Stop Overfunding Your 401(k). Do This Instead

[00:00:00]Most people implicitly assume you should contribute as much as you can [music] to your 401k, especially in the years leading up to retirement. But, there is a point where additional 401k contributions can become counterproductive. That is, there is a point where funding your 401k stops helping you and starts boxing you in.

[00:00:21]Many people don't realize this until it's too late to do anything about it.

[00:00:25]And that's especially true if you want the option to retire early. I've seen people with seven figures saved who struggle to figure out how to retire at 55. Not because they don't have enough money, but because of where the money lives. I've also seen people scared to death to live off their portfolios in retirement because of the tax implications of doing so. Luckily, there are strategies wealthy pre-retirees can use to continue to save for retirement without creating future tax headaches for themselves. And that's what we're going to talk about today. By the way, I'm Eric Gouge. I'm a chartered financial analyst and a certified financial planner. I use this channel to pass what I've learned along to you. If you appreciate this content, it would genuinely mean a lot to me if you gave me a like and a subscribe. Okay, let me be clear about something up front. The 401k is a great account. You get a tax deduction today, your money grows without being taxed along the way, and most employers throw in a match on top.

[00:01:27]I'm not here to tell you contributing to your 401k is a mistake. But, the whole system is built around two pretty big assumptions. The first assumption is that you will retire after the age of 59 and a half. And the second assumption is that you'll spend less in retirement than in the years leading up to retirement. The first one is just a restriction. Your qualified money is in jail until age 59 and a half. Pull money out of pre-tax accounts before that age, and in most cases, you'll owe regular income tax on it, plus a 10% penalty on top. So, picture someone who's 50 years old and has a million and a half saved [snorts] in a pre-tax account, and wants out at, say, 55 years old. If nearly all of that money sits in a 401k or a traditional IRA, or both, they have a problem. On paper, they're wealthy. In practice, most of their money is behind a gate that doesn't fully open for several more years. The second assumption that you'll spend less in retirement than in your working years is certainly not a guarantee, and I would argue that the lower the age at which you retire, the less likely this assumption is to be true. Because in your 50s and your 60s, [music] you have plenty of life ahead of you, and you are still likely in good enough health to do all the fun things that are on your bucket list. Now, you might be wondering what makes these assumptions about 401ks. Why why is it that saving in a 401k assumes that I'll retire after 59 and a half, and assumes that I'll spend less in retirement in retirement than before retirement. Well, for in the first place, there's a penalty if you use your money before the age of 59 and a half. So, the implicit assumption is that you will at least wait until the age of 59 and a half. The second assumption is that it's generally not valuable to defer taxes at a lower rate, and pay them at a higher rate, which is what would happen if your income increases in retirement than versus before you retire. Which is to say, if your income is higher in retirement than before you retire, it's very likely that the tax bracket you are going to be is going to be higher than the tax bracket when you're working. Which is to say, why would you defer paying taxes at 22% only to pay them later at 24%, or why would you defer taxes at 12% only to pay them later at 22%, or any combination?

[00:03:50]The point is is that these assumptions are not guarantees. They are certainly not definitely destined to play out this way. And this is why I'm a huge advocate for tax diversification in your retirement savings. That's just a fancy way of saying you should keep your money spread across account types that get taxed differently. You've got pre-tax accounts. These are the ones we've been talking about, the traditional 401k and IRA. You've got for Roth accounts rather, where qualified withdrawals come out tax-free. Whatever money you put into a Roth comes out tax-free no matter what. And you've got taxable accounts, which are just regular investment accounts with no special tax wrapper or anything like that around them. If everything you own sits in that first bucket, then retiring early gets complicated fast because we don't necessarily know when we're going to retire. We don't know how much we're going to spend in retirement, and we don't know what our tax rate will be or even what the tax code will say in retirement. Now, some of you are already typing in the comments. I can hear it. I can hear your keyboards clacking from here. They're You're saying, "Eric, what about the rule of 55?" Or "Eric, what about section 72t?" Fair. Fair enough.

[00:05:02]Let's talk about it because these are real options, and people really do use them. The rule of 55, for example, says that if you leave your employer in the year you turn 55 or later, you can pull money from that employer's 401k without paying any 10% penalty. You still owe income taxes, of course, but you you skip the penalty. But there are catches with the rule of 55. It is not a guarantee. It only applies to the 401k at the job you just left, for example.

[00:05:32]It doesn't apply to IRAs. If you want it to apply to your IRAs, you need to roll your IRAs into your 401k before you leave your job. And it doesn't generally apply to old previous employers' 401ks.

[00:05:45]Your plan also, even if you check those boxes, your plan also has to allow for flexible withdrawals and not every plan allows for that and it does nothing for you if you want out at say age 52, for example. So, the rule of 55 is certainly not a guarantee. It's just another hoop you have to jump through. Then there's IRS code section 72T, sometimes called substantially equal periodic payments.

