Retirement accounts are some of the best possible ways to save money during your working years. They allow you to defer taxes – either now or later – and reap the rewards of compound growth without compound taxes.
But there’s a catch.
You can’t withdraw money from your 401(k), IRA, or Roth IRA at any time. If you take out money from these accounts before you’re 59 ½, you may be hit by a 10% early withdrawal penalty. It’s like your money is in a safe, and you can’t get the combination until you reach that age.
There is some good news though! For each of these account types, there are ways to access your money early without paying this penalty. In this article, we’ll look at a few tax efficient retirement withdrawal strategies YOU can use to withdraw money from these accounts before you meet the age requirement.
The three most popular retirement accounts used in the United States are the 401(k), the Traditional Individual Retirement Account (also just called an IRA), and the Roth IRA. Each has slightly different rules for accessing them.
This article focuses on the “how” but doesn’t answer the question of “should you?”. My personal opinion is that you shouldn’t access these accounts unless you’re experiencing a tremendous hardship, or you’ve retired and have worked out how to live off of them going forward.
These “early access” and “withdraw penalty” are assuming you use none of the techniques discussed in this article to access these funds early.
|401(k)||Traditional IRA||Roth IRA|
|Earliest Full Access||59½||59½||59½|
|Earliest Possible Access||
You can access the account only of a job you leave.
|Early Withdrawal Penalty||10% penalty||10% penalty||
|Required Minimum Distribution||
72 years old
(age 70½ if born before July 1, 1949)
70½ ~ 72 years old
Read more on the IRS Website
|Yearly Contribution Limit||
$26,000 when 50+
for IRA + Roth IRA
for IRA + Roth IRA
|Early Withdrawal Options||• Rule of 55
• Cares Act
• Roth IRA Ladder
• 72t Distribution
• Hardship Distribution
• First Home Purchase
|• Cares Act
• First Home Purchase
• Roth IRA Conversion Ladder
• 72t Distribution
|• First Home Purchase
• Contribution Withdraw
The 401k early withdrawal penalty is the most severe one that most people will face. Fortunately there are many strategies you can use to access the account sooner! Let’s look at them one by one.
Adam says: This post is a little long. You can skip to any strategy by clicking on the link in the table above.
Early Withdrawal Strategies
There are multiple strategies for each type of account. I’ve ordered them by easiest to implement to the most difficult.
Rule of 55 Works for: 401(k)
The Rule of 55 is an IRS provision that allows you to access the 401(k) account of your job without paying the early withdrawal penalty on two conditions:
- You’re at least 55 years old.
- You leave your job.
In practice it works like this: You have a 401(k) at job that you’ve been contributing to for years.
Keep in mind that you’ll only be able to withdraw funds from the 401(k) account from your employer. You won’t be able to access other 401(k) accounts.
There is a trick you can use though! If you know you’re going to leave your job between age 55 and 59½ you can rollover past 401(k) accounts and traditional IRA accounts you have into this one 401(k). By doing that you’re bucketing all money into your single 401(k) account you can access early – and without paying a penalty!
Contribution Withdrawal Works for: Roth IRA
There’s a reason why I recommend Roth IRA’s over IRAs whenever possible: they are the most flexible. Unlike IRA and 401(k) accounts, you can withdraw the money you deposited into a Roth IRA at any time! The only money you can’t touch without paying an early withdrawal penalty is the earnings and interest.
Let’s look at an example. Say you started maxing out your Roth IRA at age 25 – putting in $6,000 a year. You continued doing that until you’re 50 years and decided to retire early (congrats!). During that time you invested it in the stock market and it grew at 7% a year.
When you’re 50 you would have saved up $422,000. $160,000 of that was from your contributions and the rest was growth in your investments.
That means that you would be able to take out $160,000 of it at any time for any reason. You could withdraw it all at once, or $20,000 a year for 8 years.
As soon as you take out the first $1 over $160,000, you’d need to pay a 10% early withdrawal penalty on every dollar you withdraw.
As soon as you hit age 59½ that early withdrawal penalty goes away and you can take out any amount you like.
Cares Act 2020 Works for: 401(k)403(b)IRA
The Cares Act is a Coronavirus relief bill passed and enacted on March 27, 2020. Amongst other things, there’s a provision in the Cares Act that allows “qualified individuals” to withdraw up to $100,000 from their 401(k), 403(b) or IRA account within the 2020 year.
