If you want to retire early-- Stop overfunding your 401k.
Updated: Jun 8
Far too often I speak with young professionals that dream of retiring early. A lot of the time they believe they are on the right track to accomplish this feat by contributing large amounts to their 401k. When in fact this behavior is just solidifying their LATE retirement. Now it isn't their all their fault--Because most of a young adults financial education ends at "max out your 401k".
But for those that want to retire early they need to look past the 401k. They have to include another very important piece to this retirement puzzle. That piece is the BRIDGE ACCOUNT.
WHAT IS THE BRIDGE ACCOUNT?
The bridge account is the account that will "bridge" the moment from when someone quits their crappy old job until the moment they are allowed to access the retirement accounts that have been patiently growing. This account has to be accessible cash. Ultimately the only option for this account will be a traditional taxable account.
WON'T A TRADITIONAL TAXABLE BROKERAGE ACCOUNT GET HIT WITH HEAVY TAXES?
No, not necessarily. With the correct financial guidance we can avoid a large portion of the taxes that eat away at non-retirement accounts. Just follow these steps.
Avoid at all costs any and all Mutual Fund investments in this traditional account. Mutual funds will have something called "turn over rate". This is the percentage that a mutual fund sell their existing positions. When this happens the investors, meaning you, will have to get ready to pay ordinary income on all of their short term capital gain sales within the mutual fund.
Positions that are sold after owning for one year are taxed at your capital gains rate. This is typically better then the ordinary gains option-- but still not ideal if we don't have to pay these at all.
WHAT IS THE IDEAL INVESTMENT OPTION THEN?
The answer is ETF's or index funds. Sounds boring, but this is the answer to lowering your tax burden when trying to accomplish the early retirement goal. This is where financial planning or speaking to a financial advisor makes a lot of sense.
Index funds don't have the "turn over rate" tax implications that mutual funds have. This is a massive tax avoidance that will occur over possibly decades.
There is the possibility to avoid capital gains taxes when owning an index fund. Of course if you sell a position there will be capital gains tax. However, what if you never had to sell the index fund? Thusly postponing a capital gains tax for years to come.
How do you do this: Own an incredibly diversified "weighted" index fund. I typically choose one that owns over 7000 stocks all around the world. The "weighted" component is also key. This simply means the fund will automatically re-adjust funds allocated within the index fund to companies that are gaining in market cap. Therefor capital is allocated to companies as they become stronger. This situation provides a balancing act without incurring capital gains taxes.
IF THE GOAL IS EARLY RETIREMENT- THEN SENDING THE BULK OF ONES PAYCHECK HAS TO FIND THE "BRIDGE ACCOUNT"
The biggest enemy to a bridge account isn't taxes. The ultimate enemy to the bridge account is time. Retiring early isn't easy--if it were then everyone would have accomplished this feat.
Situation: A 25 year old decides they would like to retire early at 45 years old with $70,000 per year until they can access their retirement accounts at 59.5 years old. We are also going to use a withdrawal rate of 10% per year from the bridge account. I know this seems high but it is actually the average withdrawal rate from retirement accounts in the United States.
As you can see in the figure to the left, if a 25 year old contributes $12,000 per year to their bridge account, they will have $750,000 when they are 45 years old. This is also assuming we are receiving the S&P500 historical return average.
THERE IS ALSO ONE LARGE PIECE MISSING FROM THE ABOVE EQUATION: INFLATION
Inflation has to be factored into all financial plans. In this one we are aiming for $70,000 per year in today's 2021 dollars. In 2041 dollars, $1,354,000 is equal to our $750,000 in today's purchasing power when factoring a yearly inflation rate of 3%. So our early retiree dreamer will have to fund their bridge account with $21,000 per year.
HOW TO FUND THE 401K IF YOU WANT TO RETIRE EARLY
First, it is important to understand that expenses is extremely important when trying to live on investments. This rings true for days living from the bridge account or the future with retirement accounts. The expenses can't be ignored but for this article we are going to stay focused on the other pieces.
An investor must secure the most money a company is willing to contribute. Leaving free money on the table is just an absolutely no-no.
If we are serious about having $70,000 when retirement begins at 59.5 then we have to begin contributing $14,000 per year into the 401k from years 25-45 years old. This is assuming the company matches 50% of contributions up to 6% of your salary at $70,000 per year in today's dollars.
The time equation is why over contributing to a 401K can nuke an early retirement attempt. Time is our friend in the 401k account because it has time to compound. It doesn't need as much in contributions during your working years as the bridge account will require.
TOTAL CASH GOING INTO THE BRIDGE AND 401K ACCOUNT EACH MONTH: $26,000 (MINUS THE COMPANY MATCH).
WHAT TYPE OF 401K ACCOUNT SHOULD BE USED? TRADITIONAL OR ROTH?
The answer is Roth, Roth, and Roth. There are two significant reasons the Roth is the better choice for an early retirement attempt then the traditional counterpart.
All of the money contributed is after tax dollars. This means the money entering the account has already been taxed today. The money then grows tax free and is 100% your once the age of 59.5 has been reached.
Roth accounts aren't subject to required minimum distributions (RMD's) at 72 years old. These RMD's can really begin to eat away at a retiree's account in their later years. This also leaves left for their heir's when the time comes.
The Roth account has a huge health insurance advantage. AN ABSOLUTELY MASSIVE health insurance advantage. Please understand that people are not eligible for Medicare until age 65. That means the retired 59 year old has six years Obamacare premiums. These premiums can be enormous if there is a lot of taxable ordinary income. All withdrawals from traditional 401k accounts are counted as ordinary income. This will be an enormous hit to a retiree pulling $70,000/per year from an account.
Why is the Roth going to help? Well remember, this income has already been taxed during the retirees working years. The money can't be double taxed. Therefor it won't count as ordinary income when applying for Obamacare. The retirees income will look minimal. Ultimately, allowing the retiree to qualify for huge Obamacare credits and a very low health insurance premium.
John Lawrence is a financial advisor and owner/founder of J.A. Lawrence Wealth Management.
J.A. Lawrence Wealth Management specializes in creating financial plans and portfolio management.