Never Pay Taxes on Your 401k Or (How does maxing out 401k expedite FIRE?)

I want to cover four topics today (use below links to skip to topic):

1. Why you should max your 401k contributions
2. How to never pay taxes on your 401k
3. How maxing out 401k expedites FIRE
4. Why I prefer 401ks to Backdoor Roth IRAs (and am against Backdoor Roths in general)

Read also: What is FIRE? (Financial Independence Retire Early)

If you never had to pay taxes on your 401k, how much would you contribute? 

7-10 years ago, I was the biggest anti-401k person and was all about Roth IRAs. I thought it was dumb to tie up money until you were 59½ years old AND pay taxes on contributions and gains. I also thought a Roth IRA was a genius way to get all your taxes out of the way and let it grow until you were ready to withdraw.

While I still think Roth IRAs are great early on in your career (before you start needing to backdoor to get around eligibility), I’ve changed my tune about 401k plans completely. 

Why you should max your 401k contributions

401k plans do two (or three) things very well: 

1. Reduces your taxable income (this helps less in the beginning of your career and more as your income ascends to new, fun tax brackets)
2. Automates investing: don’t have to remember to deposit or send money and/or choose investments; all done upfront 
3. For some, a company match (basically free money!)

“But you have to pay taxes on your contributions AND your gains!” you might say. 

There are two things many folks don’t know about 401k plans: 

1. You don’t have to pay taxes (ever)
2. You don’t have to wait until 59½ to withdraw

Yes, you can withdraw penalty-free for things like education, first-time home purchase, medical expenses, etc., but that’s not what I’m talking about. I’m talking about withdrawing all of it. 

How to never pay taxes on your 401k

To achieve both of the above (not paying taxes on the withdrawal AND withdrawing early), we need to do three things:

1. Convert 401k to an IRA (this is not taxable because they are both tax-deferred vehicles) 
2. Backdoor IRA to Roth IRA in batches*  
3. Roth Conversion Ladder^{[1] [2] [3]} 

To avoid paying taxes on the backdoor to Roth IRA, you need to fulfill two criteria:

1. You need to have zero income (this should be fine if you’re FIRE’d; if you have a pension, I’m not sure how this would work)
2. Convert/backdoor IRA to Roth equivalent to your standard deduction

The government provides a standard deduction each year to deduct from your taxable income. Since you are FIRE’d (and meeting criteria one of zero income), we will backdoor an amount equal to your standard deduction ($12,550 for 2021) to prevent paying any taxes. 

If you wanted to expedite this process, you could convert/backdoor a larger amount and still only be paying 10-12% up to ~$40k/year (drastically lower than the tax you’d pay backdooring while working full-time). 

Step one complete! You’ve managed to get your 401k money out tax free! Now, how do we access said money prior to age 59½? 

We will build a Roth Conversion Ladder[1] [2] [3]. For this step, once contributions have sat in a Roth IRA for 5 years, they can be withdrawn penalty-free. The big caveat here is the contributions. Any gains (yay) incurred during those 5 years will remain in the Roth IRA.

tl;dr: with a 401k, you can reduce your taxable income, automate investing, and in some cases get free money from your company. With some work, you can eliminate taxes on your 401k contributions AND gains and access the funds well before you turn 59½. 

How maxing out 401k expedites FIRE

By doing the above, you will do two main things that help with FIRE:

1. You’re reducing your tax burden thus increasing your savings rate
2. You’re automating your saving and investing (and preventing yourself from ever spending this chunk of money)

If you forgo contributing or maxing out your 401k, you are giving up a free tax incentive. By contributing to a 401k, you are deferring tax forever (if you follow the above steps). Yes you give up some liquidity because 1) you have to wait 5 years for access to funds; and 2) Roth earnings will be in there for the long term. You gain, however, upwards of 35% in tax savings.

The liquidity you’re losing is only on $19,500 per year, so provided you’re arguing for liquidity the bulk of your savings will be liquid in non-tax-advantaged accounts. 

tl;dr: maxing out your 401k reduces taxes and increases your savings rate. Increasing your savings rate reduces your time to FIRE

Why I’m against backdoor Roth IRAs

For folks who are already maxing their 401k contribution and contributing to an IRA (and backdooring), I have some additional thoughts.

Contributing to a Roth IRA early in your career when your salary meets eligibility rules is something I’d be open to. Contributing to a Roth IRA when you exceed salary eligibility and have to backdoor is something I’m less into. 

The two main reasons are taxes and liquidity. If you’re having to do a backdoor Roth, you are likely already paying upwards of 30ish% taxes on that income. After that, you’re trading liquidity (the ability to access those funds) for tax incentives (not having to pay taxes on those gains).

Once you hit FIRE and earn zero income, you won’t pay long term capital gains taxes (0% up to income of $40,400). Because you’ve already paid the 3X% in taxes, why lock that money up when you won’t pay long term capital gains taxes on it anyway? 

tl;dr: with backdoor Roths you trade liquidity for tax incentive; once you FIRE and have zero income, you pay 0% long term capital gains rates without giving up access to your funds. 

Final Thoughts

401k plans do a few things great including reducing your taxable income, automating investing, and in some cases capturing free money from your company. With some additional work, you can also eliminate taxes on your 401k contributions AND gains and access the funds well before you turn 59½. 

By maxing out your 401k, you reduce taxes and increase your savings rate. When you increase your savings rate, you reduce your time to FIRE.

Because 401k plans are so effective, I prefer them to Roth IRAs and other vehicles that reduce your liquidity. Using a backdoor Roth, you trade liquidity for tax incentive. Once you FIRE and have zero income, you gain a similar tax incentive by paying 0% long term capital gains rates. You can achieve this without trading liquidity and giving up access to your funds. 

What do you think? Would you rather do a backdoor Roth than max your 401k? What are some of your reasons for not maxing your 401k? Let me know in the comments! 

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