I have been posting on the Mr. Money Mustache forums for some time. Every week, new people come into the community, excited about the possibility of retiring early and trying to plan how to get there. This is great! One question that comes up extremely often, almost daily, is some variation of the following:
I want to retire early, but I am worried I have saved too much in my retirement accounts (IRA, 401(k), etc.). I can’t touch any of this money before age 59½. Should I quit contributing to my 401(k) and start saving more in a taxable account instead so that I have enough money to make it to 59½?
No! Keep saving in your tax-sheltered accounts! The idea that you can’t withdraw from your retirement accounts early is an extremely common misconception, but a misconception nonetheless.
Far from being an untouchable pot of money for an early retiree, retirement accounts are a great tool to help you save money on taxes while you’re working, while offering several options for withdrawing that money at whatever age you decide to leave the workforce.
In this post I will explain three main ways to access these funds before the “traditional” retirement age.
Option 1: Roth Conversion Pipeline
How it Works:
Roth IRAs are pretty straightforward for “normal” retirees: pay tax on your income in the year you earn it, save some of it in your Roth account, let it grow for a few decades, then withdraw it completely tax-free during your retirement after age 59½.
What happens if you want your money before age 59½? Many so-called experts would say “you can’t do it! You’ll pay huge penalties! There be dragons here!” The problem with the expert wisdom is that it’s just not true! Some lesser-known provisions related to Roth IRAs make them really great tools for early retirees.
If you withdraw from a Roth IRA prior to age 59½, the taxation and penalties depend on exactly which dollars you took out. There is a set of ordering rules that determines this. In a nutshell,
- Direct contributions come out first,
- Amounts converted from pre-tax retirement accounts come out next (older conversions before newer conversions), and
- Earnings come out last.
The direct contributions can always be withdrawn tax-free and penalty-free. Amounts converted from pre-tax retirement accounts can always be withdrawn tax-free (since you paid tax when you converted it), but there will typically be a 10% early withdrawal penalty if you take out money that you converted less than five years ago. If you dip into the earnings before age 59½, you will pay your regular income tax rate plus a 10% early withdrawal penalty on this money.
The Roth conversion pipeline is a strategy where you use these rules to your advantage, allowing you to get money out of your pre-tax retirement accounts early without paying any early withdrawal penalty.
The key thing here is the five-year rule for withdrawing conversions penalty-free. If you converted $10k in 2010, you can withdraw that $10k in 2015 completely free of tax or penalties! If you converted $11k in 2011, you can withdraw $11k in 2016 for free as well!
The idea of the “pipeline” is that if you convert some money every year, after five years you will be able to withdraw some money every year as well, completely tax-free. That’s all there is to it! You can gradually draw down your pre-tax retirement account balance during early retirement by converting one year’s worth of expenses into a Roth IRA, letting it sit five years, and then taking it out. Any growth on this money should remain in your Roth IRA, where it can continue compounding tax-free and can be withdrawn freely after age 59½.
Pros:
- This method is flexible. You are free to convert a different amount every year to account for any lifestyle changes that you may anticipate five years in the future.
- This method is easy to understand.
Cons:
- This method may result in high taxes during the last few years of work, when starting the conversion pipeline and earning money from a job at the same time. To avoid this, consider having some money in taxable accounts and/or direct Roth contributions to pay for part or all of the first five years of early retirement.
- The tax-free withdrawal amount is based on nominal dollars. If a period of high inflation begins during your early retirement, you may find the amount you converted five years ago to be insufficient to pay your living expenses in current dollars. When making a Roth conversion, use a reasonable estimate for inflation to reduce this risk. For example, if you convert 30% more than your current living expenses each year, you will be prepared for five years of 5% inflation.
Option 2: Substantially Equal Periodic Payments
How it Works:
Any early withdrawals made from retirement accounts under a series of “substantially equal periodic payments” (SEPP) are not subject to an early withdrawal penalty.
These payments can be calculated in one of three ways as defined by the IRS. The easiest method is the same as for calculating required minimum distributions: take your year-end account balance, divide it by your life expectancy (from a table), and withdraw exactly that much from the account. Do this every year to calculate your payments for the next year.
The other two methods take current interest rates into account in addition to your current age. They are a bit more complicated, but may result in a larger payment.
Pros:
- You can make withdrawals directly from a traditional IRA with this method. You do not need to transfer money between accounts periodically, wait five years, or make estimates for financial needs years in advance.
- These withdrawals are consistent. You will withdraw a certain percentage of your account balance each year, and this withdrawal will be a slightly larger percentage of your account each year as you age.
Cons:
- This method is very inflexible. If you choose to take withdrawals using the SEPP provisions, you must keep taking them for five years or until you turn 59½ (whichever is later). If you fail to withdraw the correct amount even one year, you will owe 10% early withdrawal penalties (with interest) on all previous SEPP withdrawals.
