Retirement accounts like the IRA and 401(k) are designed to help you save for retirement. So the IRS imposes penalties on most withdrawals that take place before age 59-1/2. But if you're retiring earlier than that, you'll need to find a way to access all your savings without paying that penalty.
If you plan ahead for your early retirement, there are plenty of ways you can get access to retirement savings well before age 59-1/2, and you won't have to pay that pesky penalty at all. Here are four ways to do it.
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1. Roth IRA contributions
One of the biggest benefits of a Roth IRA is that you can withdraw contributions at any point without taxes or penalties. If you consistently contributed to a Roth IRA during your career, you may be able to start withdrawing sizable amounts early without a penalty.
Technically you can withdraw contributions to a Roth 401(k) without penalty at any point, too. But there's a big difference between how distributions are treated between a 401(k) and an IRA.
With an IRA, your contributions come out first. With a 401(k), your contributions and earnings are prorated. So, if you've contributed $100,000 to your Roth 401(k) and it now has a balance of $300,000, two-thirds of your withdrawals will be subject to a penalty.
Your best course of action is to convert a Roth 401(k) to a Roth IRA before taking distributions in order to avoid the penalty.
2. Roth IRA conversions
If you convert funds from a traditional IRA or 401(k) to a Roth IRA, you can withdraw the amount converted. The only catch is you have to wait five years before withdrawing the amount you converted.
If you've saved in pre-tax accounts your entire career, you may have quite a bit of savings in a traditional IRA or 401(k). Unlike funds that are already in a Roth IRA, you can actually access the entire amount in those accounts without paying a penalty. You simply convert the entire balance, and then wait five years to make the withdrawal.
Importantly, it doesn't matter when you make the conversion within a given year. So you could convert funds in December, then withdraw four years and one month later in January without penalty.
You'll still have to pay taxes on the converted amount, but you won't incur any penalties. It's best not to convert the entire amount all in one go, as you'll face a much higher tax bill than if you steadily convert your pre-tax retirement accounts over time, taking advantage of lower tax brackets.
Some early retirees will execute a Roth IRA conversion ladder. The strategy involves converting a certain amount every year to be withdrawn five years later. Doing so provides a steady stream of retirement funds available for withdrawal.
3. The Rule of 55
There's a special escape hatch for 401(k)s that can allow you to start taking penalty-free distributions as early as age 54: the rule of 55.
The rule of 55 states that you can start taking withdrawals from your 401(k) if you separate from service during a year in which you turn 55 years old or later. So, if you leave your job the next January after you turn 54, you can immediately access all of the funds in your 401(k).
There's a big caveat, though. The rule only applies to the 401(k) plan of the employer from which you separated at age 55 or later. That means you can't take the funds and roll them over into an IRA (with lower fees and more investment choices) and still avoid the penalty.
If you like your 401(k) plan, though, it could make sense to roll some money into the plan before you separate from service. That way you'll have enough to get you to age 59-1/2, at which point you can withdraw from an IRA without penalties.
4. Substantially equal periodic payments
You can start taking withdrawals from your retirement accounts without paying any penalties as long as you're willing to continue taking withdrawals of roughly the same size every year until you reach age 59-1/2. If you follow rule 72(t) in the tax code, you'll find an exception to the 10% penalty if you make substantially equal periodic payments for at least five years and until you reach age 59-1/2.
There are three different methods for calculating how much you must withdraw under rule 72(t):
- The amortization method will amortize the value of your account over your life expectancy. This creates the largest withdrawal amount.
- The required minimum distribution method will have you withdraw a variable amount every year based on the IRS's required minimum distribution tables and your account balance at the end of the previous year. This usually produces the smallest withdrawal amount.
- The annuity method calculates a fixed withdrawal amount that takes the current account value divided by an annuity factor. The annuity factor stems from the IRS mortality tables. This method produces an amount somewhere in the middle.
Taking 72(t) distributions is much less flexible than the above three methods. Once you start, you can't stop until you reach normal retirement age, and you have limited control over how much you withdraw.
Don't let penalties stop you from retiring early
If you have the funds to retire early, but you're worried about paying the 10% penalty, don't be. As you can see, there are a lot of ways to avoid it. Use one or more of the above methods to start taking withdrawals, bridge the gap until age 59-1/2, and start your retirement on your own terms.
