Should you invest in your 401k if you plan to retire early? (2024)

Some readers brought up an interesting point in response to the 3 Ways To Define Financial Independence. Should you count your 401k and IRA when you calculate your Financial Freedom Ratio*? You can’t access these tax advantaged retirement funds without penalty (10%) until age 59-1/2. If you plan to retire at 40 or 50, wouldn’t it be better to invest in a taxable account so your saving is easier to access?

*Financial Freedom Ratio (FFR)= investable asset/annual expense. If your FFR is over 25, then you’re close to financial independence.

First of all, I count our 401k and IRA in our investable asset. We don’t plan to access them until we’re 60, but they are invested and they are growing. I wouldn’t have been able to justify quitting my job if I discounted 50% of our net worth. Here is our withdrawal plan.

• Age 40 – 60: Support our lifestyle with Mrs. RB40’s paychecks, my online income, dividend from taxable account, rental properties, and P2P lending. We can draw down from our taxable account as needed.
• Age 60-70: All of the above plus withdrawal from 401k, IRA, and Roth IRA.
• Age 70+: All of the above plus social security benefits.

For the next 20 years, we plan to have some active income to supplement our passive income. If Mrs. RB40 retires before she turns 60, then we can draw down our taxable account first and then possibly our Roth IRA contribution (no penalty.) Once we hit 60, then we will start taking distribution from our 401k and IRA. The retirement funds are a big slice of the pie and they absolutely should be counted in your investable asset, even if you don’t plan to use them until later.

For my situation, this works well because we don’t need to withdraw from our 401k and IRA until we’re 60. What if the income from your taxable account isn’t enough to support your early retirement and you can’t generate active income for some reason? Even then, I think everyone still should contribute to their 401k and IRA as much as possible. There are ways to access those accounts without having to pay the 10% penalty.

IRS Rule 72(t)

One way to access your 401k and IRA is through the rule 72(t). The rule is a bit complicated and you can read more about it in the post I wrote last year – Should you use IRS rule 72(t) to access your retirement fund? Basically, you’ll withdraw a certain amount from your IRA every year. You’ll have to pay income tax on it, but you won’t have to pay the 10% penalty. The big risk is the chance of depleting your portfolio before the end of your life. Lastly, you’d need to keep withdrawing for at least 5 years or until you turn 59-1/2, which ever is later.

If you’re 40 and have $1,000,000 in your IRA, then you can take out a little over $30,000 per year with the rule 72(t). That’s about 3% so it’s not bad.

Roth IRA conversion ladder

Another way to access your retirement fund is through the Roth IRA conversion. You can build a Roth IRA ladder and withdraw without having to pay the 10% penalty.

1. Roll over 401k to IRA.
2. Convert 1 year of living expense to Roth IRA. (You will have to pay tax when you do this.)
3. Wait 5 years.
4. Withdraw 1 year of expense from the Roth IRA.

Just repeat this every year until you’re 59 ½.

The drawback here is you have to wait 5 years before you can take out the first chunk of money without penalty. The 5 years wait only applies to Roth IRA conversion. If you contribute to your Roth IRA outside of a conversion, then you can withdraw that contribution anytime without paying the 10% penalty.

The Adhoc Approach

Disclaimer: I am not a tax consultant or financial planner so please talk to a professional if you plan to take early distributions.

I’m not sure, but it seems like you can use rule 72(t) while building your Roth IRA conversion ladder. You can take the 72(t) distribution for five years and then stop. After that, you can withdraw from the Roth IRA conversion ladder. Does anyone know if there is anything wrong with this plan?

I also think it’s a good idea to have some active income during the first part of retirement. The Adhoc Approach is to work a little, build up some passive income, use the rule 72(t), withdraw some contribution from the Roth IRA, and use your creativity to fund early retirement.

Contribute to your 401k

In conclusion, I think everyone should contribute to their 401k as much as they can while they have the income to do so. The 401k has the benefit of employer matching and tax deduction so you’re saving more than you can in a taxable account. This year I will contribute quite a bit more than the $17,500 maximum in my solo 401k and I will keep it up as long as I can. The only reason why I wouldn’t invest is if your 401k doesn’t have employer matching AND the plan is just plain bad.

There are ways to access the IRA without having to pay the 10% penalty so I don’t think you should worry too much about that. The 401k is a very useful tool whether you plan to retire early or at a normal age so please take advantage of it.

Are you maxing out your 401k contribution? If not, what’s stopping you?

Related article: What if you always maxed out your 401k.