4 Ways to Avoid The 10% Early Withdrawal Penalty

One big issue with early retirement is accessing your retirement accounts. The early withdrawal penalty is 10%. Nobody wants to pay more money to the government, especially from their retirement fund.

It’s great to invest in the traditional 401k and IRA because you don’t have to pay taxes on that portion of your earnings. This is an excellent way to defer taxes especially if your income is high. Uncle Sam will get eventually get his cut from this pile of money, though. You will have to pay taxes at the earned income rate when you take withdrawals from these retirement accounts.

Deferring tax until after retirement is usually advantageous because you make less money in retirement and should be in a lower income tax bracket. However, there is a 10% early withdrawal penalty if you want to access the money before you’re 59 ½. This could be a problem if a significant portion of your net worth is invested in tax-deferred accounts.

Our Retirement Accounts

We love our 401k and IRA because it is the easiest way to save and invest. We max out our 401k contributions every year and save a bunch of money on taxes. Those retirement accounts have grown to be the biggest part of our net worth.

Our tax-deferred accounts make up 43% of our net worth. They should continue to grow because we are adding to them. Currently, most of our new investment is going into those retirement accounts because we want to defer tax.

What if we want to access our tax-deferred accounts at some point? In 6 years, RB40Jr will graduate from high school and hopefully head off to college. At that point, we plan to retire full-time and travel around the world. We will have passive income from real estate crowdfunding and our dividend portfolio. Those should be enough to cover our basic cost of living, but probably won’t be enough for extravagant trips. We might need to withdraw from our retirement accounts. As long as we spend less than 3% of the value of our investment portfolio, we should be able to sustain a long retirement. I won’t be 59 ½ yet, so I need to figure out a way around the 10% early withdrawal penalty.

Let’s see some ways to avoid the early withdrawal penalty.

1. Roth IRA conversion

Personally, I think the best way to access your retirement fund early is to build a Roth IRA ladder. Here is how to do it.

1. Convert 1 year of living expenses to Roth IRA. (You will have to pay tax when you do this.)
2. Wait 5 years
3. Withdraw the 1 year of expense from the Roth IRA

Just repeat this every year until you’re 59 ½. The drawback here is you have to wait 5 years before you can access the first payment to avoid the 10% penalty*. This is doable for us because we could draw down our dividend portfolio and other taxable accounts during the first 5 years. Also, we plan to sell our rentals. The proceeds should help pad our taxable accounts.

* With the Roth IRA, you can withdraw your regular contributions at any time without having to pay the penalty. Conversions will have to wait 5 years to avoid the penalty.

Actually, it’s a good idea to move as much of your assets to the Roth IRA as possible. You won’t have to pay tax on that account ever again. When Mrs. RB40 retires, our income will be relatively low and we’ll probably convert a small portion to Roth IRA every year.

2. IRS Rule 72(t)

Another way to access your traditional retirement accounts is to use the IRS rule 72(t). This will help you avoid that early withdrawal penalty, but you’ll have to follow some rules. First, you will have to take “substantially equal periodic payments” (SEPPs) every year. Once this starts, you must continue to do so for at least five full years, or if later, until age 59 ½.

The calculation for rule 72(t) is pretty complicated. That alone would deter a lot of people. You probably need to hire a financial advisor or tax accountant to help with the process. I’ll use Bankrate’s 72(t) calculator to give us an idea of how much we could withdraw. This is just an example.

• Account balance: $2,000,000
• Reasonable interest rate: 2.36%
• Your age: 55
• Beneficiary age: 54
• Choose life expectancy table: Single life expectancy

I could pick one of the following methods depending on how much money we want to withdraw.

• RMD method: $67,568
• Amortization method: $94,656
• Annuitized method: $94,232

I’d probably go with the RMD method to keep taxes low. This should be plenty to fund our travel.

The main problem with rule 72(t) is you have to withdraw for at least 5 years. If you mess up somewhere, you’d have to pay 10% penalty on the total amount withdrawn. I like the Roth IRA ladder method better because you have more control over how much to convert.

3. Early 401(k) withdrawal

Here is an exception to the 59 ½ rule that’s not widely known. If you retire after 55, you can withdraw from your 401(k) with no penalty. This only applies to a company established 401(k). The age limit is further reduced to 50 for retiring police officers, firefighters, and medics. That’s a pretty nifty benefit for our public servants. Note that this provision does not apply to your IRA.

I won’t be able to use this because the only 401k I have is the individual 401k. This rule doesn’t apply to that account. Mrs. RB40 could use it if she retires in 2029. This option looks pretty good for her because that’s when our son will go off to college. The timing is nice.

4. Tap your IRA to pay various expenses

Lastly, there are a few exceptions to the IRA early withdrawal penalty. This could be a good way to take some money out of your retirement accounts if you have these expenses anyway.

• Pay for higher education. We plan to help RB40Jr with his college education so this could work for us. If his 529 isn’t enough to pay for college, then we can make some withdrawals from our IRA.
• Health insurance premium while unemployed. This might work. I’d have to stop making money from blogging and side hustles, though. In 6 years, I might be ready for that.
• Unreimbursed medical expenses over 10% of AGI. This might be good too. Our AGI should be pretty low after Mrs. RB40 retires. But it’ll be tricky because IRA withdrawal also counts toward your AGI.
• IRS back taxes. This one is very interesting. If you owe taxes to the IRS, they can levy your IRA and you won’t have to pay the 10% penalty. This seems like an incentive to not pay taxes on time. Of course, you’d have to pay a penalty for late payment so I’m not sure if this makes sense financially. The late payment penalty is the federal short-term interest rate plus 3%. I guess that’s better than 10% early withdrawal penalty.
• First-time home buyer. If you haven’t owned a home for 2 years, then you could withdraw up to $10,000 from your IRA to help with the down payment. That’s not much these days. They really need to increase this limit to $100,000.

5. Reader’s comments

• If you have a 457 plan, you can make a withdrawal without the 10% penalty. This plan is available to some state and local public employees. Some nonprofit organizations offer this plan.

Accessing your retirement account

Out of these options, I like the Roth IRA ladder option best. We have enough in our taxable account to pay the first 5 years of living expenses. After that, we’ll be able to withdraw from our retirement accounts without paying the penalty. Also, it’s always a good idea to move money into your Roth IRA because that account is tax-free forever.

Taking money out of your retirement accounts early usually isn’t a good idea because most of them are woefully underfunded. The average retirement saving of Americans between the ages of 55 and 64 is just $104,000. If you withdraw early from that account, you’d run out of money in 2 years.

On the other hand, what if you’re lucky enough to have $2 million in your traditional IRA at the age of 55? In that scenario, it would be better to focus on minimizing tax and make some early withdrawals. When you turn 70½, you’ll have to take the required minimum distribution (RMD) on your IRA. You don’t want to have a huge amount in your traditional IRA at that point because the RMD would kick you into a high tax bracket. It’s still a better problem to have than not having enough money.

Roth IRAs are not subject to the RMD rule in your lifetime. That’s another reason to move money into your Roth IRA.

Are you planning to retire early? How will you access your retirement accounts?

Image  credit dbking

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Joe started Retire by 40 in 2010 to figure out how to retire early. After 16 years of investing and saving, he achieved financial independence and retired at 38.

Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!

Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.

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