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Should you invest in 401k and Roth IRA if you plan to retire early?

by retirebyforty on January 23, 2013 · 33 comments

in investing, retirement, saving

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It’s only January, but I’m dreading tax day already. Our taxes will be quite complicated this year because I sold a bunch of stock options and the rentals will muck things up as well. Anyway, I already purchased a copy of H&R Block and I’ll fill it in as the required W-2 documents arrive. I really hope we won’t have to send the IRS a big check this year.

Save 15% on H&R Block At Home Online Deluxe

Taxes take a huge bite out of your income and nobody likes to pay them. That’s why I advise people to invest in the 401(k) and Roth IRA. An investor can use the amount contributed to the 401(k) to reduce their AGI and pay fewer taxes now. When you withdraw from the 401(k) in retirement, you’ll have to pay taxes then.  I make the assumption that most people will be in a lower tax bracket in their retirement so they should come out ahead overall. For the Roth IRA, you invest after tax money, but you don’t have to pay taxes when you withdraw in retirement (assuming you meet the qualifications.) However, you will have to pay a 10% penalty on both these accounts if you withdraw before you’re 59 ½. For those of us who plan to retire early – does it make sense to invest in the tax advantaged accounts?

Should you invest in 401k and Roth IRA if you plan to retire early?

early retirement 401k roth iraPersonally, I think it is still a good idea to invest in the 401(k) and Roth IRA. We have maxed out our contributions for many years now and built a respectable retirement portfolio for our age. Mrs. RB40 will continue to max out her 401(k) contribution as long as she can. We’ll maximize our Roth IRA contribution for the foreseeable future as well. We have 20 years left until we’ll both be 60 and then we can withdraw from the retirement portfolio without having to pay penalty. Some readers with an early retirement goal question why we would limit access to a big chunk of our net worth for 20 more years. If I retire early, shouldn’t I just focus on the after tax account?

Here are my reasons for investing so heavily in the tax advantaged retirement accounts.

Avoid withdrawal

For me, having to pay the 10% penalty withdrawal is a big deal. This psychological barrier will prevent us from touching our retirement fund until we really need it. If the funds are in a regular taxable brokerage account, it will be too easy to withdraw and spend it.

Let it ride

After 16 years of work, I accumulated a nice sum in my retirement accounts. The sum isn’t enough to retire on at this time, but it should keep increasing if I let it ride in the stock market for 20 more years. My strategy is to make the finances work without touching this retirement fund until I’m 60. In 20 years, my retirement portfolio should be able to support a comfortable retirement.

Phased retirement

Most people work very hard until they are near retirement age and then jump straight into it. My retirement strategy is a bit different. I worked hard at a corporate job until I turned 39, then I retired from that career. The 40-60 phase of my life is wide open. I am a stay at home dad now and I’m building my online business. After my kid starts school and I have more time, I would like to explore more self employment options. At this age, we are still active and can bring in some income. I don’t see the point of a full retirement this young. Also, I advocate being frugal because even a small income will go a long way toward covering your expenses.

The retirement portfolio is still accessible

There are some ways to access the fund without having to pay the penalty. First of all, the contribution portion of the Roth IRA can be withdrawn at anytime without a penalty. As for the 401k, I can use the 72(t) rule to access that fund if needed. The 72(t) rule is a bit complicated, but basically you’ll have to withdraw a portion from your fund every year. We might resort to this if Mrs. RB40 retires early (say at 55 years old) and we need the money. Anyway, we don’t plan to withdraw until 60, but it’s nice to know that there are ways to access the retirement portfolio while avoiding the 10% penalty.

Those are the reasons why I like investing in the 401(k) and Roth IRA. The money is (somewhat) off limits until I’m 60, but that’s fine. These retirement funds are for the 60+ phase of my life. Fortunately, we also have investments in our taxable accounts.

Each of these investments generates a small income. Along with my online income and Mrs. RB40’s paycheck, we can live a comfortable lifestyle right now.

Do you plan to retire early? If so, do you think investing in the 401(k) and Roth IRA is a good idea?

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{ 33 comments… read them below or add one }

My Financial Independence Journey January 23, 2013 at 2:36 am

I’m shooting for early financial independence. As such, I only invest in my 401K up to the match, because I don’t like passing up free money.

As far as I’m concerned, money locked in retirement accounts doesn’t count towards financial independence. Since I’m shooting to be financially independent by age 45, I’m going to have to focus on building those income streams.

I have no interest in phased retirement. I want the ability to walk off/be laid off and just not care. I’m also single, so I don’t have a spouses income to fall back on.

So, the amount that one allocates to taxable or tax-deferred accounts really has to be tailored to your goals and life situation. The tax sheltered accounts make sense the way you laid them out, but they wouldn’t go well with my goals.

