It’s a common conundrum. If I’m planning to retire early, why on earth would I choose to max out retirement accounts that I can’t touch until I’m months shy of being a sexagenarian?
When phrased that way, it doesn’t make a lot of sense to do so. Best to save in a brokerage account that can be accessed easily at any age, right?
The problem is that the question posed represents a misunderstanding of how retirement savings and retirement accounts work. Dr. Jim Dahle lays out an excellent argument for maxing out all tax-advantaged space, regardless of any desire to pursue an early retirement.
This post was originally published on The White Coat Investor.
Why Early Retirees Should Max Out Retirement Accounts
I’ve noticed a hesitancy among people aiming to reach financial independence and retire early (FIRE) at a young age (like 30s-50s) to use retirement accounts. 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.
So 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 will 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. And if you’re doing that, chances are that you can both max out your retirement accounts and have to save a significant amount of money in a taxable account anyway.
And of course, 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 in order to do so. Here are 6 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.
But what does that mean? Well, that means you have to take money out every year until you turn 59 1/2 and for a minimum of 5 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? [PoF: The numbers vary with prevailing interest rates. The SEPP in 2020 will be lower than they were when this was first published in 2017.]
Not comfortable spending 4%+ in your 50s? Okay, 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 mean-time and probably 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 as well that may allow you to take out even more penalty-free. These include medical expenses, disability, college for your kids, and even a house.
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 Rule 72(t)), you can always just pay the penalty. It’s only 10%. And chances are you’ve gotten more than a 10% benefit given the years of tax-protected compounding and the arbitrage.
# 2 Tax Arbitrage
What do I mean by arbitrage? I mean 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 one that you completely give up if you invest in taxable instead.
Just do the math. Say you’ve got $20K you can either invest 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% like mine is.
Option A: Invest $20K at 8% for 15 years in a retirement account
After 15 years, let’s say you pay 15% at withdrawal. So you’re left with
=FV(8%,15,0,-20000)*0.85 = $54K
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. So you’re left with
=FV(7.5%,15,0,-11200) = $33K
You get 64% more money by using that tax-deferred account. And 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. Meaning if you are successfully sued for $10M, 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. Far easier to estate plan with retirement accounts than 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 3 decades, the difference between an investment compounding at 8% versus at 7.5% is about 15% more money. Over 6 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 all their retirement money out 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.
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What do you think? Do you know anybody not maxing out retirement accounts because they have early retirement plans? Did I convince you that’s foolish? Why or why not? Comment below!
15 thoughts on “Why Early Retirees Should Max Out Retirement Accounts”
What if you plan to use ACA for health care between FIRE and Medicare eligibility age, and wish to max out tax credits and cost reducing subsidies? In order to keep your MAGI low it seems to me that this makes you have to limit the amount of taxable distribution from IRA/401/457’s. Also limits your ability to do significant Roth conversions and liquidating stocks in taxable that have large capital gains. Navigating ACA MAGI rules to keep under the ‘cliff’ seems like you have to walk a fine line and seems to deny us the ‘full’ opportunity to do all these other things being discussed?
Tax planning is key! I’m doing some right now.
Keep in mind that you don’t need a low MAGI to use ACA for healthcare. You only need it to be subsidized when choosing an ACA plan. We have a non-subsidized ACA plan purchased on the exchange.
It is smart to run the numbers based on the size of your family and where you live, factoring in your ACA subsidy and weighing that against the benefit of taking some taxable income in these other ways.
Yes – I’m planning to try to keep MAGI under 200-250% of Federal Poverty Level in order to maximize tax credits and cost reducing subsidies. MAGI relevant income will be a combination of part time work, 457 distributions, dividends, interest and municipal bond dividends. Would I be correct in thinking that if at year end when 1099’s and W-2’s all come in and I exceed my goal MAGI, I would still have until April 15th of the following year to contribute to a traditional IRA thereby lowering the MAGI to the desired level for the previous tax year?
Thanks for all your advice.
Double check the rules on using IRA contributions to lower your MAGI for ACA subsidy qualification. When I looked into this a year or two ago, IRA contributions are added back into your MAGI but 401K contributions are not.
Weird, I know, but that’s what I found. If you have a part time job with a 401K option, use your 401K contributions to shield income from the MAGI calculation. You can always take a distribution or create income from another source near the end of the year if your MAGI comes up short of the ACA minimum.
Great post! I think what really fools the FIRE community is the long term cap gains rate can be 0% of tax up to around $105K. But with Biden that might go away, and as high income docs it does not make sense really lose that tax arbitrage. Low income FIRE folks also still get a tax arbitrage albeit smaller. People behaviorally anchor themselves to that 0% long term cap gain rate.
Those numbers for the SEPP are using an interest rate of around 2.5%, the current rate is around .58%, making the number dramatically smaller. https://www.imagisoft.com/equal/federalmidtermrates.html
Thank you for the link, Stephen. I’ll update the post to indicate that the SEPP amounts will vary based upon when you elect to take them. I believe Dr. Dahle calculated these at one point in time in 2017, but they change every month.
Is the 401K 55 yr rule dependent on the plan, or is the employer bound to follow it?
That’s federal law, and it has nothing to do with the employer or plan sponsor. You can actually be 54 and collect as long as you’re turning 55 later in that calendar year.
Key stipulation not mentioned, you MUST be 55 when you retire from the company and only that company’s 401k is accessible, not all your 401Ks. https://www.businessinsider.com/personal-finance/rule-of-55-401k-early-withdrawal
Good call – another reason to rollover old 401(k)s into your employers’ plan prior to retirement.
I’d advise against it, though, if the old plan has lower fees and/or better fund options and you don’t need the money in the old 401(k) in the 5 or so years before hitting 59.5.
Per article , “While employers can allow early distributions (IRS speak for withdrawals) to departing 55-year-old employees, they are not obligated to do so. So it’s crucial to ask your company’s 401(k) plan administrator if early withdrawals, and hence the rule of 55, are allowed. “
This is an IRS exemption to the 10% tax penalty they usually assess to 401k withdrawals made prior to your age 59.5, and your employer’s plan has no say in it.
This is assuming there is nothing in your employer’s plan that forces you to roll the funds out when you separate from the company. To my knowledge, there is also a federal tax law that requires all 401k plans to allow you to leave the funds in that plan after separation, provided you have a minimum dollar amount in the plan at separation.
I used the age 55 rule for planning purposes when I signed up with my company for early retirement at age 58. I never did take any money out but needed to know the option was there in case I needed the funds, so I checked the IRS website to make sure I qualified.
This is a great article that I haven’t seen before, thanks for reposting it. I do max out my retirement accounts even though I do hope to retire early. It’s piling up surprisingly fast in there!
Very interesting that the early withdrawal options are capped around 4%. Who knew the government was into the FIRE movement as well?