Should you invest in your 401k if you plan to retire early?

should you contribute to 401k if you plan to retire early?

Some readers brought up an interesting point in response to the 3 Ways To Define Financial Independence. Should you count your 401k and IRA when you calculate your Financial Freedom Ratio*? You can’t access these tax advantaged retirement funds without penalty (10%) until age 59-1/2. If you plan to retire at 40 or 50, wouldn’t it be better to invest in a taxable account so your saving is easier to access?

*Financial Freedom Ratio (FFR) = investable asset/annual expense. If your FFR is over 25, then you’re close to financial independence.

First of all, I count our 401k and IRA in our investable asset. We don’t plan to access them until we’re 60, but they are invested and they are growing. I wouldn’t have been able to justify quitting my job if I discounted 50% of our net worth. Here is our withdrawal plan.

  • Age 40 – 60: Support our lifestyle with Mrs. RB40’s paychecks, my online income, dividend from taxable account, rental properties, and P2P lending. We can draw down from our taxable account as needed.
  • Age 60-70: All of the above plus withdrawal from 401k, IRA, and Roth IRA.
  • Age 70+: All of the above plus social security benefits.

For the next 20 years, we plan to have some active income to supplement our passive income. If Mrs. RB40 retires before she turns 60, then we can draw down our taxable account first and then possibly our Roth IRA contribution (no penalty.) Once we hit 60, then we will start taking distribution from our 401k and IRA. The retirement funds are a big slice of the pie and they absolutely should be counted in your investable asset, even if you don’t plan to use them until later.

For my situation, this works well because we don’t need to withdraw from our 401k and IRA until we’re 60. What if the income from your taxable account isn’t enough to support your early retirement and you can’t generate active income for some reason? Even then, I think everyone still should contribute to their 401k and IRA as much as possible. There are ways to access those accounts without having to pay the 10% penalty.

IRS Rule 72(t)

One way to access your 401k and IRA is through the rule 72(t). The rule is a bit complicated and you can read more about it in the post I wrote last year – Should you use IRS rule 72(t) to access your retirement fund?  Basically, you’ll withdraw a certain amount from your IRA every year. You’ll have to pay income tax on it, but you won’t have to pay the 10% penalty. The big risk is the chance of depleting your portfolio before the end of your life. Lastly, you’d need to keep withdrawing for at least 5 years or until you turn 59-1/2, which ever is later.

If you’re 40 and have $1,000,000 in your IRA, then you can take out a little over $30,000 per year with the rule 72(t). That’s about 3% so it’s not bad.

Roth IRA conversion ladder

Another way to access your retirement fund is through the Roth IRA conversion. You can build a Roth IRA ladder and withdraw without having to pay the 10% penalty.

  1. Roll over 401k to IRA.
  2. Convert 1 year of living expense to Roth IRA. (You will have to pay tax when you do this.)
  3. Wait 5 years.
  4. Withdraw 1 year of expense from the Roth IRA.

Just repeat this every year until you’re 59 ½.

The drawback here is you have to wait 5 years before you can take out the first chunk of money without penalty. The 5 years wait only applies to Roth IRA conversion. If you contribute to your Roth IRA outside of a conversion, then you can withdraw that contribution anytime without paying the 10% penalty.

The Adhoc Approach

Disclaimer: I am not a tax consultant or financial planner so please talk to a professional if you plan to take early distributions.

I’m not sure, but it seems like you can use rule 72(t) while building your Roth IRA conversion ladder. You can take the 72(t) distribution for five years and then stop. After that, you can withdraw from the Roth IRA conversion ladder. Does anyone know if there is anything wrong with this plan?

I also think it’s a good idea to have some active income during the first part of retirement. The Adhoc Approach is to work a little, build up some passive income, use the rule 72(t), withdraw some contribution from the Roth IRA, and use your creativity to fund early retirement.

