The Biggest Retirement Account Myth

You can’t access retirement account funds before 59 1/2. WRONG!

Ask anyone who thinks they understand retirement accounts when you can access retirement account funds. Even the professionals. They will probably say what has been beaten into everyone: “59 1/2 for 401(k) and IRAs otherwise you pay a 10% early withdrawal penalty”

They are wrong

You can retire early with your IRA and 401(k) without incurring early withdrawal penalties. You just have to know the correct way to access these funds.

Horrible disservice

This zeitgeist leads people to believe that if they save a lot today, they won’t get to enjoy that money until they are 60. Since they have to wait so long, this also leads the otherwise financially savvy to try to just save enough to reach some target amount at the age of 60 or when they plan on taking social security.

This causes people to save the minimum to reach that distant goal.

The correct ways to access retirement funds early

There are two main ways to access retirement funds early.

  1. SEPP withdrawals – SEPP stands for substantially equal periodic payments. This is also referred to as 72t withdrawal. Long story short, you can set up a permanent automatic withdrawal from a retirement account without incurring the tax penalty. If you are withdrawing from a pre-tax or tax-deferred account, you will liable for regular income tax on any previously untaxed funds you receive. This is not a penalty. This is just regular income tax you would have to pay as though you were getting a paycheck because this money has not yet been taxed – you would be paying the same tax at 59 1/2.If you are retired early, this means you no longer draw a paycheck from an employer and are probably in a lower tax bracket than you probably were while working. Maybe you were in the 25%+ bracket while working and you didn’t have to pay 25% tax on your 401(k) contributions. When you’re retired early, you may end up only paying 0-15% tax and only on the portion beyond your deductions.

    As with any deal from the government, there are strings attached. There are certain limits to what you can withdraw based on prevailing interest rates (they don’t want you to run out of money) and your payments must be equal or you will owe back tax penalties from previous withdrawals. I will do a more detailed write-up on this later. For now, check out this calculator to get an idea of what these withdrawals could look like for you.

  2. 401(k) to Roth IRA conversion ladder – You can rollover funds from a 401(k) to a Roth IRA without penalty and then 5 years later, withdraw those funds from the Roth IRA without penalty. You do pay income tax on the amount that is converted. This is a strategy you do once you retire and have no work income – or perhaps in a year that you had low income, such as if you were unemployed.When your 401(k) and traditional/deductible IRAs are nearly big enough for you to retire, you then need to save enough in taxable accounts to cover your living expenses for 5 years. During your first 5 years (and every year thereafter) you’ll be in a low bracket and can convert pre-tax 401(k) money to your Roth IRA, paying only income tax during those conversions. Those rollover amounts count as contributions to your Roth and you can withdraw contributions from Roth IRAs tax-free and penalty free. But those rolled over funds aren’t available for 5 years (arbitrary rule), so you need your 5 years of living expenses covered elsewhere.

    Let me repeat that last part. You can rollover pre-tax money to your Roth IRA while you are retired/low tax bracket and then access those funds in 5 years penalty free and tax-free. This is called the Roth IRA conversion ladder. You keep doing this throughout retirement. Every year, you transfer enough for you to live on 5 years from now. That’s why this is called a ladder.

My personal strategy and playbook

  1. Max 401(k) first
  2. Max ESPP if available to you at a discount – sell ESPP stock as soon as you can and then max IRA or put the proceeds into your fund of choice
  3. Max IRAs – deductible IRA if you can, Roth otherwise, traditional otherwise
  4. When 401(k) and IRAs are nearing critical mass, and if you plan to stay in your current residence, pay it off – keep contributing for 401(k) match, though. Also still good to max Roth if you can
  5. Save up 5 years of living expenses – keep in mind you can remove your mortgage payment from those expenses

The Bottom Line

For the vast majority of people working a traditional job, the best option is to max their tax deductible accounts before putting a penny in a taxable investment account. Even if you are a hot shot stock picker, it’s hard to beat the tax deduction – an instant first-year return of your marginal tax bracket and tax-free growth. If you are using a 401(k) and IRA, this means saving $18,000 in the 401(k) and $5,500 in the IRA before you put funds towards other goals such as saving in a taxable stock account or luxury spending.

Don’t get stuck thinking that money saved in a retirement account is inaccessible until you are 60. It is not. The bottom line is that once you have enough saved to retire, even if it is in “retirement accounts with age rules” you can retire early, without penalties.

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