To be a “Qualified Individual”, you must meet these requirements:
- You, your spouse or a dependent must be diagnosed with COVID-19 by a CDC approved test.
- Experience “adverse financial consequences as a result of being quarantined, laid off, or work reduced.
The full list of requirements are listed out on the IRS page about the Cares Act in Q3.
If you meet these requirements and want to withdraw up to $100,000 you have that option in 2020!
Another nice bonus is that your taxes for this withdrawal are split over 3 years. If you withdrawal $100,000 you won’t be taxed on all of it. Instead, you’ll be taxed on $33,333.34 in 2020, $33,333.33 in 2021, and $33,333.33 in 2022. You can also choose to pay all taxes in 2020 if you want.
There’s also an option in the Cares Act that allows you to repay this withdraw within 3 years. If you are in a dire financial position now, but quickly recover, this could be a nice additional way to save more in the next few years.
First Home Purchase Works for: 401(k)403(b)IRARoth IRA
As if buying a home isn’t hard enough – there are ways to make it more confusing by tapping your retirement accounts to help with the down payment. Doing so may reduce your PMI (private mortgage insurance), which could reduce your monthly out of pocket cost.
While I’m very much pro-apartment living and repeatedly mention that your home isn’t part of the 4% rule, buying a house is a dream for most Americans.
Here’s how the home purchase would work:
- Be a first time home buyer (or have 2+ years pass since your last home purchase)
- Withdraw up to $10,000 from an IRA, up to $10,000 in earnings from your Roth IRA and/or as much as you need from a 401(k).
If you’re buying a house with your spouse, you can each withdraw $10,000 from your IRAs and $10,000 from your Roths – for a total of $40,000 towards it.
You can withdraw any amount from your 401(k) as part of a hardship distribution – which we’ll talk about next.
Hardship Distribution Works for: 401(k)403(b)
Hardship and Safe Harbor Distributions allow you to withdraw funds from your employers 401(k) or 403(b) for a “heavy financial need” without paying the early withdrawal penalty. You will still pay taxes on the withdrawal.
The tax rules on what qualifies as a “heavy financial need” are specific:
- Medical care
- Buying a new primary residence
- Expenses to not be evicted from a primary residence
- Tuition & education related expenses
- Funeral expenses
- Certain expenses to repair damage to a primary residence
All of these are the type of expenses are the reason why it’s ideal to have an emergency fund of at least 6-months expenses on hand.
With a hardship distribution, you can make an early withdrawal from your 401k or 403b – but only for the amount needed to cover the hardship. You can’t take out extra for a vacation or to cover food.
Roth IRA Conversion Ladder Works for: 401(k)*IRA
401(k): This approach works for a 401(k) if you convert it to an IRA first.
If you’re unable to withdraw funds from an IRA using any of the other methods, the Roth IRA Ladder strategy is your best bet.
You can use this method to withdraw ANY amount from your IRA, pay taxes on it today and spend the money in 5 years. You can use this method at any age, whether you have a job or not.
The Roth IRA Ladder works by converting money from an IRA to a Roth IRA, waiting 5 years, then withdrawing the money from your Roth IRA
The “5 years” part takes a little explanation. Let’s assume you’re 45 years old and plan to retire at age 50 and begin spending about $50,000 a year. Here’s how it works in practice:
To keep things simple, let’s assume you have $1,000,000 in your IRA and $0 in your Roth IRA. Here’s what a yearly plan might look like:
|Age||IRA -> Roth Conversion||Yearly Spending||Roth IRA Contribution Balance|
|55||$0 (don’t need to!)||$55,203||$232,074|
The conversion from age 45 is spent at age 50. The conversion from age 46 is spent at age 51.
For the first 5 years of a Roth IRA Ladder, you won’t be able to access the funds from your IRA OR your Roth IRA. During that time you can use the contribution withdrawal strategy to access previously deposited funds in your Roth IRA if you have any. Otherwise, you can use the money saved up in an after-tax account or continue working.
