Why The Smartest Investors STOP Contributing To Their 401K and Retire Early

We have two people here who have the same $500,000 saved by 50 years old. Their goal is to retire by the age of 56. One of them makes it out, the other is stuck at her desk two years later staring into her next Microsoft Teams meeting. The difference has nothing to do with how much they saved, what they selected to invest in, or their initial timeline. But it's a dangerous trap for those who are not looking at the next three problems that I'm going to be sharing in today's video. The question as we go through, will these three problems change the way you think about investing in your 401k or company investment plan? Now, if you're on this video thinking, well, geez, I have a ton of money in my 401k. What does this all mean? Number one, if you have a lot of money, you probably have more than most Americans actually do according to the latest Vanguard and Fidelity surveys. So there is merit in that. Congratulations. Two, it's not too late to understand the key strategies we're talking about today to still achieve the best investing portfolio, which we'll talk about as we go through these next three problems. Speaking of, problem one, the wall. A traditional 401k comes with a deal built into it. The IRS lets that money grow without you paying tax on it every single year. In exchange, they decide when you're allowed to take it out without a penalty. That age is 59 and a half, not 55, not whenever you feel ready. And we're talking 59 and a half. On the calendar, no exceptions for good behavior or anything like that. So the problem arises when you try to pull money out before that acceptable age. And the IRS, well, they add a nice little 10% penalty on top of whatever income tax you already owe on the withdrawal. It is a federal law and it applies whether you're pulling the money because maybe you're ready to retire or because you need that in an emergency because the roof just had a leak or something like that and you need to sort it out. I know a few people who actually had to lean on the 401k during layoffs back in 2020, which it wiped their future retirements while at the same time hit them with a 10% penalty. I mean, that was just insult to injury at the time. But hold up, we have to quickly run the math on that for a second because the number is worse than it sounds. Some people say, well, who cares? I'll just take the 10% penalty. But say you need $60,000 in a single year and you're sitting around 22% federal bracket. Just to keep this simple, income tax alone takes about $13,200 of that. The penalty takes another $6,000. You started with $60,000 of your own money and now you're walking away with somewhere around $40,000 of it. That is a simplified version. Of course, the real tax brackets are marginal and everyone's situation is different. You can lose close to a third of your hard-earned money for the crime of wanting it before a date on the calendar. But there's a way out of it that we'll talk about throughout this video. This is the part that gets glossed over in the advice you grew up hearing. It was max it out as much as possible, never touch it, let it ride. That advice is correct for the first two-thirds of your career when the money genuinely shouldn't be touched anyway. But it stops being complete advice the moment your goal becomes leaving work before you're 59 and a half. Because now, the account that was supposed to set you free is actually the thing standing between you and the freedom door. We don't want that. Now, go back to the two people I opened with here. We're going to call them Jenny and Mike. Jenny did everything she was taught to do. Max out the 401k and never touch it. Let it grow because it's going to grow at an exceptional rate. And every raise that she got for 15 years, more of it went straight into that account. That is what a responsible person does. By 56, hers grew to somewhere close to $700,000. On paper, honestly, it's a success story. She is the person a financial planner would point to as an example. But Mike capped, he did it differently. He capped his 401k contributions right at the employer match. The free money that the company hands out and never once skipped it. But everything past that, every time he got a raise, anything like that, he redirected that somewhere else for many, many years. To anyone watching, it probably looked like he was doing less. Especially compared to Jenny. But same total dollars were saved by the time they both hit 50 years old. But he had different buckets that she did not. At 56, they both try to walk away. Mike escapes. Jenny hits the wall. I want to know where you land on this. Drop your target age that you want to walk away from work in the comments. Because I want to know what these goals are. And be honest with yourself for a second. What percentage of what you've saved is sitting somewhere with an age attached to it before you get a chance to touch it without some