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Should I Stop Contributing to Retirement Accounts if I’m Planning on Early Retirement?

A reader writes in, asking:

“The conventional wisdom of retirement saving is to put as much money as possible into retirement accounts rather than normal brokerage accounts. I’ve done this for years, but I’m considering if I should stop contributing to my 401 and IRA because I am planning on an early retirement. My employer does not offer a match, so I wouldn’t be missing anything there.”

As with any tax-planning question, the answer is, “it depends.” In most cases, however, it makes sense to continue contributing to retirement accounts, even if you’re planning on retiring early.

For people (unlike our reader) for whom a 401(k) match is available, it definitely makes sense to get that match, regardless of planned retirement age.

Accessing Your Money

A concern that many people have if they’re planning to retire prior to age 59.5, is that they will have to pay a 10% penalty to get to their money. But the 10% penalty can typically be avoided with sufficient planning.

For instance, any money that you contributed to a Roth IRA (as opposed to earnings in the account or amounts in the account as a result of Roth conversions) can be taken out of the account at any time, free from tax or penalty.

And if you retire in (or after) the year in which you turn age 55, money in your 401(k) with your most recent employer will be available penalty-free. (For public safety government employees, it’s age 50 rather than 55.)

Then there’s a whole list of other exceptions to the 10% penalty that you might be able to take advantage of. Most importantly, you can take money out of a retirement account penalty-free if you do it as part of a “series of substantially equal periodic payments” that lasts 5 years or until you’ve reached age 59.5, whichever comes later. (This rule is available to anybody, so it can be super helpful as part of an early retirement plan. It is, however, complicated. So it’s important to do your research and, most likely, work with a tax professional.)

Finally, it’s worth noting that if you’re planning to retire very early, it’s likely that you’re going to be saving more per year than you can contribute to retirement accounts anyway. So you’re going to have some savings in taxable accounts even if you continue contributing as much as possible to retirement accounts.

Other Considerations

All of the above deals with whether you would have tax-free/penalty-free access to the money. But that’s only part of the analysis.

Once you have a good idea of whether the penalty will be applicable or not for the money in question, you would want to consider the following factors:

  • What is my current marginal tax rate?* (That is, how much value would you get from having a smaller taxable income this year as a result of contributing to a tax-deferred account?)
  • What will be my marginal tax rate (including 10% penalty, if applicable) when this money comes out of the account?
  • How much value would I get as a result of having the money in a retirement account? (That is, how valuable is the faster rate of growth that will occur as a result of not having to pay tax each year on interest/dividends?**)

*As always, “marginal tax rate” might be something other than just your tax bracket. For instance, your current marginal tax rate could be greater than your tax bracket if making a contribution to a tax-deferred account would allow you to claim the retirement savings contribution credit — or if it reduces your adjusted gross income to a level such that you can claim some other deduction/credit.

**The longer your money is expected to be in the account, the more valuable this faster rate of growth. Also, a key point is that if you’re in the 15% tax bracket or below — and you expect to stay there — qualified dividends and long-term capital gains are already tax-free in a normal taxable account. So having the money in a retirement account won’t provide nearly the same benefit as it would for somebody in a higher tax bracket.

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