One of the problems people face with early retirement is getting access to the money they have saved in their retirement accounts. A 10% penalty is imposed for early withdrawal of IRA, 401k, 403b, 457, and TSP dollars.
This leads many to believe that they need to wait until age 59 ½ before they can touch their hard-earned savings for any reason other than financial hardship, education expenses, or a first home. There are a few “secrets” in the tax code, however, that allow us to withdraw money penalty free at any age.
Of course, you should leave your retirement savings alone to grow as long as possible. This could mean using other money outside of your retirement accounts first or supplementing your income with a fun part-time job. But when it’s time to use the money, it is available to you.
Here are the secrets and why you might choose one over the other if you are retiring early.
1 Roth conversion ladder
All Roth contributions are taxed at the time you make the contribution. Therefore, you’re allowed to withdraw your contributions at any time. Earnings—dividends, interest, and asset price gains—from investing those contributions cannot be withdrawn until 59 ½.
This limits your use of Roth dollars before retirement age to contributions only.
However, money from traditional (pre-tax) retirement accounts can be converted to a Roth IRA at any time. Those contributions are subject to a 5-year waiting period, and then they can be withdrawn from the IRA also.
Investopedia has a comprehensive article on the 5-year rule, which also applies to withdrawing earnings after 59 ½ if your Roth account has not been open longer than 5 years.
If you don’t have a Roth IRA yet, open one today to start the clock on the 5-year rule! Do this even if you can only contribute $50 this year.
This is the Roth Conversion Ladder strategy for early retirees:
- Make a Roth conversion before Dec 31st on year 1, filling your desired tax bracket
- Invest this contribution inside your Roth IRA
- After Jan 1st of year 5, withdraw the year 1 contribution tax and penalty free
- Note that the waiting period is actually as little as 4 years and two days if you make your contribution on Dec 31st, accounting for a bank holiday on New Year’s Day
- Repeat steps 1-3 each year to continue your Roth conversion ladder
Example 1: Roth conversion ladder
Table 1 gives an example of how a Roth conversion ladder would work for an early retiree who needs $50k in year 1, increasing by 3% each year to keep up with inflation.
For simplicity, investment returns and taxes are ignored in Table 1.
In reality, the Roth conversion will continue to be invested up until it is withdrawn. You may want to be conservative in the first few years of conversions in case there is a loss that limits the amount that you have available to withdraw. Over a long enough period of time, keeping the money invested will statistically work to your advantage.
Also, taxes must be paid, either by withholding the appropriate amount from the conversion and depositing the rest into the Roth IRA or by paying the taxes “out of pocket” with no additional withholding. Read this article for more details on taxation of Roth conversions.
In this example, the retiree must find income for the first 4 years from other sources (a taxable brokerage account, savings accounts, rental property income, part-time work, etc.). This is another good use for I bonds, by the way!
Drawbacks of Roth conversion ladders
The primary disadvantage of Roth conversion ladders is obvious at this point. The retiree from the above example needs more than $209k from somewhere else before the ladder provides any income!
Also, if you’re retiring at 55 this strategy is not of much use. You will have full access to your traditional retirement accounts around the same time that the ladder is running.
If you won’t have enough money outside of retirement accounts or will be in your mid-50s when you retire, take a look at the next strategy.
2 72t distributions
A 72t distribution refers to a section of the Internal Revenue Code. This code allows you to make early withdrawals penalty free as long as you follow two rules.
Rule 1: A series of Substantially Equal Periodic Payments (SEPP) must be made from the account for 5 years or until you turn 59 ½, whichever is longer.
Rule 2: The SEPP dollar amount must be calculated in one of three ways. This article goes into more detail on SEPP calculation for those who are interested. This article discusses some recent changes that allow larger SEPP amounts and the ability to change the calculation one time if desired.
The benefit of a 72t distribution strategy is its immediacy. The drawback is its lack of flexibility in time frame and payment amount.
72t distributions are a great option for retirees aged 50-55. They can bridge a 5-10 year gap until age 59 ½.
For those in their 40s or younger, I would suggest that more caution be taken before getting started. You will be locking yourself into more than a decade of fixed withdrawals that may not suit you well at some point. For example, if you decide to earn a large income again during one of those years your 72t distribution will be taxed at a higher rate.
The middle ground, if you’re a younger retiree, may be to split a large retirement account into two smaller accounts, then take 72t distributions on one and perform a Roth conversion ladder on the other. This will result in smaller SEPPs and more tax rate control and flexibility. You will still need to make up for a (smaller) gap in income for the first 4+ years until your Roth conversion ladder kicks in, however.
Example 2: Split 72t / Roth conversion ladder
Let’s see what happens if we modify our earlier example to use a split strategy, taking part of the income from a 72t and part from a Roth conversion ladder. We’ll assume that the account the 72t is being applied to and the calculation method chosen produce fixed SEPPs of $20k per year.
Comparing Table 2 to Table 1, we see that the retiree draws the same amount from traditional retirement accounts each year, but needs $20k less from other sources in each of the first 4 years. This is a total of $80k less that has to come from somewhere else.
Where did the $80k go? It wasn’t free. In Example 1, the extra $80k is locked up in the Roth conversion ladder and will come available in $20k chunks as time goes on.
This doesn’t necessarily make Example 1 less efficient from a total return standpoint since that $80k is still being invested. In fact, it can be seen as a good thing to have more money in a Roth for a longer period of time, growing with no capital gains tax.
The real difference between these two examples is just how quickly your non-retirement assets are being depleted.
Spend your non-retirement money first.
If you have enough, use a Roth conversion ladder and wait to spend retirement money when non-retirement money is depleted.
If you don’t have enough, a 72t can be right-sized to keep you from running out of non-retirement money before the ladder is set up.
3 The Rule of 55
The Rule of 55 is an IRS (Internal Revenue Service) guideline. It allows employees who leave their job in the calendar year that they turn 55 to withdraw from their current 401k or 403b penalty free. Some firefighters, police officers, and EMTs can qualify as early as age 50.
The Rule of 55 is much more flexible than 72t. You can stop withdrawals at any time and will not be penalized. You can also withdraw the precise dollar amount that you need.
Use the Rule of 55 instead of 72t distributions if you qualify.
Read this article for more on the Rule of 55.
Summary
If you are retiring early, careful planning will allow you get all the money you need out of your retirement accounts without penalty. There are three ways that this can be done.
- Roth conversion ladder – Use this for money you won’t need for 4+ years.
- Roth conversions are also a great tool for tax planning and to ensure that you will not be hit with large Required Minimum Distributions (RMDs) in your 70s. Consider Roth conversions in any year that you are in a low tax bracket, whether you are retired or not!
- 72t distributions – Use this when income is needed before a Roth conversion ladder could provide it.
- Rule of 55 – This is the best option, but is restricted to a small subset of people. Use it if you qualify.
Which of these strategies will you use?
Do you have enough savings outside of retirement accounts to bridge a gap for a Roth conversion ladder?
Are you currently allocating savings to pre- and post-tax accounts in a tax efficient way?
It’s never too early or too late to start planning.
Contact me if you have comments or questions. I’d love to hear from you.
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