Contribute to your 401k

In conclusion, I think everyone should contribute to their 401k as much as they can while they have the income to do so. The 401k has the benefit of employer matching and tax deduction so you’re saving more than you can in a taxable account. This year I will contribute quite a bit more than the $17,500 maximum in my solo 401k and I will keep it up as long as I can. The only reason why I wouldn’t invest is if your 401k doesn’t have employer matching AND the plan is just plain bad.

There are ways to access the IRA without having to pay the 10% penalty so I don’t think you should worry too much about that. The 401k is a very useful tool whether you plan to retire early or at a normal age so please take advantage of it.

Are you maxing out your 401k contribution? If not, what’s stopping you?

Related article: What if you always maxed out your 401k.

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Joe started Retire by 40 in 2010 to figure out how to retire early. After 16 years of investing and saving, he achieved financial independence and retired at 38.

Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!

Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.

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32 thoughts on “Should you invest in your 401k if you plan to retire early?”

  1. Nice article Mr. RB40, thank you Sir. My wife and I are ~35 years old have been maxing out our pre-tax 401ks for the past few years, and we now have a substantial amount in those accounts equivalent to about 8X our yearly expenses. We have also built up a significant post-tax brokerage account balance (in a bunch of tech growth stocks) which is now even greater than our 401ks, and about 10X our current yearly expenses. We typically save over 50% of our combined income in 401k and after-tax, and have no debt. We are currently renting but might consider buying a house in the next 2 years if we decide to stay in the US, and have just started a 529 college savings plan for our 1-year old daughter born.

    My goal is to save about 25X our desired annual expenses (2.5X our current expenses to account for more travel, living in a better house, leisure, activities for our daughter, etc.) before quitting our jobs hopefully by 45-50 years of age.

    My question is going forward should we just put in the minimum in 401ks to get company match and the rest in after-tax and 529 going forward?

    Some considerations:
    1. Want to retire before 50 if possible and don’t want money locked away in 401k
    2. More flexibility to invest in growth stocks particularly tech stocks vs. S&P index in 401k
    3. We are already in a 24% federal tax bracket and fear that by the time we are 59.5 yrs we may be in a higher tax bracket, just based on passive income from after-tax investments by then, and govt in general increasing taxes(?).
    4. Arbitrary changes to early withdrawal penalty by future administrations?
    5. We are not US citizens (soon to be permanent residents though), and may move back home to India in a few years. Scared about having money stuck in a US 401k.

    I know this is quite detailed and maybe best handled by a financial planner, but do you have any quick thoughts based on your experience for investing more in 401k (beyond getting employer match) vs after tax accounts from an early retirement standpoint?

    Thank you!

    • Great job with saving and investing. It’s a tough question because you’re not sure if you’re going to stay in the US.
      Let’s go through your concerns one by one.
      1. You can build a Roth IRA ladder to access your investment when you retire early.
      2. When you change job, you can rollover your 401k to an IRA. Then you can invest in individual stocks.
      3. This is a tough question because we don’t know what taxes are going to look like in the future. I prefer to take advantage of the savings now instead of the future. Usually, you’re in a lower tax bracket when you retire. But you never know.
      4. ?
      5. This is probably your biggest concern. But it’s probably okay to leave the investment in the US brokerage. You can access your accounts from anywhere in the world these days.

      Check with your 401k plan. Sometimes, they have financial advisors you can talk to.
      If I was in your position, I’d invest in 401k to save on taxes now. Not the max, but maybe 50% of max. $10,000/year or so.
      That way I can invest in both the 401k and taxable accounts. That’s a good balance for me because I don’t want to put too much in tech.
      Good luck!

  2. Want to open a traditional IRA. Have a retirement 401K set up and funded it myself as a subcontractor. Now have been fazed out of work and want to retire at 50. I might get a part time job later in life. Depending on my wife’s income for now. Plan on rolling over the 401K funds once I get a loan paid off to close it out (3 payments left). Can I fund the IRA with no or very limited income using my wife’s income? We have a child that is under driving age, if that makes a difference. Otherwise, will at least roll the 401 fund into one to get rid of the financial advisor fees.

