People who are a bit burned out from working jobs they have had to work are increasingly “retiring” early. Not to head to the golf course. But to focus on a new career (#RethinkRetirement) that they feel more passionate and engaged about. With this in mind, figuring out whether early retirement can happen financially is paramount on their minds. Therefore, after working through questions of life’s purpose, personal values and goals, the decision to “quit” early eventually comes down to the money.
Show Me the Money
If you are considering this, you must be wondering, How can I retire early when all of my money is locked into retirement plans and long-term savings? Locked into the types of investment accounts that often charge penalties if withdrawn at too young an age (Retire at 55 anyone? Retire 53?)? or you might be wondering, how should I plan account withdrawals to make sure:
- My money lasts as long as I do.
- I avoid any silly mistakes.
- I withdraw in a way that keeps the overall tax hit small.
- (And for some) I can take care of my family while I’m alive and leave something after I’m gone.
Thankfully, there are solutions. Ways to access your money earlier do exist! However, the methods and strategies for each person can differ. This is not often a cookie cutter, one size fits all prescription to this challenge. There is in many cases, an optimal way for each person to make this happen. Especially considering the four bullet points above. Let’s examine some ways you could access funds earlier than age 59 1/2 without penalties and surrender fees.
Note: 59 1/2 is the standard penalty free age for retirement accounts under normal circumstances. Though many exceptions do exist.
Tactics for Accessing Money without Penalty for Early Retirement
Here I will outline some of the ways (in no special order) that you could access money. Remember, some or all of these might not be right for you. Therefore, have your personal finances carefully reviewed before making planning decisions!.
Tax-Free Return of Contributions with The Roth IRA
Many people realize and use the Roth IRA as a tool to build and access tax free funds for retirement. The keeps the tax bill and the all important “adjusted gross income” figure lower. Lower than it might have been had all IRA money been taxable. Keeping adjusted gross income/taxable income on the 1040 low proves increasingly important as more and more penalties and fees hit retirees with relatively average incomes. We will discuss this a bit later in the article. But for early retirement purposes (and the purpose of this article), aggressive Roth savers have a secret weapon. Contributions are considered simply a return of capital and can be withdrawn anytime.
Therefore, withdrawing contributions from a Roth could effectively bridge your income between early retirement age (retire 53 anyone? 55?) and penalty free access to earnings and regular IRA assets at 59 1/2. A simple example. You:
- Want to retire at 57 – 2 years before you can access your IRAs without penalty.
- Determine that you need $15,000 each of the next two years to “bridge the gap.”
- Have a $95,000 Roth account and $45,000 of the balance represents contributions.
The $45,000, or in this specific example, $15,000 per year for the next two years can be accessed without penalty until penalty free withdrawals become available at 59 1/2.
Point of caution on Using the Roth First
If you decide to use Roth contributions, you are by default delaying the use of taxable assets. People planning for retirement need to be cognizant of spreading taxable income over the course of their expected retirement lifetime. Why? To avoid if possible, years of high taxable income later in retirement. People who defer retirement accounts until age 70 1/2 at the expense of other assets often experience this. As their Require Minimum Distributions at 70 1/2 grow large and cause tax bracket and other related cost increases.
Cost Basis Roll Outs from a 401(k)
If you have a 401(k) balance with cost basis, you enjoy the option of rolling the entire balance over. Or, alternately, and more interestingly, of stripping out the cost basis and receiving that money directly in a check*.
This cost basis amount may or may not be much, but it could help bridge the gap to 59 1/2 a bit along with other techniques mentioned here.
NUA – Net Unrealized Appreciation of Company Stock
Another “sneaky” tactic available to you might be taking advantage of the rule on Net Unrealized Appreciation (NUA) of company stock in a plan. This benefit applies only to 401(k)s – as a 403(b), TSP, or 457 shouldn’t contain company stock.
This handy rule allows you to “strip out” the company stock from your plan at work. Then, pay income tax on the cost basis of the stock and treat the gain (current price minus price purchase when inside the 401k) as capital gains. More than the beneficial tax treatment, this removes that asset from the 401(k). And subsequently, from the rules of the 401(k)! Therefore giving you potentially early access to what was retirement funds without the penalty! But potentially with a much more generous tax treatment. I cover NUA more in this article HERE.
Access Your IRA 401k or 403b Penalty Free with IRC Section 72(t) Substantially Equal Periodic Payments
Another exception to the 59/12 rule which can be exercised at any time is the 72t rule. Internal Revenue Code Section 72t explains how you could withdraw retirement money penalty free before age 59.5 in a Substantially Equal Periodic Payments plan (SEPP) by following certain parameters. The basic tenets of this plan are:
- You typically must use one of three approved payout methods.
