401(k) and Early Retirement

Dear Terry and Deborah,

Is the 401(k) overrated? What is the best way to prepare for an early retirement?

-- Thao

Dear Thao,

I'm not by any means an expert about money. I do know that my own accountant is not a fan of the 401(k) as a retirement tool, either for us as individuals or to offer through our small business. Rather than attempt to explain, I asked him to weigh in.

Yes, 401(k)s are overrated, but that doesn’t mean a 401(k) is a bad idea for you. 401(k)s are overrated for young families trying to gather a down payment for a house, or for people with a lot of consumer debt that needs to be paid off. These folks would do better by not tying their money up in a sheltered arrangement because it will cost them 35%-47% in tax and penalties to get the money back out again. 401(k)s are also overrated for those with modest incomes, paying tax in the 15% bracket – they aren’t necessarily a terrible idea, but, yes, they are overrated. In the end the answer to the question needs to be tailored to the individual. -- Randall Kilgore, CPA

As for the early retirement, set a target date, do the math, and start saving. The investment firms have retirement calculators on their websites. You'll need to educate yourself about how to make good, sound investments or find someone you can trust to guide you.

I'm not a good resource for information here. So unless Terry is hiding a wealth of knowledge from me, I doubt that either of us is a good candidate for the "Who Said It Best?" poll!!

-- Deborah

Dear Thao,

I thank you for writing. The 401(k) is a legitimate investment tool. Of course the best 401(k) is one where the employer makes the entire contribution or matches your contribution. If you are simply allowed to invest into a qualified 401(k), it may not be the best choice.

I applaud your effort for planning for an early retirement. The biggest problem that people are facing now is that we live too darned long. Expect to live at least until your late 80s or even to 100 or more. As you can see, the challenge of living entirely from your retirement income is that you may need to save enough to live on for 30 years or more. So the simplest answer is to start as early as you can and do not touch your investments until you have retired.

I am not a licensed investor or financial planner. The biggest advantage to tax-deferred retirement plans is just that, the tax deferral. You exempt your investment from income taxes in the year it was invested and any earning or dividends it may pay before retirement. Presumably, when you retire and are in a lower tax bracket, you will pay less tax on the money when it is withdrawn. Of course there are steep penalties for taking it out early. If you need it for an absolute emergency, then taxes are due on it as well.

Every financial planner will recommend that you diversify your investments so as to not have all your eggs in one basket. How they recommend dividing up the pie can vary significantly. Much of it you can do on your own by educating yourself about the various investment choices such as individual stocks, no load mutual funds, bonds, real estate, etc. Online brokerage services have become quite sophisticated and offer a great deal of information at low to no cost. This will allow you to invest some of your money without paying large commissions. This does not mean you should never work with a broker or financial planner because they, of course, are the professionals

-- Terry