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retirebyforty January 23, 2013 at 2:51 pm

Your plan sounds good for you situation. What do you want to do after FI? I’m curious.

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My Financial Independence Journey January 27, 2013 at 1:27 pm

I don’t really have post-FI plans. I really like my job right now and could do this for a while. Mostly, I think of FI as insurance against random layoffs, being forced to move to some place I don’t want to live for a job, and against materially adverse changes in my work environment.

Probably not the answer you were looking for, but unless I came into a boat load of money, I just can’t see things changing for me that much. But life has a way of taking me places I would never expect, FI just makes the transitions easier.

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Mike January 23, 2013 at 3:24 am

I think both are essential but one shouldn’t solely rely on them. 401(k) and Roth IRAs can provide you that chance to make your money do some work for you while you move on to other things. I think you have the right idea by also expanding out into other niches and sources of money. This way you have a better chance of avoiding making any withdrawals (or withdrawing smaller amounts).

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Integrator January 23, 2013 at 4:41 am

Like MyFI above, I’m planning for an accelerated retirement/ independence within 5 years, so I only contribute up to my match in my 401k.
I want the dividends from my dividend paying stocks available to me now to live off and not tied up in a retirement account. Its why the majority of my dividend stocks are held in taxable accounts. With the concessional dividend taxation now in force, I dont see too much downside to this.

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retirebyforty January 23, 2013 at 2:52 pm

I like having my dividend paying stocks in a taxable account as well. It’s nice to have that income.

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Glen @ Monster Piggy Bank January 23, 2013 at 4:51 am

I also dread tax time – it always comes around so fast!
I have started using my brother who is an accountant to do all mine as he flys through it in a tenth of the time it takes me.

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retirebyforty January 23, 2013 at 2:52 pm

That’s great! I don’t know anyone in that field. :(

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JC @ Passive-Income-Pursuit January 23, 2013 at 6:39 am

I still contribute to my 401k and Roth IRA even though I’m targeting early FI. I won’t call it quits until my taxable accounts and other non-traditional retirement accounts can support my wife and I with the hopes of letting that money to continue to grow until I can withdraw it penalty free. I’m no longer maxing out the 401k because I’m really focused on reaching early FI. I still plan to have some form of work but much more on my own schedule as opposed to the job I currently have where I’m at their beck and call.

I’ve never really dreaded tax time and this year won’t be too big of an issue, but starting next year it’s going to start getting more complicated. Unfortunately the way the tax code is, it’ll most likely continue to get more complicated.

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retirebyforty January 23, 2013 at 2:54 pm

Good luck! It sounds like you have similar goals. Working on something you like is a huge difference.

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Kurt @ Money Counselor January 23, 2013 at 7:37 am

Unless you can’t deduct any contributions and expect to be in a zero tax bracket when you begin making withdrawals, I think it’s the right strategy to continue with tax-advantaged vehicles like IRAs even if you plan to retire early. Working on a plan to hold down all expenses–including taxes–in retirement is even more more important if you aim to retire early.

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retirebyforty January 23, 2013 at 2:55 pm

Yeap. Tax is such a big bill that it’s worth the time to try to minimize it.

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jim January 23, 2013 at 10:57 am

Joe, are you doing quarterly taxes? Seems with your income sources that you might have to do that sooner or later.

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Brick by Brick Investing January 23, 2013 at 11:56 am

I would only invest the amount in which my company matched.

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krantcents January 23, 2013 at 12:32 pm

If yo are going to retire early, you will need to establish a brokerage account or have some other source of income. I used my income property to support my needs. I added businesses so I would have multiple income streams. The good news was I paid capital gains tax on the growth of the those investments and continue to do so. Similar to Mitt Romney!

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Aloysa January 23, 2013 at 2:08 pm

This post resonated with me very well. I am thinking to start ROTH, and I already have 401K (my employer does not have a match, sadly.) Do you know if ROTH has any income limitations? Thresholds?

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Gen Y Finance Journey January 23, 2013 at 3:39 pm

I’ve been contemplating reducing my 401(k) contribution to focus on my taxable investments. I’m having a hard time going against what I’m “supposed” to do.

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retirebyforty January 24, 2013 at 1:03 am

I know what you mean. It would be nice if you can do both right?

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Lance @ Money Life and More January 23, 2013 at 4:25 pm

I guess I hope to semi-retire early. Live off of a small side income and still work part time or something like that. I max out a Roth IRA every year and contribute to my 401(k) because I want my “young” money (I’m in my twenties) to be in tax advantaged accounts and as I get older I may explore a taxable account for early retirement savings.

