Mr. Everyday Cat Already Well into Retirement

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, lets 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 doesnt have its fingers in ityet!
• When you retire and make withdrawals from your plan is when you pay the taxman. Youll be taxed at your income tax rate, which should be lower like the 10% or 15% bracket because youre 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 youre 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 IRSs 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. Theres 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; youre 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.

My Choice

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%. Thats 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. Its 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 .

Whats been your strategy for saving the money youll use for early retirement? What other options are there besides the ones I mentioned? I know theres a lot of smarter people than me reading this blog, whats the best way to approach early retirement from a tax standpoint?

thechicagofinancialplanner.com/ Roger Wohlner

Couple of comments: 1) I suggest analyzing your expenses and, if taxes are your biggest expense, then you should try to cut down taxes by maxing out traditional 401ks/IRAs. 2) If you are getting a higher return from your individual stocks as compared to the S&P 500, do you try to determine if its simply more risk (compensated by higher return) thats responsible?

Great tips John. It is a very important exercise to see if you can slip into a lower tax bracket by committing more money to a 401(k) or IRA. Unfortunately, I would not be able to get down into the 15 or 10% brackets in doing so.

mreverydaydollar.com/3-reasons-not-to-invest-in-index-funds/ .

I really like the idea of a 72t. My plan is to get enough money in my retirement accounts to total 1 1.5M, roll everything into one IRA, and then pull the plug and retire at 45. Using the calculator from above, that would give me 40 60k / year which should be plenty of money to live on considering we will have some rental properties pay off shortly after I turn 45, and the house we will be living in will be paid off. All in all, I am looking at 40 60k / year plus another 20k in rental income which I think should do the trick to free my self from the man and try out the FI/ER life. Pulling 40 60k from my master IRA with it having 1 1.5M should not change the balance all that much, and then I can take a substantial raise if I want to when I turn 59 1/2. Am I missing something?

mreverydaydollar.com/ Mr. Everyday Dollar

Hi David, youre not missing anything. If you havent already, it may be prudent, now, to talk to a professional who has set this up for a client to make sure you know what will be involved, as it is rather complex. That way, no surprises down the road.

Depending on your expenses, it sounds like you will have plenty of money available via SEPPs to live on, but youre also buying yourself some protection with rental income, great.

mreverydaydollar.com/retirement-income-planning/ for some guidance.

Well done, let us know how it turns out!

www.hereverycentcounts.com/ hereverycentcounts

I wish my employer matched my 401k investments. Ive never had access to 401k match. I just max out my 401k ($17500) and try to invest at least $2000 more a month in taxable accounts (Vanguard & Sharebuilder.) My goal is to increase my networth $50k $75k per year while Im still single. I have $259k in networth right now and my goal this year is $325k. Im 30 years old and I want to have $500k networth before I have a kid, so if Im good and the markets cooperate I should be at $500k by the time Im 33. Id like to have my first kid at 33 and my second at 35/36.

Hi Joy! Thats unfortunate that youve never had 401(k) match, but it sounds like youre doing an awesome job without it! Im also completely astounded by the folks that do have match yet leave money on the table by either not contributing at all, or not contributing up to the max.

hereverycentcounts.com/my-portfolio