There is a MAJOR caveat to this approach. For each year from age 45 to 54, you’ll need to pay taxes on your IRA to Roth IRA conversion. If you’re still working you may end paying a higher rate on your conversion. If you have no other way of paying these taxes, you’ll need to convert more in previous years (like 45-50) so you can use that money to pay taxes 5 years later.
The best-case solution is to have 5 years of cash in a brokerage account or use your existing IRA use the contribution withdrawal strategy. This allows you to lower your tax rate and pay fewer taxes for your IRA conversion.
- Climbing The Roth IRA Conversion Ladder To Fund Early Retirement from Root of Good
- How to Access Retirement Funds Early from The Mad Fientist
72t Distribution Works for: 401(k)*IRA
401(k): This approach works for a 401(k) if you convert it to an IRA first.
IRS Rule 72(t) seems like a solution to all early withdrawal problems – at least at first. After reading more and trying to create a plan for it, most realize it’s actually a heavily restricting and sometimes costly mistake.
A 72t distribution allows you to withdraw money from your IRA early without paying the 10% penalty. A 72t distribution works by locking yourself into a payment plan where you withdraw a calculated, set amount each year for the rest of your life. This effectively turns your IRA into an annuity – providing income each year. The amount you can withdraw each year is based on your age (and therefore your life expectancy) and a “reasonable interest rate”.
The way it works is terribly confusing. Let’s look at an example then break it down.
First off the requirements. You must agree to take out annual withdraws for at least 5 years – or until age 59½. You can’t modify how much you withdraw each year. If you do you’ll pay a 10% early distribution penalty retroactively since the beginning (!). On the bright side, you can stop withdraws if they’ve gone on for 5 years or you’re over 59½.
Let’s say you’re 50 years old with $1,000,000 in your IRA. You could retire now if only you had a way to access it! You decide to look into using a 72(t) to start cashing it out now.
Step 1: Calculate how much you can withdraw each year. This isn’t a simple calculation. I’d recommend using a 72t calculator to compute this. These calculators will give 3 options for how much you can withdraw each year using different computational methods:
The required minimum distribution method bases the amount on your age, life expectancy, and account balance. With this method, you’ll recalculate the withdrawal amount each year based on the previous years’ balance.
The required minimum distribution method. The annual payment for each year is determined by dividing the account balance for that year by the number from the chosen life expectancy table for that year. Under this method, the account balance, the number from the chosen life expectancy table and the resulting annual payments are redetermined for each year. If this method is chosen, there will not be deemed to be a modification in the series of substantially equal periodic payments, even if the amount of payments changes from year to year, provided there is not a change to another method of determining the paymentsIRS description of the required minimum distribution method
The fixed amortization method works similar to a mortgage. You calculate out a payout schedule based on the applicable federal rate and your life expectancy. This method matches up with when the account would run out of money if you lived until your life expectancy was up and your money was invested in mid-term government bonds.
Side note: If you’re invested in stocks your money will almost surely last a lot longer.
The fixed amortization method. The annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years determined using the chosen life expectancy table and the chosen interest rate. Under this method, the account balance, the number from the chosen life expectancy table and the resulting annual payment are determined once for the first distribution year and the annual payment is theIRS Description of the fixed amortization method
The fixed annuitization method calculates your distribution in the same way an insurance company might. This works by dividing your IRA balance by a lookup field.
The fixed annuitization method. The annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer’s age and continuing for the life of the taxpayer (or the joint lives of the individual and beneficiary). The annuity factor is derived using the mortality table in Appendix B and using the chosen interest rate. Under this method, the account balance, the annuity factor, the chosen interest rate and the resulting annual payment are determined once for the first distribution year and the annual payment is the same amount in each succeeding yearIRS description of the fixed annuitization method
For the example above, our early retiree is a 50-year-old man. According to the IRS, his life expectancy is another 34.2 years. From there you can calculate how much $1 would grow in 34 years assuming the current federal mid-term rate of about 2%.
You can calculate out the annuity factor using this equation in Google Sheets or Excel:
=PV(rate, duration, starting balance, ending balance, calculate at beginning of period?). Filing this in with our example we get:
=PV(0.02, 34.2, 1, 0, 0).
That’ll return -24.6. $1,000,000 / 24.6 = $40,650.40. That’s the maximum amount they could withdraw using this method.