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retirebyforty January 24, 2013 at 1:04 am

That’s a good way to put it. Your young money will have a long time to grow and the tax advantaged accounts are good for that.

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anon e. mouse January 23, 2013 at 5:59 pm

We’re shooting for early financial independence. Whether we choose to retire or not at that point is immaterial, we’ll be able to if we decide to.

To that end, we save about 40% of our combined income. We max out our tax-deferred contributions first, and then sock the rest in savings, both in cash and mutual funds.

I allocate our assets into 3 buckets:
short-term: Any money that we could get /today/ without penalty if we wanted. Taxable accounts, cash, vested stock options.
mid-term: unvested stock options, deferred income accounts, etc..
long-term: retirement savings with penalty for early withdrawal

The sum of these three buckets represents the portion of our net worth that can be applied to financial independence. Our goal is to reach a number at which we can live off of 3% of this total (currently we need ~$4M in these three pots to reach that point). I am somewhat arbitrarily shooting for 20% of that to be in short-term, 40% to be in medium-term, and 40% to be in long-term buckets.

To answer the question posed by the post, we save in tax-deferred accounts because there is a significant benefit to this savings, and we plan to live beyond the point at which we can withdraw money from those accounts.

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retirebyforty January 24, 2013 at 8:49 am

Great goal! What’s your projected date on meeting your target. I like your bucket system too. We only have 2 buckets short and long terms. I don’t have any more stock options or deferred compensation. :( They never worked out anyway. Intel is worth 1/3 of what it was in 1999.

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Suba January 23, 2013 at 11:46 pm

We do invest quite a bit in 401k (at least until last year). Our plan for early retirement depends on the income streams we set up, not on the actual retirement accounts. Currently we re shooting for CDs, dividend stocks, p2p investing and any side hustles we have.

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retirebyforty January 24, 2013 at 8:55 am

Good luck! It seems many bloggers have similar goals of setting income streams as well.

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Kin @ Journey of Success January 24, 2013 at 2:36 am

I recently wrote a post on my blog that concerns this topic. My decision is to contribute to only get the match, which automatic 100% on the money I contribute, and avoid contributing anymore. The reason, in short, being that the advantages of having the money tax-deferred but locked up is minimal to saving the money outside in taxable accounts, etc. from my analysis.

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retirebyforty January 24, 2013 at 3:06 pm

Let me see if I can find that post. :)

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William @ Drop Dead Money January 24, 2013 at 4:57 am

Before I retired, I maxed out on both 401k and IRA contributions. The benefit of not having to pay tax on gains is enormous, as each “gain event” (cash dividends or gain from a sale) would have been nickled and dimed away with income tax.

I also did “regular” investing, but found that that worked best for me if I didn’t get dividends and didn’t sell. You avoid tax when you buy a stock and simply hold it while it grows. The challenge, of course is finding stocks that reliably grow so you never need to sell them… easier said than done. :)

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retirebyforty January 24, 2013 at 3:07 pm

That’s what I think too. The more you keep the more the retirement account will compound.

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Steve January 24, 2013 at 1:27 pm

This is one of those questions that depends on what specifically you mean when you say “retire early.”

If one plans on leaving a corporate career to become a part time blogger/landlord/stay-at-home-parent, and meanwhile one’s spouse keeps working, then sure you can put everything in retirement accounts. Another situation is if you plan on fully retiring just 5-10 years early and relying on 72(t) withdrawals. Or after age 55 and using the early distribution from a 401(k) rule.

On the other hand, if you plan on retiring super early (for instance… by 40), then you might not want to lock yourself in to 72(t) for a couple decades. And if you plan on starting your own business, and that business may require startup capital. In those cases, you almost certainly want some unencumbered savings/investments.

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retirebyforty January 24, 2013 at 3:09 pm

You are right. Everyone’s situation is different. You’ll have to find the right answer yourself. :)
Retiring super early and not having much in retirement account still seems risky to me though. What if you run out of money when you’re 60?

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Martin January 25, 2013 at 3:21 pm

I do not agree that in retirement age you will be in a lower tax bracket. taxes will be higher overall by then and you will not have deductions you have these days such as mortgage deduction, kids deduction and many others, so personally I think my taxes will be higher at retirement. Thus I like ROTH IRA a lot and invest in 401k only because of the employer’s match.

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retirebyforty January 25, 2013 at 11:11 pm

I’m in a lower tax bracket today because I left my job. The paycheck is a big source of income and most people won’t be able to replace that after retirement. I’m pretty sure only a few people will be in the same bracket after retirement. Even if tax goes up, most people will be in the lower bracket.

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mark white November 19, 2013 at 3:49 pm

My job is going to provide me with a pension and I’m investing in a unmatched deferred comp would it be also beneficial to invest in a roth ira

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