn’t fund a taxable account for retirement if I still had retirement space available to me.
Hello! I have this same question and would love some more clarification. Can you help me understand the pros/cons of both of these options?
Contribute the remaining 35k into after-tax 401(k) rolled into a Roth 401(k)
VS
Contributing that remaining 35k into a taxable account
The first one seems better to me in nearly every scenario. Why invest in taxable when you can invest in Roth?
I’m fairly new to this — what scenarios make it better?
I could be wrong, don’t taxable accounts have potential for lower expense ratios, more flexibility of stock options, and easier access (besides the points mentioned in this article)?
What investment can you get in your taxable account that has a lower expense ratio than a Fidelity Zero Index Fund I can buy in a Roth IRA?
I guess if you want to buy options (which is usually a mistake) you can do that in taxable but not a retirement account.
Easier access? That’s what the article is about. I’ll gladly trade a little flexibility for a lot more money, wouldn’t you?
That makes sense. I did look into it and it looks like Fidelity Zero Index Fund isn’t an option for the employer Roth 401k.
So how much more are you willing to pay in taxes to avoid the higher ERs (whatever they may be) in the 401(k) until such a time that you can roll them into a Roth IRA with low ERs? I would submit unless you’re looking at truly insane ERs (2%+) that you’d be better off in the tax protected account, even with higher ERs.
Excellent, that makes sense. Thank you for digging in a little deeper and helping me walk through that — super valuable to me!
In the example, you lost me on using 8% in one option and 7.5% in the other. Please explain.
Also, any resources on 72(t) would be appreciated. Thx! Harry
The 0.5% reduction in return is from the tax drag of being in the taxable account. More info on 72(t) can be found here:
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
Retirement could be a headache in the case where you plan to retire early and have no future plans. Early retirees should take into account the investments and savings before they decide to get retirement, and make sure that after-tax amounts are calculated as that’s all what actually comes to your pocket. Pre-plan the future income and expenses as well to avoid facing unexpected situation.
I think the big takeaway here is the significant difference between Marginal tax rates while working and when retired.
It can be even more significant, depending on the retirement income, as even the marginal rate while retired may not be appropriate – a lot of the income may be taxed at zero before hitting the marginal rate. I had a marginal rate last year of 22% (baby SS tax torpedo) and still only paid 3% total on my taxable retirement withdrawals.
So I have a question about maxing retirement out. I have a 403b, 457 and a define contribution plan which is entirely employer contributed. I know the total retirement account contributions for all accounts for 2018 is 55k and this includes employer contributions. I don’t know if that includes the define contribution plan as well?
It includes the 403b and the defined contribution plan but not the 457.