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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?

Chris W. Rea
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Scott Anderson
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2 Answers2

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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.

littleadv
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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.

Craig W
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