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Logistically speaking, how would one retire early without getting hit with withdrawal penalties?

As far as I know, most tax-incentivised retirement accounts slap you with penalties for making withdrawals before retirement age.

Let's assume that I am 40 years old and have enough money in my 401k and Roth IRA to retire. I want to retire and live off of the growth of these funds. How would I make withdrawals from these accounts without incurring penalties?

I've seen plenty of guides on early retirement (FIRE), but I can't find material on actually retiring early.

David G
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ewiggin
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4 Answers4

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There is a provision for this. It’s called Sec 72(t) and it permits you to take annual withdrawals according to your age, for 5 years or until age 59-1/2 whichever is later. Tax is due, but this avoids the 10% penalty.

Note - while not really part of the question, you should be aware that the 401(k) withdrawal has a fixed 20% withholding for taxes. Depending on your situation, this may set you up for a large refund. Better to use the IRA for withdrawals where you can adjust the tax withheld.

Edit - in response to the comment. By breaking the funds into a number of accounts, one can choose to tune this process to a sum to give a minimum amount that makes sense, e.g. $24K/yr which for a couple is the standard deduction, no tax due. Of course, a mix of pre and post tax money would probably be best.

JoeTaxpayer
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The most common method for early retirement from IRA/401k is to use a Roth conversion ladder optionally combined with taxable accounts. With a Roth conversion ladder you would start 5 years before your planned retirement and convert a years worth of expenses to a Roth IRA each year. Then on year 6 you can withdraw what you converted 5 years ago because it is 'seasoned'. Basically you avoid the early withdrawal penalty by paying taxes on and waiting 5 years and by doing it every year you can put together a ladder of converted money that can be used penalty free once you retire.

Some notes:

  • Many people plan to simply use taxable accounts for the first few years before starting the ladder because the converted 401k/IRA money adds to your taxable income and can push that money into a higher tax bracket.
  • Tax brackets are the same reason you wouldn't want to convert all of your money in a given year.
  • There are other methods like 72(t), but it is much more complex and as I recall they lacked flexibility
  • For folks in lower tax brackets (0% cap gains bracket) taxable accounts with tax efficient re-balancing are also a valid option.
stoj
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8

You are assuming that the funds saved for your retirement must all be in specific tax accounts at the outset.

First of all, you should be wary of the difference between your investment portfolio (ie: which stocks/bonds/etc. you invest in), and the investment 'vehicles' that you use to make those investments (ie: 401k vs IRA etc.).

This distinction is especially important when reading information online, which may not be based on your jurisdiction, and therefore won't incorporate the tax concerns you may be having.

Whether any of this matters to you will depend on how much you have already invested through 'tax deferred' vehicles (not all of which penalize you for early withdrawal).

If you have a specific question about your specific financial situation + goals + tax jurisdiction, you should ask that separately.

Grade 'Eh' Bacon
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The Section 72(t) and the Roth IRA conversion ladder are the two methods I've heard of for USA residents

I follow several early retirement blogs, most of which ignore this issue. The one that deals specifically with advice regarding tax advantaged accounts is the MadFientist

His article on this subject provides more detail for further reading, as well as example scenarios of each https://www.madfientist.com/how-to-access-retirement-funds-early/

He also does the math comparing the above against paying the 10% early withdrawal penalty.

In his example, the math demonstrates the 10% early withdrawal penalty is an affordable expense in certain situations only loses out slightly against a conversion ladder or a Section 72(t)

Example graph: https://www.madfientist.com/wp-content/uploads/2016/07/early-withdrawal-strategies-graph.jpg

Definitely review the examples and run the numbers for your situation

borktroll
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