    • You need to fund the IRA with earned income. So you’d need to have some income or else you can’t contribute. Check with your tax guy. You could rollover your 401k into an IRA. That’s what I did when I left my job. Good luck!

  3. Don’t forget IRS rules regarding a 401k and 403b. If you leave your employer, you may begin to take withdrawals from these accounts at age 55 penalty free. You’ll still pay income tax. So you may not want to roll these accounts into an IRA because then you’ll have to wait until 59 1/2 for the penalty free withdrawals, unless you do a 72t.

  4. I’m pretty sure you can pull your principle out of a Roth IRA at any time. Just not any profit. So for 10 or 20 years you get (5,500 a year X 10 years = 55,000) or (5500 X 20 years = 110,000) that you can slowly withdraw with no penalties or taxes. That should help get to the normal retirement age.

  5. Personally I am not investing in 401k or Roth at the moment. My reason is simple, I am 40 and close to my retirement age. I don’t have a company sponsored 401k (my boss is a cheapskate, and I curse him in the mirror every morning). I have a Roth and Rollover accounts which have significant funds in it already. Why would I take good money, put it into a tax advantaged plan, just to take it out in a few years, and be penalized for doing such if I am retiring soon. I am using my non-tax advantaged accounts first, then will hit the tax advantaged accounts when I am older and hopefully can benefit more from them.

  6. What about a Roth 401k? Should I (23 yrs old) contribute all to Roth 401k rather than traiditional 401k? Or contribute to both? I am maxing out a Roth IRA, just not sure which 401k is a better option. Also, would the 72(t) rule apply to a Roth 401k?

    • It depends on your tax bracket. If you’re in a low tax bracket, then you probably should go for Roth 401k. If you’re in the high tax bracket, then go for traditional. Yes, the 72(t) should apply to Roth 401k as well.
      Good luck!

  7. Very interesting discussion. My research shows that maxing out your traditional 401k first ($17,500 x both spouses if possible), followed by $5,500 in Roth IRA x 2, after that you could put money in taxable or Roth 401k.

    For me, if we plan to retire, say at 48, I need some major $ readily available in taxable investments to tap in those years. I know there are scenarios you can get at your Roth $, but letting those build over the long term and accessing Roth last seems to be a winning strategy.

    Keep your costs as low as possible, saving more is better than making the highest %, keep it simple and stay the course.

  8. Investing in a 401K is a no-brainer. It lowers taxes, gets an employer match, teaches you have to live more frugal, and is a great way to build wealth.

    I typically max out my 401K by the end of Feb. 75% of salary, until I hit my $17,500 + $5,500 = $23,000.

  9. I can only contribute 6% to my 401k (because of some combination of my higher salary and lower-salaried co-workers not participating if I understand it correctly). Never seen anyone else comment on this situation, is it that unusual? There is an employer-held fund with set return I can contribute too also, but not in a true retirement vehicle.

    • I read that it is not unusual for executives in the manufacturing sector. The regular employees are not participating enough and that put a cap on the high income earners. That’s one reason why more companies are opting their workers into the 401k plan as a default. Maybe you can talk to your HR and see if your company can try to get more people to participate.

      • Unless you are in a “safe-harbor” plan, a 401(k) plan is tested annually to make sure that highly-compensated employees (HCEs, think the cutoff is around $80-100k in saary) are not disproportionately benefitting from the plan, as it’s not supposed to be a perk that primarily benefits senior management.

  10. If there is an employer match then its almost a given that you should invest in the 401k at least up to the match. The match is free money and outweighs any potential negatives.

  11. We lost the ability to contribute to a 401(k) for me last month. Dad still contributes the max though. With our income, unless something changes, we’ll be paying an extra 6k in taxes to Uncle Sam because we can’t defer the taxes 🙁 Anything we were going to put into a 401(k) for me will go into a taxable account. Because we expect our taxes will be so high this year, we’re pretty sure contributing to a Roth is not the best option for us, even if we do qualify, as we’re almost guaranteed to have a higher tax rate now than when we withdraw the money.

