Retirement. Ahh, life on the golf course, pants hiked up well past the waist, watching the Wheel of Fortune, dinner at 4:30 PM, and a big ole retirement account. I recently learned something new about 401(k) plans that should be of interest to the FI (Financially Independent) / RE (Retire Early) folks. It freaked me out because it caused me to question the strategy I am using to reach financial independence. But it all turned out okay.
First, let’s review some basics about 401(k) plans – and their cousins 403(b), 457 and TSP:
- You decide what percentage of your income you want put into your plan and you decide what you want the money invested in.
- Some employers will kick in extra dollars for you which is called a matching contribution. This is usually a 50 cent match for every dollar you contribute up to a certain percentage (say 3%-6%).
- Plans differ on the investment choices you have but they are typically something like index funds, mutual funds and the new kid on the block: target date funds.
- The money you contribute comes out of your pre-tax income so the IRS doesn’t have its fingers in it…yet!
- When you retire and make withdrawals from your plan is when you pay the taxman. You’ll be taxed at your income tax rate, which should be lower – like the 10% or 15% bracket – because you’re not working anymore.
- If you withdraw money earlier than age 59.5 you will pay the taxman as noted above plus a 10% penalty.
- In 2012 you can contribute up to $17,000 if you are under 50 and up to $22,500 if you are over 5o.
- Overall, 401(k) plans are useful for the tax breaks and, if you’re lucky, a matching contribution which is free everyday dollars!
So what I ran across is an IRS rule called 72t. What better to read about it than in the IRS’s own jargon:
“Section 72(t)(2)(A)(iv) provides, in part, that if distributions are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancy) of the employee and beneficiary, the tax described in section 72(t)(1) will not be applicable.”
I highlighted the most important part of this. And yes you read that right, tax will not be applicable. What exactly does this mean? Well, it means that before age 59.5, you can withdraw money from a retirement account – an IRA or 401(k) – without penalty by taking distributions called Substantially Equal Periodic Payments (SEPPs). However, the money is still taxed at your income tax rate.
I freaked out because I thought to myself, “I could have been maxing out my 401(k) while getting a very nice tax break and then used our friend 72(t) to pay myself without penalty when I retire early.” So it was time for an investigation.
Strategy 1 : The 72(t) Loophole Approach
A person maxes out their 401(k) and uses the 72(t) rule to take distributions when they retire early. There’s a definite benefit here in that the money going into your 401(k) is tax deferred. One of the downfalls of this strategy is that most 401(k) plans have limited investment options; you’re typically stuck with some managed funds to pick from.
If this strategy fits your situation, you need to max out your 401(k) contribution to the maximum $17,000 and probably add the $5,000 annually to a Roth IRA to minimize your tax burden.
Of course, there are some complex rules about how you take distributions. I would suggest playing with a handy 72(t) calculator like the one at Bankrate to see what the SEPPs might look like.
If you are interested in 72(t) for early retirement it could be worth taking the time to talk through it with a tax expert.
Strategy 2 : The Mid- and Long-Term Two-Prong Approach
A person invests some money in a 401(k) and some money in a brokerage account. The brokerage account – the mid-term money – is where the dollars will come from to take the early retiree from retirement (say, age 42) to real retirement (say, age 65). The 401(k) – the long-term money – is where the dollars will come from to take the early retiree from age 65 the rest of the way.
This is a decent strategy because you take advantage of the 401(k) benefits but also have more options for investments with your brokerage account. One of the downfalls of this strategy is that a brokerage account is the least tax-efficient vehicle for your dollars.
However, a person might not be comfortable with investing money in a brokerage account. This is where other options for investing your mid-term money become limitless! Maybe your thing is becoming a landlord with rental properties, buying REITs, investing in municipal bonds (usually tax-emempt) ladders, peer-to-peer lending services like Prosper or Lending Club, holding gold bars and ammunition, or investing in a laundromat or car wash.
I use strategy 2. My long-term money is in a 401(k). If you get matching contributions, I would suggest that you not leave money on the table by contributing up to the company match. For me, my employer contributes 50¢ per $1.00 up to 8% of pay. And, because my employer eliminated the company pension, they put in another 4%. So I put in the 8% so I can get the free 4% plus the other 4%. That’s 8% of my salary I get for free just by participating in the 401(k) plan!
My mid-term money is in a brokerage account. I like the control it gives me over how and where I invest my money. What I currently do is automatically transfer a fixed amount of money every month from my regular savings account to my brokerage account. After that, I am free to choose where to invest it, which for me typically means individual stocks. I like to invest in individual stocks. It’s fun and I am able to eek out a few more percentage points than the S&P 500.
For a lot of great information on this topic, head to the Bogleheads.org article on tax-efficient fund placement.
What’s been your strategy for saving the money you’ll use for early retirement? What other options are there besides the ones I mentioned? I know there’s a lot of smarter people than me reading this blog, what’s the best way to approach early retirement from a tax standpoint?