Early Retirement 401K Investing

Motivation behind investing in a 401K

Having started a new job, and being thrown in the depths of all that is the adult world, one thing I learnt about is retirement savings primarily through 401Ks and Roth IRAs. Contributions to a 401K are tax deferred which is just a fancy way of saying that instead of paying taxes on it now, you pay taxes on it when you withdraw the money. This is great if you know you’ll be in a lower tax bracket when you retire. It means that instead of earning $1 now, giving 30 cents in taxes, and investing the remaining 70 cents. You can invest the full $1 right now, and then pay 15 or 20 cents tax when you’re 65.

Downside to 401K

As always, there is a catch to this. Any withdrawals you make from a 401K before the age of 55 incur a 10% penalty fee.

The loophole

Let’s say you want to retire earlier than 55, or you need some of the cash in your 401K for whatever reason. One option is to just withdraw the cash now and take the 10% hit. If your employer matches your 401K contribution, this might seem like a great idea because for the $1 you contributed, you still got $1.90 back. If you know you’re going to need this cash though, with a little bit of planning you can get the full $2. The way to do this is to roll over the 401K into a Roth IRA. You will pay full taxes on whatever you rollover based on your current tax bracket. The advantage, is that you can withdraw the principal from a Roth IRA after 5 years. Withdrawing the principal means you can only withdraw what you put in at the time, not any interest you may have gained on it.

Comparison with other approaches

To clarify with an example, let’s say you contributed $1 to your 401K, and your employer matched 100% of it for a total of $2 in your 401K. Let’s say you left it there for 2 years with an interest rate of 8%, so at the end of 2 years, you have a total of $2.33 in your 401K. Now you roll that over to a 401K, and let’s say you pay 15% tax on it. So your total rollover amount is $1.9805. After 5 years, with 8% interest, your Roth IRA will have a total of $2.91, of which you can withdraw $1.9805 leaving a total of $0.9295 in your Roth IRA. If you’d left it all in your 401K, you’d have $3.43 in the account, and if we assume you were 55 and withdrew it at a 15% tax rate, then you’d have $2.9155 in hand which is slightly more(or significantly more depending on the number of zeros in your real investment) than the rollover approach. If you had more years to retirement, your investment would also grow more with the full 401K approach, so if you know that you won’t need the cash until 55, then that approach is probably better for you.

Let’s say in comparison you tried to invest your $1 the regular way. So you paid taxes on it based on your current tax bracket of 25%. So you have $0.75 left, and invested it for the 7 years with an 8% tax rate, that will result in a total of $1.29.

Note that this does require you to be in the lower tax bracket at the time of rollover, which is 5 years before you can see the money, so it requires some planning on your part, and won’t work for an emergency situation.

Why not just invest in a Roth IRA to begin with? Well for one you pay taxes on your $1 right now. The yearly contribution limit is also only $5000 in comparison to the $17,500 of the 401K.