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Worried about over-contributing to 401k & Roth?
Old 09-18-2004, 10:03 PM   #1
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Worried about over-contributing to 401k & Roth?

Hi All,
I'm 22 fresh out of college, and have just started working. I'm worried about over-contributing to my 401k and my Roth IRA because they are so very illiquid until you retire (early or regular...it's a long ways off for me). Right now my plan is to do 8% to the 401k (plus the max 3.5% employer contribution) and $3k per year to the roth. But what concerns me is that these funds will be unavailable for so very long (without paying 10% penalties and losing the tax benefits...and who wants to do that). Is this a valid concern? I am thinking of potential uses for the money down the road, things like buying a house, starting a business, who knows what opportunities could come along. Am I being silly about this?
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Re: Worried about over-contributing to 401k & Roth
Old 09-18-2004, 10:12 PM   #2
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Re: Worried about over-contributing to 401k & Roth

Quote:
Hi All,
I'm 22 fresh out of college, and have just started working. I make a decent salary and I have sizeable savings (in cash and savings bonds) but I'm worried about over-contributing to my 401k and my Roth IRA because they are so very illiquid until you retire (early or regular...it's a long ways off for me). Right now my plan is to do 8% to the 401k (plus the max 3.5% employer contribution) and $3k per year to the roth. But what concerns me is that these funds will be unavailable for so very long (without paying 10% penalties and losing the tax benefits...and who wants to do that). Is this a valid concern? I am thinking of potential uses for the money down the road, things like buying a house, starting a business, who knows what opportunities could come along. Am I being silly about this?
Hi soupcxan,

Well . . . you aren't being silly, but the 401K funds aren't as difficult to get at without penalty as you might think. Certainly, you want to have some emergency funds available before you put funds in a 401K or IRA -- so you don't have to go to the 401K funds over something trivial. But if you decide to retire very early or need your 401K funds before age 59 1/2, there is a 72t clause in the law that allows you to withdraw without penalty. The only catch is that you have to withdraw substantial equal periodic payments (SEPP) for at least 5 years.

You can read more about the details of the 72t at:

http://www.retireearlyhomepage.com/wdraw59.html

Good luck.
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 01:08 AM   #3
 
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Re: Worried about over-contributing to 401k & Roth

Hello soupxcan! I don't think you are silly either.
Once I found out about 72t, I researched the hell out of it as I was certain I would have to begin an early
withdrawal on my IRA. Eleven years later, I haven't touched it yet, one of the happy surprises of ER. It
looks now like my streak may be running out and I will
have to dip into it soon (60 now), but maybe not.
Stay tuned....................

John Galt
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 08:51 AM   #4
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Re: Worried about over-contributing to 401k & Roth

I asked this question a while back and it seems that it all depends on your age, how much you are saving in the Roth/401k each year, how much you think you need to retire on after 60, and what other sources of income will you have after 60.

I put together a spreadsheet for my situation, you are welcome to take a look, it can easily be modified.

http://cruisenews.net/independence/x...01kplanner.xls

I did it on Open Office but saved it in excel format, I hope it works for you.

The overview is that I estimated that I would need about 375K in Roth/401k plans to cover my retirement after age 60 (today's dollars). This is assuming that I will have other income plus social security for a total of $35K annual income, see the spreadsheet.

I would reach that amount in 15 years, contributing $15K each year. However, I will be age 58 then, so I don't have the benefit of a lot of time to compound interest. I am also starting out with 50K in the Roth/401k plan.

At your age, you could try maxing out your Roth/401k plan for about 10 years, then shift 100% of your investment to non-tax deferred plans to cover the period between your early retirement and age 60.

I am still trying to work out an overall plan but for now I just keep trying to save as much as possible and hope that as time goes on, all will be revealed.
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 09:14 AM   #5
 
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Re: Worried about over-contributing to 401k & Roth

Hello Skylark. I think you are on the right track, although 15 years to wait sounds like an eternity to me. One thing you can be certain of is that
"in time all will be revealed", sometimes too late to do you any good though.

