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I've been listening to some financial independence podcasts where people claim that if you save 75% of your income into tax deferred retirement accounts, you wind up paying no income tax even with an income like $100k, since you would only have $25k of taxable income. I thought the max you could put in a 401k is $17.5k, and the max in an IRA is $5.5k, meaning you could save $23k. What would you put the other $50k in?

Also, these same people claim that if you save this much, you could be financially independent in as little as 10 years. I thought you also could not withdraw from these accounts until you are 59.5 though. What would you live on until then? Do they account for the taxes and 10% penalty for early withdrawl? Am I missing something?

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  • These investments are typically tax-deferred annuities and are hawked by many financial independence preachers and insurance companies. Yes, one could be "financially independent" in ten years. In the 1950s, the Readers's Digest used to have lots of advertisements showing smiling WASPs on sailboats and tennis courts and golf courses saying "I retired at age 40." I do wonder how many of them managed the inflation since then...
    – Dilip Sarwate
    Oct 18, 2014 at 2:31
  • There are few people who have the discipline to live at such a fraction of their income. Living on $25K is pretty tough, $75K, not so much. So a $100K earner might actually save 25%, but good luck pushing it over 50%.
    – JTP - Apologise to Monica ♦
    Oct 18, 2014 at 16:50
  • Check out www.mrmoneymustache.com/forum/ if you want more information on this sort of strategy. You also forgot an HSA for tax deferred savings. There are a lot of tricks you can do with an HSA. What you are describing takes diligence but is more or less achievable (especially if you have a family, then you can have 2x 401k/403b and 2x IRAs.
    – enderland
    Oct 21, 2014 at 10:55

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There are some truths and some half-truths here, and obviously some misunderstandings.

people claim that if you save 75% of your income into tax deferred retirement accounts, you wind up paying no income tax even with an income like $100k, since you would only have $25k of taxable income.

Well, that's nice, but what are you going to live on? $25K/year is not much, and a person earning $100K will probably not be able to eat in a soup kitchen and ride old bicycles everywhere while living under the bridge.

I thought the max you could put in a 401k is $17.5k, and the max in an IRA is $5.5k, meaning you could save $23k. What would you put the other $50k in?

That's the part of misunderstandings. You cannot save 75% of your income in a tax deferred account if you earn $100K. Maximum allowed per law for employees is about $51K (i.e.: 50%), + 5.5K you can put into an IRA. So we're at about 57%, not 75%.

The 51K are comprised of both the employee contribution (which is limited to 17.5K, as you have correctly pointed out) and the employer's match. Now go find me an employer to match 200%. Never heard of that (except people working for themselves, of course).

Now when people are working for themselves, there's another limit: 25% of the net income (or the compensation, if solo 401(k), in addition to the $17.5K). So if you earn 100K as self-employed - you can only put the same $50K in a tax-deferred account.

So I cannot see how you can save into a retirement account 74K a year.

Also, these same people claim that if you save this much, you could be financially independent in as little as 10 years

IF you save that much, may be (do the math yourself). But as we've seen, that's a big if.

Do they account for the taxes and 10% penalty for early withdrawl

No, they rely on IRC Sec 72(t)(2)(A)(iv) which allows for periodic payments from the plan to be penalty free under certain conditions.

Bottom line - don't believe them. While there's some grain of truth there, what you described is an exaggeration and misrepresentation of the current state of affairs in this area.

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I'm not sure about the first part of your question. To make matters worse, if you have access to a 401(k) and your income is relatively high, you won't be able to deduct your IRA contribution. I'm very skeptical you could avoid all income tax on a $100k income.

As to the second part of your question, according to this post, if you can save 75% of your take-home pay you should actually be financially independent in 7 years, not 10!

There are a few ways to access money in tax-advantaged accounts before traditional retirement age without penalty. One is substantially equal periodic payments (SEPP). This seems like a good deal but you can't change the payments until you turn 59.5. The other is a Roth IRA conversion ladder. It is explained here, but basically you live off of capital gains in the 15% federal income tax bracket while you convert Traditional IRA money to Roth. All of this is tax free if the amounts are low enough. Then after 5 years you can access that money from your Roth without tax or penalty.

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    It is worth keeping in mind that if a person has worked for only 7 years in the US, then based on this person's earnings alone, this person is neither eligible for Social Security benefits nor for Medicare when retirement age arrives. Both require 10 years (40 quarters) of earnings that have been subject to Social Security tax and Medicare tax. (Some State governments do not participate in Social Security and Medicare, and some of their life-long employees qualify for Social Security and Medicare based on their spouse's earnings.)
    – Dilip Sarwate
    Oct 18, 2014 at 3:59
  • @DilipSarwate don't forget high school jobs or part time jobs count, as well. I had close to 25 credits by the time I started fulltime work after graduate school. I think by age 28 I would have the full 40 credits?
    – enderland
    Oct 21, 2014 at 10:59
  • The Roth conversion ladder is a key component to dramatically minimizing your actual income taxes. For someone planning on retiring early, their taxable income will be low and you can "fill up" that income with converting your IRAs (or 401k) to Roth and then having access to the principle as Craig says. You won't pay much or any income tax on this, especially if you remain below your deductions/exemption totals.
    – enderland
    Oct 21, 2014 at 11:00
  • The Roth conversion doesn't allow you accessing your money tax free. We've covered this in another question on the matter you've asked. You can only withdraw tax free your contributions to Roth, not conversions. With conversions - the amount converted and the gains are prorated on withdrawal, and the gains are taxed unless the withdrawal is qualified.
    – littleadv
    Oct 25, 2014 at 2:28
  • @littleadv I thought that was only for a Roth 401(k) to Roth IRA rollover. For a Traditional 401(k) to Traditional IRA rollover to Roth IRA conversion, my understanding was the Roth conversion ladder was a sound strategy.
    – Craig W
    Oct 25, 2014 at 3:10

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