[00:06:10]In plain English, you agree to take a fixed series of withdrawals from your account every year calculated using an IRS formula and in exchange, the penalty goes away. But there are a bunch of catches with this one. For example, the formula that you choose is generally locked in. Once you start, you have to keep taking those exact payments for either 5 years or until you turn age 59 and a half, whichever is longer. If you break the schedule, even by accident, and the IRS can go back and apply penalties retroactively all the way back to your first withdrawal. So, yes, there are escape hatches and yes, they exist, but here's the thing, even when they work, they can create a new problem and this next part is the piece that most people miss. Every dollar you pull out from a pre-tax account counts as ordinary income on your tax return. So, if you need to pull out $100,000 for a new purchase, then you really need to pull out perhaps $125,000 in your late 50s, for example, is likely when you are trying to keep income low for a number of reasons. Here's why.

[00:07:19]There's a window that a lot of early retirees hit that I call the retirement income valley. The paychecks from your employer have stopped, Social Security hasn't started yet and the required withdrawals from your retirement accounts are still years away. In those years, your taxable income can drop to almost nothing and that opens up some of the best planning opportunities you'll ever get. The first one is with regard to health insurance. If you retire before the age of 65, you're not on Medicare yet. So, you're probably buying coverage through the Affordable Care Act Marketplace. The government can subsidize those premiums that you pay for your health care through something called the premium tax credit, and the size of that credit depends on your income. So, keep your income low and your health insurance might cost a fraction of this sticker price. But, every pre-tax dollar you withdraw pushes your income up, and that can shrink or even eliminate your credit. The second reason people try to keep income low during this period is Roth conversions.

[00:08:23]That's when you move money from a pre-tax account into a Roth account. Pay tax You pay taxes on it now and let it grow tax-free from that point forward.

[00:08:33]The valley years can be the cheapest time you'll ever have to do this because you can convert while sitting in low tax brackets. Your income is bare bottom after all, so you will be in very a very low tax bracket. A third related opportunity here is called capital gain harvesting, and this lets you pay 0% taxes on income from taxable brokerage accounts under certain thresholds. Now, here's the conflict. If you're living off pre-tax withdrawals, those withdrawals compete for the exact same low brackets you wanted to use for conversions, your Roth conversions, or health care premium tax credits. You can't fill the same bucket space twice.

[00:09:13]So, even if the rule of 55 or 72t gets you access to your money, which is just another hurdle you have to jump through to even get access to your money, even if that you get that access, you might find yourself uncomfortable actually using it because every withdrawal is competing for your health insurance premium tax credits and your conversion strategy. And that's the trap.

[00:09:37]Basically, by having all your money in a 401k, access to your funds is more difficult, less flexible, and not very tax-efficient. Okay, so that's the problem. Now, here's the fix. Consider redirecting some of those savings to a taxable brokerage account. That's just a regular investment account. No special tax treatment, no contribution limits, and no age restrictions. And I see this all the time. I see a lot of people who show up at my door with a healthy 401k and then like $200,000 in a high-yield savings account or or or or a bank savings account of some sort. You can and perhaps, depending on your situation, should consider putting some or all of that money in a taxable brokerage account. Now, you should have a certain amount of cash on hand for emergencies and expenses that you are know that you know that are going to come up at some point during the year.

[00:10:29]I'm not saying that you shouldn't, but having too much cash on hand is a in itself a risk. You can put as much into these accounts as you want and you can take out as much as you want at any age with no penalty because there's no special tax wrapper around a taxable brokerage account. And here's the part, rather, that people underestimate. The taxes on a taxable brokerage account are surprisingly gentle. When you sell an investment in a brokerage account, you're only taxed on the gain. You're not taxed on the whole amount. Part of every sale is just your money coming back to you, and that part is tax-free.

[00:11:06]And if you've held the investment for a year or longer, the gain gets taxed at what's called long-term capital gains rates, which are lower, sometimes far lower, than ordinary income tax rates.

[00:11:19]Some or even all of those gains can potentially land in the 0% capital gains bracket. So, being diversified across tax-deferred and taxable accounts sets up cool strategies such as partially funding living expenses with pre-tax accounts to keep taxes low now and then funding the remaining living expenses with your taxable brokerage account to simultaneously take advantage of the 0% long-term capital gains tax bracket.

[00:11:49]Taxable brokerage accounts, like Roth IRAs, are also a great way to hedge against a future undetermined tax code.

[00:11:57]Let me make this concrete. Say a couple retires at 56 and needs $150,000 to live on for the year. If all of their funds were in a pre-tax 401k or IRA and they use the standard deduction and assuming they have some way to access those funds penalty-free, their tax bill for the year would be about $15,300.