    • Can you open a solo 401k or SEP IRA? That might be a good option if you’re looking for some tax deduction. You’re self employed, right?

  12. @Jamie: You can withdraw principal from your Roth IRA at any time without penalty. Thus you are almost certainly better off maxing out your Roth IRA opportunities prior to investing in a taxable account.

    That said, it is useful to open a taxable account and get accustomed to making small contributions while you are young. Surprisingly enough, one obstacle to saving I’ve heard from some friends and family (even affluent) is the hurdle of opening an account at Vanguard, and understanding how mutual funds work well enough to

  13. Mr. S is correct. Once you begin 72(t) distributions, you must continue for five years or until you reach 59 1/2, whichever is longer. If you stop distributions, you will have to retroactively pay the 10% penalty on all previous distributions.

  14. I think is really depends on income levels. If you make $150k a year, then the tax savings of the 401K outweigh any other considerations.

    If you are making $35K, then you might not be saving that much in taxes by using a 401K vs. a Roth IRA. And you might not be able to save more than the $5,500 max.

    Mrs. Frugalwoods and I both max out our 401Ks for the tax benefits. With our current income level and tax situation we’d come out ahead in ER even if we just made a straight withdrawal from the 401k and paid the penalty and tax.

    Of course we’d never do a simple withdrawal with all the other methods of tax efficient planning available. But it’s interesting to know that the math is so heavily tilted in favor of shielding income from taxes now.

  15. Unless the IRS rule has changed, I believe that once you start taking distributions under 72-T you have to continue for five years or until you turn 59-1/2, whichever comes LATER. That may have changed, however, because there were cases of people who depleted their 401(k) during market meltdowns and were still being held accountable by the IRS for not continuing to take distributions for the required period.

    • Yeap, that’s right. I had that in my previous article, but not here. I’ll update it now. Thanks for catching that.

  16. I can’t max out my 401K because I don’t make enough money. I do contribute double the amount required to qualify for the whole company match (this year I surpassed the 5K mark in my portfolio – Yay I am getting somewhere!). I also contribute a small amount to a Roth IRA each month. Once I am out of debt (2-3 years), I am going to be opening taxable investment accounts, as I want to retire early. I’m all for putting as much away in a retirement portfolio, but if I have an extra $500 each month, I’m not putting all of it in my Roth or 401K because I’d have to wait til I’m older to use it. I think I’m going to be splitting the extra money 40/60 or something so I’ve got a little bit here and a little bit there.

    • Great start. I’d max out your Roth before investing in a taxable account. The Roth IRA is very flexible and you can withdraw your contribution at anytime without penalty. Good luck!

      • Thank you for the suggestion! I hesitate to do that because while I *could* withdraw the contributions, I don’t want to see it as another sort of banking account. Right now, I try to focus on it being another branch of income I’ll have at retirement and therefore currently untouchable; If I were to start withdrawing the contributions, I’d then have less to accrue income during my later years. Because I’m not entirely sure where else I’ll have money coming from (besides my 401K), I don’t know if I want to shift that mind set? I really don’t know.

  17. One should max out their Roth before 401k. You yield a far larger tax benefit garnering a non trivial tax tax benefit from all gains accrued from start to retirement. 401k just saves you point in time taxation which is not that much. No compounding effect takes place.

    • If your employer doesn’t match, then it’s probably a good idea to max out the Roth first. If you’re in a high income tax bracket, I’d say the 401k is still a good option. You can always do the Roth conversion in years with low income.

    • If you’re a high earner, you should ALWAYS max out a 401k (which saves you at your highest marginal tax rate; when you withdraw, it will be at the lowest brackets first) before doing a ROTH IRA. Paying 28% tax to contribute to a ROTH, so that you can take out the money and avoid 10% marginal tax rate on it makes no mathematical sense.


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