Once you have the three options, you can choose which one to go with. Your IRA provider will give you a Form 1099-R to file with the IRS when you do your taxes to show what’s happening.
Keep in mind, that you cannot change this amount. If you end up earning additional income later and don’t need the money: that’s too bad. You’ll still need to withdraw it every year and pay taxes on it. Luckily you can stop it after 5 years, but it could be a costly mistake.
72(t) distributions are the least flexible, the most dangerous, require the most paperwork and are the most prone to
How to Withdraw Funds Early
There are a lot of strategies – each with their own work and pitfalls. In my opinion, the absolute best solution involves the most work upfront but is the most flexible:
During your earning years, save up enough money in a brokerage (after-tax account) to cover:
- 5+ years of your full spending
- As many years as needed to reach age 60 with your full spending minus $24,000 a year.
As an example, if you retired at age 50, married, and spend $60,000 a year, you’d need to have (5 x $60,000) + (5 x ($60k-24k)) saved up: or at least $480,000.
With that mix of accounts, you could use the Roth IRA Ladder strategy until you reach 60 all while not paying any taxes during your 50s. All because you limited your IRA to Roth IRA conversions to the standard deduction (the amount you can earn each year without paying taxes on it).
You could roll over $24,000 a year from your IRA to your Roth IRA tax-free. Any long-term capital gains on your brokerage account would also be tax-free if you stay in the 0% long-term capital gains tax bracket.
This approach is similar to our plans to pay no taxes.
Whatever you approach to retirement is, one part is clear: taxes and early withdrawal penalties can make or break your plan. Take the time to craft a plan that minimizing taxes and maximizes your chance of success!
9 CommentsWhy not add to the conversation below? Your voice is welcome!
Caroline at Costa Rica FIRE
June 30, 2020
Such an important post! We were a dual-income household in high-cost, high-tax NYC for the first 25 years of our career so never qualified for a Roth. We maxed out our tax-advantaged retirement plans b/c the tax burden in NYC is so high. Now that we have the means on paper to FIRE, we would face a penalty to withdraw any of those funds. We’re using a mix of non-retirement plan assets and part-time consulting to bridge us till we’re penalty-free. We also have a solo 401k, and we can borrow from that. In the beginning of our careers, we didn’t think about FIRE and so didn’t even think we’d need our retirement monies till 59+ or even older. Still, we were glad to get the tax breaks when we really needed them.
July 1, 2020
Whew yeah, in high-tax states those accounts are the most useful for sure. Starting my career in Florida that wasn’t something I thought much about, but it makes sense.
Borrowing from 401k’s is another big one for sure. I haven’t researched that one yet myself, but I’ll have to look into it. The Cares Act has a provision for borrowing w/the ability to defer which year you pay taxes too, which is handy.
July 1, 2020
Great summary article Adam! I will be using this as a reference point, especially when discussing with those new to the concepts.
One potential method I am looking into is the 72t method, but splitting my full IRA balance amongst different custodians to better customize how much I want to withdraw each year. There is a short statement about it in the FAQs of the article you referenced, but nothing substantial. The idea would be in your example where you have $1,000,000 in an IRA, maybe you send $300k to a different custodian and start 72t distributions, if you find you need more money in a later year, you send $100k to a different custodian and start 72t distributions there, and so on. After 5 years you have the option to stop on the first one and can continue to adjust.
July 1, 2020
I’d completely forgotten about that situation with multiple custodians, but it sounds like a great idea. That allows you to start low and increase your withdrawals as you realize you need more, while ideally preventing yourself from taking out too much. Sounds like a solid plan for sure.
July 3, 2020
Great read, thank you. These are important to consider, especially now. Great Article!
July 5, 2020
How does the Roth IRA ladder work if you only have a ROTH IRA and therefore don’t need to convert any money from a tIRA to a roth IRA? Meaning, can you take money out of a ROTH IRA earlier than 59.5 years old?
July 10, 2020
On the bright side you can still remove money from a Roth IRA – but only your contributions. I haven’t found a way to withdrawal gains from a Roth (beyond the ones listed here). If I find anymore options I’ll update this post though!
July 22, 2020
Amazing summary of so much information in 1 place. I bookmarked it to come back and do a deeper read.
July 27, 2020