[00:12:22]It'd actually be $15,340 if you wanted to be precise. If instead they had a sizable taxable brokerage account alongside their 401k or IRA that was, let's say, 75% gain and 25% basis, not only would they avoid having to jump through the hoops to access their funds, they can pull those funds from the taxable brokerage account at any point, but they would literally owe zero taxes due to the 0% long-term capital gains tax rates. The reason this works is because in an account with 75% capital gains and 25% basis, only 75 cents of every dollar is taxable. If they need $150,000, that comes out to $112,500.

[00:13:10]That's just 0.75 * 150,000 of realized income. So, $112,500 of realized income.

[00:13:16]Meanwhile, the standard deduction for this couple would be $32,200, which brings their taxable income down to $80,300, which is well below the threshold for the 0% capital gains tax rate. Now, of course, they wouldn't have to solely rely on their taxable brokerage account.

[00:13:35]They could, and I talked about this just a minute ago, they could, for example, pull $32,200 out of their pre-tax account to do a Roth conversion, perhaps, or to simply take advantage of the standard deduction. None of that money is going to be taxed because their standard deduction is $32,200, so it's going to be wiped out whether they do a Roth conversion or they simply use it for living expenses. But, in that scenario, they still wouldn't owe a single dime in taxes, and they would be reducing their pre-tax accounts, which would have the nice benefit, or side effect, rather, of reducing their future required minimum distributions. So, think about what the brokerage account does for the valley years. You can generate the cash you need to live on while keeping your reported income low. That helps protect your health insurance tax credits, and it leaves your low tax brackets open for Roth conversions. You live off of the brokerage account, and you use the empty bracket space to convert pre-tax money to Roth dollars at rates that you might never see again. The brokerage account isn't just an access tool. It can be the thing that strengthens your conversion or tax planning strategy in retirement.

[00:14:52]Now that you see how important tax [music] diversification can be to your retirement plan, if you want help determining whether this strategy is right for you, click the link below to schedule a free, no pressure call to analyze your specific situation to see if this applies to you. Okay, so, let's recap for where where we've been. The 401k can't box you in before 59 and a half. The escape hatches exist, rule of 55s, section 72t, there's others, but they come with catches and tax conflicts. And, the brokerage account is the flexible piece most early retirement plans are missing. So, what does funding your 401k intentionally actually look like? Well, first, whatever you do, I strongly suggest you keep, at the very least, capturing your full employer match. That match is an immediate 100% return on your money that no other account can offer you, and nothing in this video is going to change that. You should certainly take advantage of an of a match if you have access to it. After the match, though, the question gets a little more personal. If you're on track to retire at 65 or later, maxing the 401k beyond the match might not cause any big headaches for you. It's probably something that you would want to run some simulations on or model out to see how it impacts your future plan. But, perhaps it doesn't cause you any problems. But, if you want the option to retire early, perhaps at 55 or 52, some of those dollars might do more for you and a brokerage account or a Roth IRA.

[00:16:25]There's no universal split. It depends on your timeline. There When I say universal split, let me back up just quick a minute here. What I mean to say is there's no universal breakdown such as you should have 33% in your taxable account, 33% in your 401k, or 33% in your Roth IRA. Nothing like that exists.

[00:16:44]It depends all on your timeline, your tax bracket today, what you expect to spend in those early years, and thus what you expect your income to be in those years early in retirement and later in retirement. So, here are a few key questions worth working through, either on your own or with an advisor, to nail some of that down. Number one, when do you actually want the option to stop working? This is a tough question for a lot of people, but I do find asking when you would like the option is much easier to answer than when would you when do you want to retire? Because I think the truth is many people retire when they didn't necessarily expect it.

[00:17:25]And sometimes that decision happens much quicker than they otherwise would have expected. But I in my experience have met many people who can talk about when they would like the option to retire. So that's the first thing. Number two, what would you live on between and then in terms of funds with with with the money what would you live on between the ages when you stop working and 59 and a half if you want to retire early? Because you need to know that number and you need to be able to access those funds. And then number three, if I look at my accounts today, how many of those dollars would you be able to access without penalty or having to jump through a hoop? If that last answer makes you cringe a little bit, that might be your signal that you need to diversify your tax savings or your tax exposure rather a little bit.

[00:18:15]But here's the bottom line. The 401k isn't a bad account. It's not the enemy here. Over funding it on autopilot is a risk. Retiring early takes more than a big number on a statement. It takes money you can actually reach at tax rates you can actually live with. This is exactly the kind of planning we work through with clients at YNAB Advisory where I'm a fee-only fiduciary. That means for me the advice is the product.

[00:18:42]I don't earn commissions for selling you funds or life insurance or anything like that. If you're within about 10 years of retirement and you're wondering whether your mix of accounts can support the retirement you actually want, there's a link in the description to book a consultation with me. We'll look at your specific situation, not any rules of thumb, and tell you whether you are on track to retire. Thanks for watching. I will catch you in the next video.