type of penalty? I read every comment. I want to know from you guys. Are we trying to achieve early retirement? Or are we all kind of in the, ah, I'll be way past 59 and a half and I'm okay with that. Just let me know down in the comments. Problem two, the menu that you did not choose. Here's the second thing your 401k doesn't advertise on the enrollment page, right? They don't let you know about your investment options. Because somebody in HR picked a provider. And that provider built a menu. And it's usually somewhere between 15 and 30 funds. And that is what you're choosing from. Sometimes that menu is actually very fine. But honestly, in my experience, it's been a hit or miss within the fund program. The danger lies in those who simply accept investing in whatever is defaulted without looking at the data. A lot of my friends just went in and they're like, yeah, I'm just investing in whatever it's telling me to invest in. I didn't really look at it. Well, I'm like, yo, when I originally looked at my plan and my 401k, once I figured this all out, I realized that my invested fund carried a whopping 1.1% expense ratio. That's a fee of 1.1% yearly. Sounds small until it isn't. Take $500,000 and grow it at a 7% a year for the 20 years. That turns into just under $1,935,000. Now grow that same $500,000 at 6% because we're going to subtract down a percentage point for the same 20 years. That's $1,603,000. That's not cool. That's money that's just kind of going out the door. And I'm not telling you that every single plan is expensive. Just don't settle for the default. What we want to do is go in, look for low cost options, and don't just assume. Dig in and make adjustments if you can. If you thought that was easy though, watch out for problem number three, your own money dictated. This one catches people even after they're doing everything right. And it's separate from the tax code that we talked about earlier. It has nothing to do with the IRS. It has everything to do with your specific plans paperwork. And I had to go through and do some additional digging because I was like, is this actually factual? Does this make sense? So even once you qualify to take money out penalty free, your plan decides how. And the real numbers on this are worse than most people assume. The Department of Labor tracks this directly through its National Compensation Survey. Across savings and thrift plans, and that's the category that 401k plans fall into, 86% of participants have a lump sum option available. Only 38% have any installment option at all. Only 12% have an annuity option. Do the subtraction on that for a second. For a majority of people sitting in a 401k plan right now, lump sum isn't one choice on a menu. It's the only item on the menu. And here's the part that people get wrong when they hear this. It's not your custodian's decision. It's not like Fidelity is deciding this to hand you that $500,000 all at once. Vanguard doesn't either. Whoever holds your 401k is just administering whatever actual rules that your employer wrote when they set the plan up, sometimes decades before you were even hired. The custodian is the delivery driver. Your employer's plan and document is the one that decides what's in the box. If you want to know which kind of plan you actually have, the question isn't for Fidelity. It's for your HR department or your plan administrator. And it's worth asking now, not the week you're trying to retire. I mean, if we just picture pulling out like $500,000 in a single year because that's the only option that the plan gives, that entire amount hits your tax return as ordinary income in 12 months. So you could get rocketed from a moderate tax bracket into one of the highest brackets that exist and it has nothing to do with how much you saved or how smart your investments were. It's a paperwork problem. And the only way to find out is to ask. There is a chance that you have to take that lump sum even if you're past the age of 59 and a half. I'm not talking about this for early retirement only. We're talking about you might have that full dump afterwards. This is why I stopped maxing out my 401k. I only did up to the match while I was still working. Every other dollar went into either a Roth IRA, a traditional IRA, or mostly into my taxable brokerage account, which allows me to do what I want when I want. Now, someone left a comment on the channel recently and gave me permission to share this story. He's 49 years old and he's been contributing to his 401k for almost 25 years since the day he started his current job. And he did it the way most of us were told to, get the match, keep on increasing it by percentage as your raises come in. Today, he's putting 15% of a $77,000 salary. His employer matches 3% dollar for dollar plus another 2% at 50 cents on the dollar. And every bit of it, all 25 years of it, sits in a single Vanguard target date fund. Now, here's what's cool about the Vanguard fund. That fund runs