In my post titled Three Sentences that Lead to Wealth, I made the following comment:
The 401k up to the full match is a no-brainer. After that, it depends what you are trying to accomplish and by when. I maxed out all my tax-advantaged accounts and wish I had put a bit of that money into taxable accounts for easier access.
One reader responded to that with the following:
In response to the rule about maximizing contributions to tax advantaged savings accounts, you said ‘I maxed out all my tax-advantaged accounts and wish I had put a bit of that money into taxable accounts for easier access.’
May I suggest this as a topic for a future post? Tax advantaged accounts are rightly touted as great tools, but I’m curious to hear your thoughts about how they relate to people who are targeting ‘retirement’ before age 59.5. Maybe the answer is as simple as ‘contribute to a taxable account.’
There seems to be conflicting objectives in the advice “max out your 401(k) so that you can retire early.”
Another commenter chimed in with:
To get money before 59.5 without a 10% penalty isn’t all that difficult.
The Substantially Equal Periodic Payments (SEPP) rule is the exception to get into your IRA when you retire. You essentially “annuitize” your IRA from the when you retire until 59 1/2. Your life expectancy is calculated, and then take out an = amount each year = to the balance of the IRA divided by your life expectancy. Once started, you must continue to take these withdrawals for at minimum 5 years, or until age 59 1/2. When you do this, you DO NOT have to pay the penalty.
Your 401k can be accessed penalty free after 55 when you leave your employer, but if you roll that plan over this benefit is forfeited.
Also there are numerous exceptions to the 10% penalty…
Unreimbursed medical expenses > 7.5% of your adjusted gross income (which may not be that high if you’re retired)
Inherited IRAs. (if your mother leaves you her IRA, you can take out the money before you get to 59 1/2)
Pay for medical insurance, Disability
Qualified Higher Education Expenses- for you, your kids, or your grandkids
A First Home. Keep in mind the IRS definition of a “first home” is that you haven’t owned one for the last 2 years. Also, it doesn’t have to be YOUR first home, it can be your kid’s or grandkid’s first home too. See how this works? You pull out $8K from your IRA to pay toward their home, and they gift you $8K for Christmas. No 10% due. Ethical? Perhaps not. Legal? Certainly. Keep in mind there is a $10K limit.
Reservist Distribution. A military reservist can withdraw money while activated without paying the 10% penalty.
However you are right in that if you retire before 59.5 it would best be wise to drain a taxable account first and then a 457 before touching the others. Nevertheless if you are maxing out the other accounts it would be most advantageous to do that.
Interesting discussion, huh?
Since I was asked about the topic, I thought I’d share my take and then allow you to comment.
Here are some thoughts I have on the issue:
- Like much of personal finance, I don’t think there is one “right” answer. What is best for any individual or family depends on a wide variety of factors. The factors that make one option the best choice in one situation make another move the best choice in another situation.
- That said, I think good advice for the largest group of people is to “contribute to a 401k to get the full company match.” I’m sure there are times when this is not good advice but for the majority, this will work well. How could it not when you lock in a 50% or 100% return immediately?
- Once you max out the match, the debate occurs. Should you continue to put as much in the 401k as possible (building to your war chest, avoiding some taxes this year, and allowing for tax-deferred growth) or should you balance your investments and split up the remainder into 401k contributions and investing in taxable accounts (which doesn’t offer many of the benefits yet gives you complete and immediate access to all the money)?
- If you decide to split the money, there’s then the question of how much of the remainder goes into the 401k and how much into the taxable account? The splits can be done in a ga-zillion different combinations.
- I think a key in answering the “amount over the match” question is “when will you need the money”? If you plan to retire at 59.5 or later (which was my initial plan — to retire at 60), then I’d go with most of the money in the 401k. But if you plan to retire sooner, and especially if you plan to retire much sooner, I think it’s wise to consider moving more into a taxable account.
- The reason for this is money accessibility. If you retire at 40, 45, or 50 and you’re going to need that money, you want complete and unrestricted access to it. There’s nothing that allows this other than to keep it in a taxable account.
- Yes, you can get to some of it by taking SEPP, but that amount is determined by law, not by you. Also, the commenter above noted that he thinks it “isn’t all that difficult” to do but he does not have personal experience in doing so. I’m a bit more skeptical. When dealing with government rules and IRS options, things are rarely easy. And even if it is easy, you still can’t get to all the money since you don’t control it.
- Separate from the SEPP, the other reasons (medical expenses, education expenses, etc.) for getting the money out noted above are rare as well.
- I contributed the max to my 401k for many, many years (over a couple decades, really) since 1) I didn’t need the money, 2) was planning on retiring at 60, and 3) wanted to save on taxes as much as possible. That’s why roughly half of my net worth (and well over half of my investment portfolio) is now in rollover IRAs.
- Now with the benefit of hindsight, I made the statement above simply because I retired at 52 and have access to only a portion of my investments.
- Fortunately for me, I have several other factors that make this ok including 1) I had a high income and a high savings rate so I was able to contribute the max to my 401k AND save some to a taxable account and 2) I bought rental properties which along with some other income generate more than what we spend annually. So it isn’t really much of an issue for us personally.
- That said, I wouldn’t mind having more in taxable accounts so I could get higher, regular, dividend checks. They would give us another margin for safety.
Those are my thoughts on the issue.
What’s your take?