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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 09:22 AM   #6
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Re: Worried about over-contributing to 401k & Roth

soupcxan,

Also be aware of something I just learned myself -- You can withdraw your Roth IRA contributions penalty free at any time. Earnings are another story.

And FYI, the yearly Roth contribution limit is going up to $4,000 starting in '05.

Good luck,

G.
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 09:36 AM   #7
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Re: Worried about over-contributing to 401k & Roth

Thanks for the advice everyone! I am aware of the 72t rule but my concern is that I might need to get a lump sum (not all of the retirement money but a portion of it) long before I am ready to start taking 72t distributions. For example, I know that I won't be ready to retire in 10 years, but what if one of my friends is starting a business and needs capital?

The choice is between:
1) Putting money in a taxable account where I get taxed up front and taxed every year on the gains, but having ready access to those funds.
2) Putting money in my 401k where I pay no taxes up front and tax on gains is deferred until a later day, but if I do ever need those funds, I will have to pay the taxes plus the 10% penalty.

Clearly, the 401k is the better place to put my funds if I know that I won't need the money (and with the $50k in savings bonds that I already have, maybe I won't ever need to get at my 401k). And even if I did that, the 10% penalty would still be an option if I absolutely had to.

As for the post about estimating my retirement needs, it's really difficult to forecast 30 years out into the future...I have no idea what my circumstances will be 10 years from now, let alone 30.
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 03:08 PM   #8
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Re: Worried about over-contributing to 401k & Roth

Hi soupcxan,

Go back and read G_Mack's post about ROTH
contributions. He speaks the truth!

Yea verily,

Charlie
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And if all that's not reassuring enough...
Old 09-19-2004, 03:45 PM   #9
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And if all that's not reassuring enough...

... first-time home buyers can also withdraw funds from their IRAs.

Take a look at the gospel-- <a href="http://www.irs.gov/pub/irs-pdf/p590.pdf">IRS Pub 590.</a> Only 101 pages!
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 05:33 PM   #10
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Re: Worried about over-contributing to 401k & Roth

John, I wish I knew of other options, but right now that is the best information I have to work on. Remember that I frittered and wasted my time in an offhand way before I started working a real job at age 36. In short, I ER'ed most of my youth backpacking in Europa, partying in the ghetto and cross country road tripping, and would do it again that way. Of course I did work at a lot of jobs to finance the lifestyle, but didn't really get a career job until 7 years ago. I figure that working for 20 years or so out of your life to get a house paid off and to get money saved up for the golden years is not too bad of a situation. Although having a taste of freedom, then being trapped in a career makes it all the more difficult.

I am overstimating my ER income needs, and hopefully underestimating return on investments, just to be conservative. When I get closer to deciding to ER, I will be able to work the numbers with better info, and probably cut a few years off of the waiting period before ER.
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Re: Worried about over-contributing to 401k & Roth
Old 09-19-2004, 05:43 PM   #11
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Re: Worried about over-contributing to 401k & Roth

soupcxan;

Your first priority should be the Roth, because at your age you have the potential to earn a lot of interest which can be withdrawn tax free after retirement.

Interest that you earn on the 401k will be taxed eventually.

I would suggest that you plan on reaching retirement age, and set aside money now to cover your living expenses then. I know it is a long way into the future, but the time will come. Once you have enough set aside for the after 60 years, then you can set yourself up for financing your early retirement between now and age 60.

Do as I say, not as I do.
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Re: Worried about over-contributing to 401k & Roth
Old 09-20-2004, 07:21 AM   #12
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Re: Worried about over-contributing to 401k & Roth

Quote:
The choice is between:
1) Putting money in a taxable account where I get taxed up front and taxed every year on the gains, but having ready access to those funds.

.
Wrong! You are indeed taxed up-front, but you don't necessarily get taxed every year in a regular account. Yes, you pay taxes on interest and dividend income, but if you buy and hold you pay no cap gains taxes until you sell. Its not that hard in a taxable account, but you just have to do a little planning to invest on a tax-efficient basis.

