It is often to see people who are interested in early retirement putting most of their retirement savings into taxable accounts because they believe IRAs, 401(k) plans, and other tax-advantaged accounts “lock up” their money until they are 59½. If you are interested in retiring before 59½, this is one of the worst mistakes you can make.
It’s a mistake because the premise isn’t true at all. There are many ways you can get access to retirement funds before age 59½ and all without that horrible 10% penalty for early withdrawals.
(Note that taxable accounts make total sense for some early retirement situations and in many non-retirement situations and this are discussed some more down below.)
Some of the ways you can get money out of tax-advantaged accounts to fuel early retirement
- SEPP: Section 72(t) specifies how you can take distributions received in substantially equal periodic payments (SEPP) without penalties. There are several different methods to calculate how much you can withdraw and stay within the rules (which allow you to decide when you start SEPP if you want less money or more money), but this method is a bit inflexible because you can’t modify things until 5 years have passed or you reach the age of 59½. Nevertheless, this is often a good choice for early retirees. Money Crashers has a good article with more information on the topic and there’s a FAQ at the IRS too.SEPP tends to recommended more often for a small number of years prior to age 59½ and it’s also a good option when you don’t have sufficient Roth IRA or taxable investments to use #2 or #3. It is possible to work around the inflexibility to some extent if you have multiple accounts since SEPP is done or not done with each retirement account separately.Finally, SEPP from a employer plan requires that you separate from that company first, but IRAs do not have any requirement like that.
- Roth IRA contributions: If you have a Roth IRA, you can withdraw the portion of your Roth IRA that comes from your contributions without penalty. (Note that you cannot withdraw any earnings penalty-free until 59½, only your own contributions.)
- Set up a Roth IRA ladder. You set up a series of Traditional IRA to Roth IRA conversions early in your retirement (when you are presumably in a lower tax bracket). After seasoning the money for 5 years, you can withdraw the converted principal from from your Roth IRA without penalty (any earnings from that period of time need to hang out until 59½). Root of Good has a good article on this.This is now one of the most popular methods for early retirement. It does require that you have a different method to fund the first 5 years of retirement. A taxable account, Roth accounts, or a 457 would all be good ways to do that.
- Retire after age 55 with a 401(k). You can withdraw from a 401(k) if you left that job after age 55 (technically, you just need to be 55 or older in the calendar year in which you leave that job). If most of your money is in IRAs, you can simply move that money into your 401(k) before you leave that job (some 401(k) plans don’t allow roll-ins so check first). Note that withdrawal frequency and some other aspects of this are specific to the 401(k) plan.If you have self-employment income, you can also use an Individual 401(k) for this, but also make sure that your provider allows roll-ins.
- Be lucky enough to have a 457 plan with your employer. In a 457, there is simply no 10% penalty for early withdrawals. 457 plans are only available for some government and certain non-governmental employers (generally just some non-profits), but they are a great option if you have access.
- An HSA can be used like an IRA if you keep your receipts (requires actually having medical expenses prior to age 65, of course). Using an HSA like this is discussed more at Free Money Finance and Mad Fientist.
The IRS lets you withdraw penalty-free from an IRA for a few reasons unrelated to retirement:
- $10,000 can be withdrawn for the purchase of a new home.
- You can spend money on qualified education expenses for yourself, your spouse, children, or grandchildren.
- Hardship withdrawals: qualifying for these is difficult, but it is possible to withdraw penalty-free for excessive medical costs, medical insurance premiums while unemployed, total and permanent disability, and, well, if you die, your beneficiaries can withdraw without penalty.
Additional advantages of tax-advantaged accounts
- IRAs, 401(k) accounts, and other qualified accounts are much more protected from creditors in the case of bankruptcies and lawsuits. The protections tend to be strongest for employer 401(k) plans, followed by individual 401(k) plans, and then IRAs. (Protections for individual accounts varies depending on your state.) All are much more protected than taxable accounts.
- Rebalancing is a bitch. Want to exchange some of one mutual fund and buy another in a tax-advantaged account? Easy. No capital gains taxes. Do this in a taxable account and you need to worry about capital gains taxes, holding periods, etc.
What are some situations in which taxable investing makes sense?
There are actually times when taxable investing makes more sense than using tax-advantaged retirement accounts. Not everyone wants to retire early and there is more to life than retirement too.
You should be using a taxable account for these situations:
- If you’ve maxed out your tax-advantaged options, taxable is your only option.
- If you are saving for major expenses that you’ll incur before retirement (examples: buying a car or a home), taxable accounts are the way to go! Use savings or CDs if you’re only 1-3 years away from a purchase and a conservative mix of stock and bond funds for longer periods of time.
- If you have no plans to retire early and are on schedule or are ahead of schedule for retirement savings, you can go either way (taxable or tax-advantaged). It’s up to you.
Note: Your emergency fund and short-term savings should generally be kept in checking, savings, or CDs.
A simple example: maxing out a 401(k) and IRA for 21 years gets you to about $1M with 6% inflation-adjusted growth. It’s 23 years if you assume 5%. That’s a pretty early retirement if your spending is around $35K to $40K.
Even if you have a decent taxable account to fuel your early retirement years, these techniques are often helpful (especially Roth IRA ladders) and may be required as your taxable account is depleted.
Finally, retiring at 50 or 55 may not sound that early to everyone, but let’s remember that the average retirement age in the US is 62… and that includes all early retirees. 🙂
Originally posted by dequeued.
401K limit is actually 53K if you use the mega-backdoor (or have a REALLY generous match).
Add in the IRA limit of 5.5K, and the real limit is around 58.5K a year.
Assuming 6% ROI, that will get you into the $1m range in 12 years. If you start saving at 22, that in theory means retirement in 34.
Essentially, you add money into after-tax 401K, and then roll that over to a roth IRA.