The Extreme Early Retirement Account Everyone Needs to Know About
In Part 2 of our Fundamentals of Early Retirement series, we learned that we’ll need about 25 times our estimated annual expenses saved up before we’re ready to retire.
Now you can calculate your own wildly giant number that seems crazy unreachable, but I promise you is totally possible.
But where exactly should you be saving money for this massive retirement nest egg?
Under the mattress or in your checking account seem like really bad options, yes?
What if I told you there was a retirement account where you could get a 100% return on your money every year completely tax-free?
Would you be interested in learning more?
Now, what if I told you this incredible account was available to nearly 80% of Americans, but only half take advantage of it. Would you worry you were missing out?
The good news is that this account actually exists, and more than likely, you have access to it.
This crazy magical extreme early retirement account is…
…dut, da, dum…
…your 401k plan at work.
Really?! 401k Plans Are That Great?
I get it. I get it. That doesn’t sound like a very financially sophisticated answer.
But for most people who retire early, their 401k is by far the most powerful retirement account to get there. (In other job sectors it may be a 403b or 457 plan, but the concept is generally the same.)
So what makes this account so powerful for building up our wealth for retirement?
There are 3 main reasons the 401k account is the extreme early retirement account that everyone needs to know about.
1. 100% Return on Your Money
If you talk with a financial advisor, they will often quote their investment products or the stock market in terms of an average annual rate of return on your money. This is a percentage rate return.
A decent online savings account may give you a 2% annual percentage rate return on your money.
That means if you put in $1,000, at the end of the year the bank will give you $20.
The US stock market is known to produce average annual returns of 7%. So if you put in $1,000, in an average year you’ll see your money grow by $70.
Some hot stocks will have years where they grow by up to 30% or more. You put in $1,000 and in a year it’s worth $300 more. Wow!
But what if I told you there was a place you could invest your money and you were guaranteed to get a 100% rate of return? You put in $1,000 and you get $1,000.
That sounds ridiculous, right?
Well, that’s exactly what your work 401k plan does if your company matches any portion of your contributions.
A 401k plan that includes a “company match” means your company will match dollar-for-dollar what you put into your 401k plan up to a certain percentage.
Let’s Look at an Example
Let’s say you work at ABC Company. They offer employees a 401k plan with a company match of 3%.
This means that if you put at least 3% of your paycheck into your 401k plan, the company will match the dollar amount of that 3% with their own money and add it into your 401k plan.
That is an instant 100% return on your money!
Let’s say your salary at ABC Company is $50,000 a year. If you put in 3% of your salary into the 401k, that’s $1,500 over the course of the year.
Since the company matches that 3%, that means your company is also going to put $1,500 into your 401k plan.
This means it will only cost you $1,500 to put a total of $3,000 into your 401k.
That’s a fantastic deal!
It may not seem like much right now, but let’s say you take advantage of this 3% match for 10 years. That’s a free $15,000 the company has given you.
And that’s assuming you never get a raise over those 10 years. As your pay increases, that 3% of your pay equals a larger dollar amount, and a larger amount that the company is matching.
I’m no financial genius, but when my company wants to offer me free money, I take it.
2. Tax-Free Contributions
The second thing that’s awesome about your work 401k is that the money you contribute is completely tax free.
This is often called “pre-tax” savings.
This is because the money you contribute to your 401k isn’t counted as income when you file your income taxes at the end of the year.
The government is basically saying, “Don’t worry about that money you put into your 401k. We’ll tax it later when you take the money out.”
The more money you can put into your 401k, the lower your income is when you file your income taxes at the end of the year.
We often don’t think of income tax as an expense because it’s automatically withdrawn directly from our paycheck, and we don’t even think about it until we hope to get a tax refund when we file our taxes.
But taxes are an expense, and like any expense, we have options that allow us to pay less.
Putting money into our 401k is a decision to pay a lower tax bill at the end of the year.
And when we pay less money in taxes, we have even more money available to save and invest.
Did You Know: You can contribute up to $19,000 to your 401k account in 2019. That’s a lot of money! But just contributing anything is better than doing nothing.
3. Tax-Free Withdrawals in Retirement
But wait, won’t I just have to pay taxes later when I retire? Won’t it be more expensive then?
And aren’t there early withdrawal penalties if I try to access this money before age 60? This sounds like a horrible early retirement account to me.
This is one of the biggest challenges for the early retiree to get a handle on.
Let’s tackle each of these issues one at a time.
First, yes, we are required to pay taxes on this money when we withdraw it later on in life…
US tax law is not awesome at best, and downright confusing at worst.
But if we’re willing to do a little bit of planning, there is a way to access all of our 401k money COMPLETELY TAX FREE!
In Part 4 of this Early Retirement series, I’ll show you exactly how that works.
But for now, just know that we are looking at the 401k through the lens of being able to both contribute money completely tax free up front, while also being able to withdraw the money completely tax free on the back end as well.
That is a pretty awesome deal!
Second, yes, there are early withdrawal penalties if we pull our money out before age 60. (Technically age 59 and a half, but we’ll leave the government’s weird tax rules on the sidelines for now.)
But what if I told you the same method we are going to use to access our money completely TAX FREE also allows us to access our money before age 60?
How cool would that be?
Well, it’s true. And we’re going to learn all about how in Part 4 of this series, so stay tuned.
Conclusion – Your Work 401k Plan is the Extreme Early Retirement Plan That Everyone Needs to Know About
In Part 1 we learned that reducing our monthly cost of living is critical to being able to retire early.
In Part 2, we learned how to estimate how much money we’ll need to sock away for retirement.
And today in Part 3, we learned that our work 401k plan is a fantastic way to start saving and investing money for early retirement because…
- we can get a 100% return on our money if our employer matches any portion of our contributions.
- the more money we contribute to our 401k, the lower our tax bill will be for the year.
- we can contribute money completely tax free, and then, after we’re retired, we will be able to withdraw the money completely tax free…and before we’re age 60.
All these things make our 401k plan one of the most powerful wealth-building accounts available.
And with 80% availability in the US, it’s likely this tool is available to you right now.
If your company has a 401k plan and you’re not participating in it, make that change today.
If your company matches any portion of your contribution, try to contribute at least that much so you can take full advantage of that 100% return on your money.
Free money doesn’t come along every day, but when it does, I say take it.
If you’re not sure which funds are a good place to invest your money inside your work 401k plan, check out Part 4 of my Beginner’s Guide to Investing to get some ideas on what types of funds might work best for you.
Now that we know a great place to invest our money to build wealth, and we have a general idea of how much money we’ll need to retire, how do we access our glorious nest egg tax and penalty free once we quit working?
Now let’s jump into Part 4 of our Fundamentals of Early Retirement series, and we’ll look at how you should be planning and preparing well before your last day of work.