Since you think that you may have other funding needs in the next several years, I would suggest that you invest some in the 401k, some in after tax accounts, and perhaps some in a Roth. Try to figure out what your interim funding needs might be and save toward that bogey in the taxable account. Excess savings should go into the 401k, although make sure you get any employer match (best ROI on any low risk investment).

I know it is difficult to look so far into the future, but rest assured that no matter where you are in 10, 20, or 30 years, more savings will be better than less. The best thing I ever did was sock it away in my 20s. I maxed out my 401k, threw the limit in Roths and tucked away some nice amounts in a taxable account. I turn 31 today and we had our first child this year. Although I recently read the scary fact that the best predictor of bankruptcy is having kids, I am not in the slightest bit worried. Why? All our early work on savings has put us in the top 5 or 10% rank for net worth in the 30 to 39 year-old set. Unless I suddenly turn into a disastrous spendthrift, all I have to do is add modestly to my savings over time (under 20% of gross income, mostly tax-advantaged) and I will retire before 50 with more than enough dough to last the rest of my life. This is the time to pile it up and get time on your side. Once you have a solid financial foundation, you will have set yourself up for life. Do it!
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Re: Worried about over-contributing to 401k & Roth
Old 09-20-2004, 08:29 AM   #13
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Re: Worried about over-contributing to 401k & Roth

Good point, I was thinking of dividends and interest. So the solution is really to allocate my funds between the taxable, 401k, Roth, cash, and savings bonds accounts - easier said than done!

Quote:
Wrong! *You are indeed taxed up-front, but you don't necessarily get taxed every year in a regular account. *Yes, you pay taxes on interest and dividend income, but if you buy and hold you pay no cap gains taxes until you sell.
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Re: Worried about over-contributing to 401k & Roth
Old 09-20-2004, 08:43 AM   #14
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Re: Worried about over-contributing to 401k & Roth

Soup, I just looked at your blog. You are starting out in pretty good shape, but I gotta ask: why do you have the bulk of your net worth in savings bonds? Not much upside there. I also would just scrath the car off the balance sheet entirely, since it is a wasting asset that you are consuming.

With that much dough in savings bonds, you definately don't need to keep lots of extra cash around, since the bonds could be easily liquidated in an emergency scenario. Time to start moving towrad a higher trisk, higher return portfolio, especially at your age.
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Re: Worried about over-contributing to 401k & Roth
Old 09-20-2004, 09:19 AM   #15
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Re: Worried about over-contributing to 401k & Roth

well if you think the stock market is highly overvalued, and that interest rates will rise while inflation remains fairly tame and controlled, savings bonds might be a reasonable place to have the bulk of your money.

As it turns out, my dad built his portfolio of 100% EE bonds and retired successfully on that.
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Re: Worried about over-contributing to 401k & Roth
Old 09-20-2004, 08:30 PM   #16
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Re: Worried about over-contributing to 401k & Roth

Good question. The I-bonds were acquired over the last few years, mostly during the period when you could buy them on a credit card, get the 1% cashback bonus, cash them in 6 months, then buy them back again to get another bonus...eventually the treasury department wised up and I've just held on to them since then. A substantial portion of them are earning interest at 5.4% and 4.1% respectively, which is pretty good in my book for a (virtually) risk-free investment that is also tax-free. However, you may have a point about the portions at lower rates...I was/am fairly conservative because I saw the dot-com bubble on the way up during high school and the way down during college.

I also think the scenario proposed by TH is possible given the inflation in home values across the country driven by low interest rates plus the huge deficit spending by the government - so the SBs are a good hedge against inflation. But really, my savings bonds are my security blanket (aka my "oh ****" fund should a really good opportunity or a really bad disaster come my way) and I hesitate to give them up.

Agree with you about moving towards a higher risk/return ratio for my overall portfolio...but how to do it wisely? While the conventional wisdom says that I should take more risks because I am young.