an expense ratio of around 8 hundredths of a percent. That's about as cheap as a fund gets, cheaper than even most people's do-it-yourself portfolio looks like. The fee isn't the problem here that I talked about earlier with the 1.1%. His problem is simpler and easier to miss. 25 years of savings, one account, one glide path, one age attached to all of it. Now, he didn't do anything wrong here. The fact that he's even investing, believe it or not, is well above a majority of Americans. But what he told me is that he's only just started looking at Roth IRAs and brokerage accounts as he's gotten older because a 401k was the only thing he really understood well enough to trust. And honestly, that was me too. You're in good company. That's the exact gap this video exists to close. Here's the part worth sitting with. At his income, $77,000 is nowhere near the income limit that blocks somebody from contributing to a Roth IRA. What changes is where the next dollar goes. If somebody in this position is contributing well past the match purely out of habit because it's the only account that they've ever used, that habit is the thing worth interrupting. It's not too late. It's just a different starting line than Jenny and Mike had. And the plan has to account for that instead of pretending it doesn't exist. If that's you, here's one concrete thing to do this week before you touch a single dollar. Log into the plan, confirm whether it allows partial withdrawals after you separate or only a lump sum, and take two minutes to actually check your funds expense ratio instead of assuming it's high. But hold up, hold up, hold up, hold up. What about a Roth 401k? And that is a great question. I got you. Don't worry. But be sure to subscribe if you're loving this content and want more. A Roth 401k genuinely solves a tax problem. You're going to pay tax on contributions now. Everything after that grows and comes out absolutely tax free. So if you build that up a lot and it grows to like a million dollars, that's all money that is tax free in the future. And as of 2024, it doesn't even have required minimum distributions once you get to that age anymore. It matches a Roth IRA from that perspective. But it does not solve the problem that the video is about here. A Roth 401k does not have a mechanism for withdrawing contributions. If you take a withdrawal, it doesn't work like a Roth IRA where contributions come out first. It's prorated. So you are taxed and penalized based on the percentage of the total balance that is not due to your own contributions. That is, of course, unless you roll that over into a Roth IRA. Here is how I decided to shift my own investing timeline. This is the order that I put my money in. If getting out early is part of your plan, here's the order, whether you're starting from zero or redirecting from here. Number one, contribute enough to get to the full employer match every single time. That's an immediate guaranteed return on your money. And there's no version of this where skipping it makes sense. This step doesn't change regardless of your timeline. Number two, look at a Roth IRA. You fund it with money you've already paid tax on, but it grows tax free. And unlike a 401k, you can pull out the amount you personally contributed, not the growth, at any age without penalty or waiting for a birthday or an age. If your income is too high to contribute directly, which is common if you're in a higher earning year, ask a CPA about a backdoor Roth conversion. Number three, everything past that. If an early exit is an actual goal that you have, build a standard taxable brokerage account. No special tax treatment going in, full flexibility coming out. This becomes your bridge account, the account that carries you through the years between the day you're actually done working and the day that the IRS says your 401k is fair game. You don't need a separate account for every goal. One brokerage account built consistently, it does the job. This is exactly what I did to semi-retire. Notice what order it's not. It's not an abandoned and it's not stop trusting the match that your employer is trying to give you. What it is, is stop treating 401k as the only account that matters because as you get older, you want to scale that back and look at different opportunities so you can get your money out when you need to get your money out. No amount of maxing it out changes that math. I maxed out my 401k in 2021, 2022 and I stopped if I recall somewhere in 2023 and I only went down to the match and redirected all my other money because I'm like, wait, wait, wait. I'm not letting this get trapped up because if it gets trapped up, early retirement's off the table. Even if I had $10 million in my 401k because at the end of the day, I ain't taking a 10% hit. I don't know if many savvy people would. Your financial adventure continues by checking out this video up here next. Keep building your sharp money and I'll see you on the next video.