I recently wrote a blog post concerning the Financial Independence/Retire Early mindset and what it takes to retire before your 60s, as is traditionally considered retirement age. Two questions that comes up a lot when I discuss this with people is, “aren’t all retirement accounts inaccessible until you reach 60? And wouldn’t I lose a lot of tax savings by not utilizing them?”
The answer is that they are not as inaccessible as you may think, and you absolutely would lose a lot of tax savings if you didn’t utilize them! That’s why it’s so important to know your options and leverage them to retire on your own terms, not on an arbitrary age imposed on you by others. When it comes to saving for an early retirement, you can have your cake and eat it too, but it takes planning.
The Elephant in the Room – Your 401k/IRA and the 10% Early Withdrawal Penalty
The IRS allows us to set aside funds for retirement and delay paying tax on that income until we reach retirement age. Millions of people utilize 401k/403b/IRA accounts to lower their current tax liability by tucking that money away until later in life, where it will be taxed upon distribution at a time when your earnings should be lower and thus your tax rate lower as well.
In order to implement these plans, the IRS had to codify what retirement age would prevail for taxpayers to be able to access these funds. That age is 59.5 years young, meaning all of your retirement funds can be accessed penalty-free so long as you are at least that old when taking the distribution. If you are younger than 59.5 and don’t meet any exceptions, your withdrawal will be subject to a 10% penalty, effectively nullifying any tax advantages to the account and then some.
So what is an early retiree to do? Certainly not take a 10% penalty – that is disastrous to your savings and will set your retirement back years. Luckily, there are some very good options available to anybody who would like to access their retirement funds a little earlier than the magical 59.5 age milestone.
Option 1: Roth Conversion
By converting your traditional IRA to a Roth, you can withdraw as much of the principal funds as you like penalty-free once they have remained in the account for 5 years. The Roth conversion amount will be taxable in the year that you initiate it, so tax planning is critical here. The best course of action is to have other funds readily available to get you through the first five years of retirement, allowing you to initiate the Roth conversion during your first retirement year so as to minimize your taxable income (as you are retired, you should not be earning income other than passive investment income). Also, if you can hold out on distributing some or all of the Roth funds until you are 59.5, the earnings will be tax free as well (the traditional benefit of a Roth).
Option 2: Substantially Equal Payments
Also called a 72(t) distribution, this little-known code section allows you to access your retirement funds early and without penalty so long as you set up a series of equal payments that will happen over the course of the rest of your life. You must use an actuarial life expectancy table to set up your plan based on the expected years you have left to live, and once installed you cannot take more than the equal yearly amount or you will subject yourself retroactively to the 10% penalty. However, this is a fantastic option because substantially equal payments are what most people tend to gravitate towards anyway, and you can easily structure your portfolio to give yourself access to larger lump-sum amounts outside of this plan as well, in case the itch to buy that boat you’ve always wanted is dying to get scratched (just say no!)
Option 3: Borrow from Yourself
This is by far the least recommended of the options, but you can borrow from your own 401k (but not IRA). Generally, you are limited to $50,000 and a 5 year term, but some plans may offer lower amounts and terms or not offer loans at all, as it is not required. A 401k loan is typically regarded as financial suicide, but that is because the person taking the loan is usually still employed and in a desperate situation. Unlike that person, if you are retiring early and are using the loan more as a distribution and a bridge loan to 59.5, then a lot of the negatives no longer apply.
Planning Ahead for an Early Retirement
If you are considering pushing yourself to achieve financial independence at an early age and thus stop working before the traditional retirement age, it is critical to plan ahead. While options like the ones listed above exist if you need to access retirement funds early, the best course of action is to have a plan in place to have access to funds that aren’t in 401ks/IRAs.
A taxable account can be a great idea to diversify your holdings, act as an emergency fund, and allow for flexible cash distributions that are only subject to capital gains tax and will not incur any early-withdrawal penalties. While there are no tax benefits for depositing to a taxable account, there is still a place for it, and it may be your only option if you are maxed out on your retirement contributions.
Another fantastic option is an HSA account, which are available for high-deductible medical insurance plans. HSAs have the best functionality of both a traditional IRA (pre-tax contributions) and Roth IRAs (non-taxable earnings), but they can only be used for qualified medical expenses and contributions are limited to $3,350/$6,650 per year, single/married. However, unlike an FSA, HSAs rollover year-to-year and you are almost certain to incur increased medical expenses after you retire and no longer have an employer-subsidized health insurance plan. Plus, even if you are as healthy as can be, you can eventually take distributions for non-medical reasons once you reach 65, which are penalty-free but subject to regular tax (like an IRA).
Wrapping It Up
Long story short, you should not let the IRS tax code (or societal pressure) force you to retire later than you want. There are plenty of options to access retirement funds earlier than 59.5 if needed, and as long as you have created a large enough nest egg to last you and yours until the end of your days, why put off the freedom of retirement any longer than you have to?