Quote:
Soup, I just looked at your blog. You are starting out in pretty good shape, but I gotta ask: why do you have the bulk of your net worth in savings bonds? Not much upside there. I also would just scrath the car off the balance sheet entirely, since it is a wasting asset that you are consuming.

You definately don't need to keep lots of extra cash around, since the bonds could be easily liquidated in an emergency scenario. Time to start moving towrad a higher trisk, higher return portfolio, especially at your age.
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Re: Worried about over-contributing to 401k & Roth
Old 09-21-2004, 10:34 AM   #17
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Re: Worried about over-contributing to 401k & Roth

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I do agree with you that given the SBs, I have too much cash in the bank, and I'm moving some of it to my Roth and taxable brokerage accounts. Also agree with you about moving towards a higher risk/return ratio for my overall portfolio...but how to do it wisely? While the conventional wisdom says that I should take more risks because I am young...I feel like I have such a great starting position that I don't want to jeopardize it unnecessarily.
I can't tell you to do anything outside of your risk tolerance. Not much in the way of retuirns is worth it if you cannot sleep at night. However, if you do not accept some increased investment volatility, you will be unlikely to have high enough returns to grow much above inflation and you will have a much bigger pile to try and save.

I suggest that you look at the historical volatility and return patterns of diversified portfolios to see what kind of volatility and return trade-off you might find acceptable. Scott Burns (a columnist for a Dallas newspaper) has some neat articles showing how his simple "couch potato" portfolios performed over past years, including pointing out the max downside associated with them. I'd also point out to you that a 10% fluctuation either way for a year or two means very little if you do not expect to tap the portfolio for another 20 to 30 years.

Personally, I tend toward individual stocks. I like this approach because I can choose precisely the kinds of risks and rewards I will and won't be exposed to and it is a bit easier to remember that each position is a piece of a business, rather than some amorphous intangible index fund. However, this route requires a lot of education to do right, and it takes more work.
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Re: Worried about over-contributing to 401k & Roth
Old 09-21-2004, 10:41 AM   #18
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Re: Worried about over-contributing to 401k & Roth

All true. But he'll be one happy camper if the stock market drops 30-40% sometime in the next few months or years, and very happy if it just goes sideways for 10 years like it did in the 60's/70's.

I agree with good asset allocation, up to ones risk level. But many people DO retire entirely on government bonds, and for some time periods in our history, that turned out to be a pretty good idea.
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Re: Worried about over-contributing to 401k & Roth
Old 09-21-2004, 10:50 AM   #19
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Re: Worried about over-contributing to 401k & Roth

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However, this route requires a lot of education to do right, and it takes more work.
I'm not sure that's true. There are plenty out there with lots of education who do very poorly (viz. just about any managed mutual fund particularly over 10 year or more time frames). It's probably more true that it requires a lot of luck and the ability to imagine that one's luck was actually due to skill.
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Re: Worried about over-contributing to 401k & Roth
Old 09-21-2004, 11:12 AM   #20
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Re: Worried about over-contributing to 401k & Roth

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I'm not sure that's true. *There are plenty out there with lots of education who do very poorly (viz. just about any managed mutual fund particularly over 10 year or more time frames). *It's probably more true that it requires a lot of luck and the ability to imagine that one's luck was actually due to skill.
I don't think that a managed mutual fund is a reasonable comparison to an individual investor. Most mutual fund managers work under a number of constraints that don't trouble me in the least. I don't have to stand ready to meet redemptions every day. I don't have to put cash into the market whenever it comes in the door. I don't have to pay a team of analysts and pay for fund infrastructure. I can change my investment approach or criteria whenever I like. Perhaps most importantly, I can take any positioin in any instrument, long or short, and do it for any length of time. I also can buy shares of the tiniest, most illiquid stock there is. I don't have to worry about making sure I look good on next quarter's relative performance chart.

Makes a big, big difference. However, you do have to understand what you are doing, otherwise you run a substantial risk of blowing yourself up.
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