06 June 2007

Roth 401k: optimal vehicle for early retirement?

I've been giving early retirement a lot of thought lately. Specifically, I've been trying to figure out which investment accounts can be best used for this purpose. Should I throw money into a taxable account, paying only capital gains taxes when I need to sell some for income? Should I put it in a Roth IRA so that I can withdraw contributions tax- and penalty-free before I am 59 1/2? Should I put it in a 401k and take the 10% penalty when I need to withdraw some?

One thing, to me, is obvious. The Roth IRA is the best solution. It beats the taxable account hands down, essentially eliminating the capital gains tax as long as you only withdraw contributions. It also beats the 401k (on which you would pay ordinary income taxes plus 10%) in most situations. But there's a problem here; you can only shelter so much money in a Roth IRA each year. Currently it's $4k, soon to increase to $5k. If you plan on retiring very early, say at the age of 45, it's unlikely that you could have built the Roth IRA up enough to support you until "retirement age."

The Roth 401k is a solution to that problem. The limits on the Roth 401k are just like the traditional 401k-- in the neighborhood of $15k per year and set to increase in the future. Contributions are also after-tax, meaning you can contribute more overall than in a traditional 401k (considering the front-end nature of the Roth taxes). Withdrawal rules are similar to the 401k, so you have a 10% early withdrawal penalty as well as mandatory withdrawals at age 70 1/2. But just as you can rollover a 401k into a traditional IRA, you can rollover a Roth 401k into a Roth IRA . . . and in the process you can circumvent these withdrawal restrictions. As long as you wait 5 years to withdraw funds, you can withdraw contributions from the rolled-over Roth 401k tax- and penalty-free. In essence, the Roth 401k allows you to increase your contribution limits on your Roth IRA, from a paltry $4k per year to a hefty $19k per year, getting you much, much closer to being able to support a long early retirement. You simply have to do a timely rollover when you leave your job.

This is a phenomenal tool, and one that most companies to date are not offering access to. Fortunately mine is-- and I am about to change my deferrals to take advantage of it. As long as the government keeps its promise and does not tax Roth withdrawals, the Roth 401k will be the ideal tool for preparing to retire early.

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I really liked your article, and want to include it in the Carnival of Employee Benefits. I post it on my blog on Fridays - the Pension Protection Act Blog at http://www.qualifiedpensionconsulting.com/ppablog.

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