A few questions have come in more tailored to personal finance and one item that keeps coming up is 401K distributions and contributions. This blog does not advocate usual advice which is to “max out and wait” because this likely limits your mobility, your assets are tied up in taxable income and of course if you’re still worried about income at 60 you’ve chosen the wrong career. Here is a good guide for someone who is going to join the work force and wants to maximize his liquidity.
Year 1: The thing about jobs after college is this… You’re only working half of the year. This means you have minimal taxes because bonuses are generally not paid until January and even if they are paid in December you’re not getting a full year, it’s just a stub payment. So if you’re starting in June/July here’s a non-conventional move… Max out your 401K in the half year.
Why? The reason why is you’re forcing your income bracket down a peg. You make maybe 45K in total ($10K sign plus your 35K or so for the half year) which throws you into the 25% income bracket, which starts at $36.250K. That is a 10% increases from the 15% tax marker under this level. So in short, max out your 401K if possible in your first year or at minimum enough to remain at the 36.25K level.
The $10K Rule: This is the amount of money every single person should have in their 401K.
Why? There are many workarounds. You can draw down $10K for a home (which we advise you do not buy right now) and you can also use this as a water mark for high deductible health care. The last part is likely confusing, so what we are referring to is the idea that you should choose the cheapest healthcare at your firm that has a higher deductible closer to the $5K mark. By having $10K in your 401K account if you have a real accident, you can use the money for medical purposes.
For medical expenses exceeding 7.5% of your adjusted gross income you can use the money without penalty. Also you do not need to itemize the items in order to claim the medical exception.
Company Match: This level of investment is the water mark for how much you should absolutely contribute every year. If your company has a 5% match, you should always contribute 5%. This is free money. If you are making $100K a year, that’s is $5K on the table, 100% returns for simply delaying 5% of your spend. A no brainer transaction.
Rollover To Get Liquid: Assuming you’re good at your job, you’ll likely be jumping ship after 2-3 years unless you get promoted. Roll your 401K over to a Roth IRA on December 31.
Why would you do this? The answer again lies in liquidity and taxes. Ideally you’ll have somewhere around $30-40K in your 401K by the time you jump ship and you’ll make somewhere around $150K. So if you run the math correctly your rollover and tax payment will be just under the $183.25K tax bracket. If you hit the number on the head then you’re looking at paying the normal 28% tax on the rollover. Next year you’ll be closer and closer to the 33% bracket so do it as soon as you jump ship.
Why December 31? The reason is the way taxes currently work for the Roth. So now that you’ll be paying taxes on it you likely want it to be liquid as fast as possible. If you roll on December 31 this counts as January 1, 20XX. This means in 4 years and 1 day you can take out the entire principal tax and penalty free. Now you’ve got even more liquidity and mobility in your life. It is called the “5 year rule” but really it should be called the 4 years and 1 day rule if you play it smart.
Investing: Notably at the age of twenty five or so, you’re still unlikely versed in investing so you should stick to a 7% or so return profile. In another 5 years or so, you’ll be much better positioned for a more aggressive investment approach.