- Once begun, You must continue payments to age 59/1/2 or 5 years, whichever is later.
- You can not “substantially” change the distribution plan once started.
For certain IRA holders this is a no brainer. Take the relatively recent stories of tech stock CEOs stuffing their IRAs with pre-IPO stock options and watching those IRAs explode in value. If your IRA were worth $100M you’d likely have no worry of spending it all. Or losing to inflation even if you started withdrawing at age 40 using the 72(t) rule.
But for regular people like us (excuse the snarky example above please), the pros and cons must be weighed. The Section 72(t) SEPP option is often a good plan when other assets are available and growing and you want to spread the tax bill over a longer period of time. And keep realized taxes low to take advantage of tax deductions, and lower costs on certain programs like Medicare later on. 72t can also provide an excellent bridge to later years when retirement accounts become fully penalty free.
Note: the downside to 72(t), as with the Roth early withdrawals, is the potential shortfall in average retirement savings for those living a long life. I discuss 72(t) more in depth in this article HERE.
Age 55 Rule (or Age 50 Rule)
A hidden gem that can make life very easy for you to retire early is the age 55 rule. It simply states that:
- If you have a 401(k)/403(b)/457/TSP/qualified retirement plan, and
- You separate from service from your company in the year you turn age 55, and
- You leave the money in your work plan (i.e. no rollovers!),
Then you can take withdrawals from your retirement account penalty free.
Retire at 50: Public Safety Employees Get an Additional Break
Furthermore, due to a recent change in the law, (The Defending Public Safety Employees’ Retirement Act of 2015) certain Federal, State and Municipal public safety employees can access money in their 457 plan or TSP under this rule at age 50!
Using this tactic can also help with the idea of spreading taxable income out earlier in retirement to avoid the negative effects of having too high a a taxable income later. I plan to discuss this in a future article (and likely a video).
Annuitizing Your “Non-Qualified” Annuity
Payout levels may not be generous at younger ages, but non-qualified (i.e. non IRA/403b etc) “annuitized” annuities avoid 10% early penalties. If you elect to take a payout option from your annuity – life option, life with 10 years certain etc – you will not pay a tax penalty on earnings. Typically withdrawals from annuities are subject to 10% penalty on earnings withdrawn before age 59 1/2. But not when you annuitize. This is similar to IRC 72(t) exceptions for qualified retirement accounts.
Life Insurance Cash Value
You can work with life insurance cash value a few different ways, depending on how much cash you have in the policy and current rate schedules. Policy owners can access policy loans or withdraw funds. Both ways are tax-advantaged. Loans do incur interest which always seems to be 1% or so more than the interest credited. Therefore your cash balance will likely hold up fairly well despite the interest costs if you don’t borrow the entire balance (better to limit it to no more than half the cash value).
Withdrawals are handled on a first in first out basis with life insurance meaning, similar to Roth IRAs, cost basis is considered withdrawn first. If you deposited $100,000 into your policy and it later grows to $250,000 and you withdraw $50,000, you will pay no tax. As for tax purposes, that 50k came from your $100,000 contributions and is considered a return of cost.
In both ways you could bridge an income gap until age 59 1/2 when other moneys such as an IRA go penalty free.
Capital Gain Assets
In some ways we might want to touch this last, or perhaps just before accessing Roth money. It has to do with tax strategy which is discussed in part below (I will save detailed discussion of that for another article).
But simply, stocks and other capital assets you own can be sold without tax penalty and the proceeds used to fund early retirement.
Note: caution for those in high state income tax states and those in high income brackets. State taxes and the Affordable Care Act Investment surtax might be applied on any asset sale.
Bonus Tactic to Help You Retire Early – Downsize Your Home!
If you really want to change your life, and you are fortunate to have enjoyed significant real estate gains, then the capital gains exemption on primary residence ($250,000 for single people and $500,000 for married couples) offers a potentially large source of tax free money to help you retire early. And now might be an especially timely to time sell as house prices, according to one expert, nationwide have never been on average this “unaffordable” to the average buyer.
You can use some of these techniques with a 401(k), 403(b), 457, Thrift Savings Plan (TSP) or an IRA. Some rules, like the Age 55 (50) rule, only apply to Qualified Employer Retirement Accounts such as a 401k, 403b, 457 or TSP, but not to an IRA.
