I would like to dispel a commonly held belief. Just because you put money into a retirement account, it does NOT mean that you cannot access your retirement funds early.
A reader recently commented that he was not fully funding his 401k, because he was planning on retiring before 50. That comment stopped me dead in my tracks.
I hope he reads my post on the brutal effect of taxes on your savings. The difference between saving in tax-deferred or regular accounts is huge.
I’ve always taken the position that I would rather have $1 million in the bank pre-tax rather than $700 thousand in the bank post-tax, because it gives you more options in the future. That’s why I always fund my tax-deferred accounts first.
It’s disconcerting to me that someone who is trying to save as much money as possible to retire early would willingly give huge chunks of their money away to the government each and every year, when it’s not necessary. I’ve always known there were strategies to enable you to access your retirement funds early, but I had never looked into what they actually were.
With the impetus of that reader’s comment, I set out to investigate, hoping to shed some light on this matter for us all. I hope that reader finds this helpful. Here’s what I found.
Three Strategies for Accessing Your Retirement Funds Early
The problem with retirement savings accounts is that they are setup to facilitate a traditional retirement at a traditional age. They encourage you to keep your money invested until you are at least 59 1/2 years old and discourage you from withdrawing your retirement funds early.
Retirement accounts will hit you with a 10% penalty, on top of normal income taxes, if you try to access funds before the target age of 59 1/2. That’s a big penalty, and you should avoid it if you can. For prospective early retirees, the alternative is to save some funds in non-retirement accounts.
The problem with saving in non-retirement accounts is that you pay income taxes on that money when you earn it, and then you pay income taxes every year on your investment returns. That’s an even bigger penalty!
Here are three strategies for handling the early withdrawal of retirement funds:
Strategy #1: Take 72(t) Substantially Equal Periodic Payments (SEPP)
A common strategy for accessing retirement funds before the age of 59 1/2 is to take advantage of the IRS’s 72(t) Substantially Equal Periodic Payments (SEPP) plan. It was established for just this type of a situation. The plan allows you to withdraw funds without penalty from a traditional IRA. Here’s how you would access the plan:
- Upon leaving employment, rollover your 401k/403b into a Traditional IRA account.
- Figure out how much money you would want to withdraw from your account each year until reaching the age of 59 1/2.
- Try each of the three different approved distribution calculations that the IRS guidelines outline to see which one comes closest to the figure you determined in #2.
- Talk to a tax professional before starting your withdrawals to confirm your calculations in #3. You don’t want to make a mistake and accidentally incur the 10% penalty that you were trying to avoid.
- Keep making your withdrawals every year for at least five years or until you reach the age of 59 1/2. At that point, you will no longer be subject to the 10% early withdrawal penalty.
I like this strategy because it is pretty straightforward and you can start taking withdrawals immediately upon retirement. The next strategy requires you to delay your withdrawals by a few years.
Strategy #2: Utilize a Roth IRA Conversion Ladder
This strategy utilizes the Roth IRA, but there will be a delay before you can access your money. Five years to be exact, so you would need to have five years’ worth of living expenses covered by some other means if you were to utilize this strategy. Here’s how it works:
- Similar to strategy #1, upon leaving employment, rollover your 401k/403b into a Traditional IRA account.
- Determine how much money you will need in five years’ time.
- Convert the amount you think you will need from #2 above into a Roth IRA. You will have to pay income tax on this amount, so take as little as possible and time it so that you are in a low tax bracket if possible.
- Wait five years. While you are waiting you can execute additional Roth IRA conversions each year to cover expenses in years 6, 7, etc.
- After five years, withdraw your funds from the Roth IRA account tax-free and without penalty!
While this strategy does have a five year waiting period, it has its pluses as well. It allows you to take different amounts every year and if five years go by and you don’t want or need the money, you can leave it in your Roth and let it keep accruing interest. This strategy gives you lots of options.
The final strategy may be controversial.
Strategy #3: Just Pay the 10% Early Withdrawal Penalty
This was a strategy that I had never really considered because I knew that there were ways around paying the 10% penalty. But, let’s assume that the other two strategies do not work for you. Does it make sense to just pay the penalty?
You’ll see from the table in the brutal effects of taxes on your savings, that over a 20 year period, you will have a 31% higher balance if you put your money in tax deferred accounts and are in the 33% tax bracket. If you assume that you will be in a lower tax bracket after retiring, which is almost always the case, then the difference is that much greater. With that much difference in returns, you can afford to pay the 10% early withdrawal penalty and still come out ahead.
What are the benefits of this strategy? You withdraw only what you need when you need it. It also gives you options. Maybe you decide you don’t want to retire early and you want to keep working. No problem, your funds are still earning their returns year after year in a tax-deferred account.
What’s the Net Worthy Approach?
After doing the research for this article, I’m more convinced than ever that the only rational approach is to stuff as much of your retirement savings as possible into tax-deferred accounts. If you do end up retiring early, then there are several strategies to help you avoid the early-withdrawal penalties and access your retirement funds early. You can even just pay the penalty and still come out ahead.
Consider this, what if you decide to fund your early retirement in normal taxable accounts. Each year you’ll be giving huge chunks of cash to the government for taxes on your earnings and then another chunk on your investment returns.
But then, as fate will have it, let’s say you later decide not to retire early, either because you can’t or because you lose interest in early retirement. Think of all of those tens of thousands of dollars that you would have thrown away because you had not protected them in tax-deferred accounts. The prospect of that alone would terrify me.
Were you aware of the different strategies for accessing your retirement funds early? Have you been putting the maximum amount in your tax-deferred accounts? Are there reasons to not fully fund your retirement accounts?