The 401k plan is a wonderful retirement savings tool. Considering most people will continue to work until social security kicks in at age 62, the 401k’s 59 1/2 year penalty free withdrawal age is actually quite reasonable. But for those of us hoping to retire even earlier then 59 1/2 years of age, does it make sense to contribute to the 401k?
You should absolutely be contributing to your 401k plan regardless of your current age or the age you plan to stop working and retire. By contributing pre-tax earnings, your 401k account will continue to grow tax free for years to come. Also, most employers offer a company match. Not contributing is like turning down free money.
It is likely that you will rely on funds from several different sources to fund your retirement. The 401k being just one of them. Do not plan for the 401k to be your only source of income in retirement. If you are planning to rely on it as such then you are doing it wrong.
There are advantages and disadvantages to a 401k plan regardless of your intended retirement age. What is important is that you examine both and come up with a plan that works for your goals. Hopefully, by outlining the good and bad here, I can help you to gain a better understanding. In turn, you can successfully plan for the great escape from the rat race.
Disadvantages of contributing to a 401k plan of you are hoping to retire early
OK Bad news first. There are several disadvantages to contributing to your 401k plan especially if you are intending to retire before age 59 1/2.
#1. You are not liquid.
Money you are contributing to the 401k can not be spent without penalty until you reach age 59 1/2. So if you are 45 and have a serious emergency, you can’t access those funds without paying a large penalty.
There are such things as loans available, but there are limits to them and payback schedules, interest, etc. If you wish to have 100% access to your 401k you have 2 choices. Wait until retirement age or pay a penalty and give up some of the money.
#2 Taxes
While you are contributing to your 401k plan tax free now, and you are earning gains tax free now, you better believe at some point you are going to pay the government those taxes. When you begin to take withdrawals from your 401k, they will be taxed as income. You have not contributed tax free, you have simply deferred those taxes to a later date. Many retirees actually find themselves in a higher tax bracket after they retire. Furthermore, they do not educate themselves adequately and fail to plan for this. This results in them experiencing a shortfall in their cash flow.
#3 Required minimum withdrawals
Most people don’t know this, but the government actually requires you to make withdrawals from your 401k starting at age 70 1/2. And the minimum withdrawal increases each year as you get older. As I mentioned before, the government will get their hands on their portion at some point.
What this means is that you can not just allow those funds to sit and grow and grow and grow deferring taxes until you are 90 and then leave the money to your great grand children.
Advantages of contributing to a 401k plan if you plan to retire early
# 1 Tax free contribution
The fact that you can contribute you your 401k retirement plan directly from your earnings before you pay taxes is as much an advantage as it is a disadvantage. This is especially true in your younger years when you are first starting out.
Most young people just starting in their careers aren’t making much money. If can be tough in those years just to make ends meet, let alone have money left over for savings. Most people in their 20s aren’t thinking about retirement at all and the fact that these contributions are automatically taken from your income and placed into a savings account for you before taxes makes it a lot less painful whereas, were they left to do it themselves after taxes, most would not even make the attempt.
#2 It lowers your taxable income
This is directly related to the first advantage on our list. Because the funds are automatically taken from your income before taxes, it does not count towards your annual total taxable income thus lowering that dollar amount. It is quite possible you could be put into a lower tax bracket and pay less overall taxes leaving more money for you.
#3 Protection from creditors
Hopefully you never have to experience this, but your 401k plan is protected from creditors. This simply means you wont be forced to take money from your 401k to pay for the bad financial decisions you made in the past.
# 4 Company Match
Most 401k plans will have a company match. This is money the company contributes to your account to match the money you contribute. It is basically free money. For example, the company may offer 50 cents for every dollar the employee contributes up to $5,000. This is $2,500 of free money each year the company is offering. Take it!
To summarize, here are the key points you need to know about the 401k retirement plan before devising your strategy for how you plan to use it to help fund your retirement.
The 401k retirement plan allows you to…
- Contribute prior to paying taxes
- Grow your nest egg tax free
- Earn free money in the form of the company match
You must…
- Wait until age 59 1/2 before you can take penalty free withdrawals
- Pay income taxes on all withdrawals made
Because you can not begin to withraw money from a 401k plan until the age 59 1/2, it begs the question of someone hoping to retire at say age 50, Why should I contribute?
Here is the strategy I came up with that will allow you to take advantage of the 401K plan while still moving forward aggressively with your early retirement plans.
How and why to contribute to your 401 k plan in your 20s and 30s
How much you plan to contribute to your 401k should be influenced by 2 factors. Your desired retirement age and your current age as well. Someone who is 25 now and wants to retire at 55 is very different from someone who is 45 now and wants to retire at 50 or even 60.
In your younger years you will have more time on your hands to grow the money in your 401k. Compound interest will be kinder to someone who allows it to work for them for 30 years vs someone who only has 10 years.
Some people will give a 20 year old kid bad advice. They will tell them they have all the time in the world to save and shouldn’t be thinking about retirement. Those people probably failed to think about it in their 20s themselves and now find themselves unprepared for the future. If there is one thing I hope I can teach my own kids about money it is the importance of saving and to always pay yourself first.
The best thing you can do in your 20s and 30s in my opinion, is to contribute as much as you possibly can without putting yourself in debt. This will allow more money to grow over a long period of time. You will wake up one day in your 40s or 50s and be shocked at how your account has grown.
How much to contribute to your 401k plan in your 40s and 50s
In your later years how much your contribute and your reasons for doing so will be very different then they were in your 20s and 30s. Hopefully, by the time you have reached your 40s or 50s you have already made the necessary steps required to put you in position to retire early.
The answer to the question of how much to contribute really depends on how much you have saved so far. Also, when you plan to retire. If you have not done any proper saving until you reach your 40s or 50s, you ain’t retiring early. I suggest you contribute the absolute maximum allowed including any catch up contributions you may qualify for.
Conversely, if you managed to do some saving along the way, you may be able to stop contributions altogether.
Here is what I did.
Once I realized my 401k was self sustaining, I lowered my weekly payroll contribution. I contributed the absolute minimum required to achieve the full company match. What I mean by self sustaining is that the account had reached a level that I did not need to contribute another dime to reach my goal total by the withdrawal age provided the continuation of a steady 7% market increase.
For example, lets say you want to retire with $2 million in 10 years. You are 45 years old and your 401k has a balance of $1 million. You can safely assume that if you continue to receive about 7% annually, you will double your money and reach your goal well before the minimum withdrawal age of 59 1/2.
After I lowered my contribution I took the difference between the minimum I was still contributing and my old contribution amount and I invested it into my own personal brokerage account. This was, of course, after taxes and would now be available to me to use, penalty free, at my will. The only taxes needed to be paid were for any capital gains or dividends I had received.
The bottom line is, there are a million different strategies that can get you to the finish line effectively. The important thing is that you educate yourself on the advantages and disadvantages of each and make a well informed decision that best suits you.
For more information, check out my helpful guide to 401k early cash out
Good Luck
Earl