Roth IRAs can enjoy the cost basis withdrawal feature. Also note that some people have cost basis in their 401(k)s (as noted above) and traditional IRAs. Plans will often permit the Cost basis in a 401(k) to be distributed separately upon rollover.
IRAs, 401k, 403(b), 457, TSPs and non -qualified annuities can all be “annuitized” whether through purchase and election with a commercial annuity company or through the Substantially Equal Payment Plan outlined in 72(t).
Note: Disability & Death can also trigger an exception to the 10% penalty. If you have to retire early due to disability, you might be able to access retirement funds. You’ll want to coordinate and weigh the options as I discuss below in regards to retirement planning. in order to find the best way to meet current needs and to make the money last as long as you need it to.
If your spouse or other retirement account owner passes away and you inherit a retirement account, the 10% penalty is waived in that case also. Special rules apply when inheriting a retirement account. Be sure to consult an advisor before deciding what to do.
Extra Reading: 6 Inherited IRA Mistakes to Avoid
Pulling it All together: Retire Early, Access Your Money Before 53, before, 55, before 57, Whenever!
We’ve discussed the tactics for rethinking retirement planning here in this article but not the strategy. The overall strategy for you requires much more information to develop. So many variables including age, needs, family dynamics, longevity and desired lifestyle come into play.
For example, here is one of the major planning considerations that I would strongly recommend you factor in:
Spreading taxable income over retirement – Don’t fear accessing taxable retirement funds earlier and saving tax free assets for later to prevent part of what IRA expert Ed Slott calls the retirement time “bomb.”
Early Retirement Time Bomb from Tax Deferrals
The retirement time bomb happens to those who place deferring taxes as their primary motivation. They spend after tax dollars first early in retirement (e.g. bank money, Roth money, stocks) and avoid withdrawing from their IRA, 401k, 403b, 457 or TSP until age required at age 70 1/2.
This leads to a much larger required minimum distribution (RMD) because they’ve deferred withdrawals so long. I am seeing this much more now in my “travels” than I ever have. Besides investors purposely delaying withdrawals, another reason I see this more often is simply that 401(k)s have been around long enough that many people have large pre-tax accounts.
Furthermore, many of these folks hold the belief that they should defer taxes as long as possible and voila – the ticking retirement time bomb. The big RMD! These big RMD’s spike the retiree’s income pushing them into higher tax brackets and causing a slew of other problems such as:
- Tax on social security benefits.
- Loss of deductions on medical expenses.
- Increases in Medicare premiums for “higher earners.”
- Phase out of deductions and exemptions.
It often makes sense to explore spreading taxable income over the entire course of one’s retirement years. This prevents large taxable “hits” later on and potentially keeps taxable income low enough to continue to qualify for certain deductions and avoid certain other cost increases.
Spreading Taxable Income from Early Retirement On – an Example
For example, if you want to retire at 60, and you’re married, own an IRA with a $600,000 balance, & a bank balance with $400,000, and your taxable income prior to an IRA distribution is $50,000, you may be tempted not to touch the large IRA and let it continue to grow. You may even decide to tap your bank assets or other after-tax assets first to supplement income. In order to keep current taxes low.
The problem is that when you retire early, and let your taxable IRA assets compound at 7% per year to age 70 1/2, you will have $1.2M PRE-TAX dollars. This occurs at the expense of your AFTER TAX MONEY. Your RMD will start at $43,795 at age 70 1/2 (and potentially get bigger each year!). This puts taxable income at $93,795. Whether you want that distribution or not. And married income over $79,500 in 2017 is taxed at 25%! If you could have kept that income lower throughout the years perhaps other assets could have been left to grow and the IRA distributors could have been taxed at only 15% over the years.
Furthermore, your Medicare premiums increase if you are single and your “modified adjusted gross income” exceeds $85,000 in a year. Here is the graphic from Medicare outlining how your premiums will increase if you earn “too much money” in any year:
Control Taxable Income in Retirement!
Hitting a higher tax bracket and increased Medicare premiums are just two of many increased costs you will encounter if you don’t find a way to control TAXABLE income before this happens. How do you control taxable income? This is a subject for a whole other article and has been the subject of many presentations I have given. Suffice to say the strategy will differ from person to person.
Can I help?
if you have questions about Rethinking Retirement and you are curious about how you can rethink retirement and change career gears (well) before age 60, reach out. You can inquire about working with us by clicking HERE . And remember, don’t do any of this stuff without consulting an advisor. Some if not all of these tactics involve irreversible decisions. Therefore, though these tactics can very much help you retire early, they can also hurt if used improperly without a solid overall plan.
Thanks for reading!