- An early retiree will likely find that SEPP payments for a younger person are a low percentage of their account. Someone in their 30s will withdraw 1.9%-2.7% of their account if they use the required minimum distribution method. Therefore someone depending on a 4% withdrawal rate will need to get some money from other sources (taxable accounts, rental real estate, etc.) to bridge the gap.
- SEPP withdrawals from a Roth IRA are possible, but this money will be taxed as income.
Option 3: Pay the *%&@ Penalty
If you take money out of a traditional or Roth IRA before age 59½, and no other exceptions apply, you will pay your regular income tax rate on this money plus a 10% early withdrawal penalty. This doesn’t mean you “can’t” do this, just that there’s a cost to doing it.
Given the alternatives above, paying the penalty shouldn’t generally be your first choice. However you should be aware that it is an option, and you should not be afraid to use it if it’s the best option available to you at the time.
For example, suppose that you’re relying on the Roth conversion pipeline for the bulk of your early retirement expenses. You planned ahead for some inflation, but the actual inflation rate turned out to be higher than you expected. If this happens, you can simply withdraw some extra money from your traditional IRA and pay an early withdrawal penalty. The world will not end if you need to do this sometimes.
Remember, if your tax rate is at least 25% while you’re working and 15% or below when you’re retired, paying tax and an early withdrawal penalty during retirement will be no worse than if you paid your regular tax rate on that money while working and saved it in a taxable account! Again, the strategies above can help you do even better for the majority of your spending, but a little bit of early withdrawal penalty here and there is okay.
Final Thoughts
I hope this post helps debunk the myth that you can’t touch your retirement accounts until you turn 59½. You don’t need to quit saving in your tax-deferred accounts if you want to retire early. You may find some extra flexibility during early retirement from having some of your money in a taxable account. A diversity of possible income sources can help you optimize your life from year to year, taking advantage of things like ACA health insurance subsidies and other programs. However, contributing the bulk of your savings to tax-deferred retirement accounts will generally help you pay less tax and retire sooner. The strategies above can help you tap into that money before 59½.
Have questions? Ask them below!
A key disadvantage that is not listed for Option 1 is that if the laws regarding Roth conversions change at somepoint, and you rely on that strategy, you will be in a difficult spot – forced either to do 2/3.
That’s a fair point, but the possibility of legislative change really isn’t unique to the Roth conversion pipeline. Congress could change the laws at any time to eliminate the SEPP option, change the 10% early withdrawal penalty to something much higher, or any number of other things that could severely hamper my early retirement.
While I’m aware these things could happen, I personally don’t spend much time thinking about them. These things are impossible to predict and beyond my control. When dealing with a long retirement, flexibility is essential.
I have a hard time believing that Congress would act specifically to close off this means of accessing traditional retirement account investments. Why would Congress want to prohibit taxpayers from paying taxes now and require them to pay those taxes later? When an early retiree starts a Roth conversion pipeline, the federal government gets to benefit from the time value of the taxes paid rather than the taxpayer. The concern I do have is that this means of accessing traditional retirement investments would be closed off by a mostly unintended and unnoticed effect of more comprehensive tax reform.
Great information and appreciate the guidance you’ve been giving in the MMM forum on my Investor Alley post. Have gone from “I am saving something for retirement” to a “gonna do everything in my power to get immediately onboard with FIRE”.
You say that you withdrawal a certain percentage of your account with SEPP but that is not true. For the RMD method you recalculate every year and the percentage will increase as your life expectancy decreases.
Under the fixed amortization and fixed annuitization methods (which allow the largest withdrawals and are therefore the most attractive) the SEPP rules require that the withdrawal amount be exactly the same (to the penny!) in every year until age 59.5 . This means you calculate a withdrawal amount once and withdrawal exactly that amount with no adjustment for inflation or anything else. This is spelled out on page 710 of the IRS document you linked: “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 the same amount in each succeeding year.”
If you do this wrong, you will owe 10% on all the money you took out above what the rules allow which could be quite a lot over many years if you improperly recalculate the amounts each year!
This makes SEPP very inflexible. It’s still a good method, but once you implement it you are pretty locked in.
Thanks for the clarification. You’re right that SEPP is an inflexible method with potentially huge penalties if you mess up, which I did mention in the post. I could add a little bit more about the other two methods to reiterate that they require exactly equal distributions each year.
What do you do if you don’t know how much money you have in contributions versus conversions versus earnings in your Roth? I am 40 and started my Roth in 1998 when I was in my early 20s; I did not keep track of how much I contributed each year over the past 17 years. Not only has the maximum contribution changed several times since then, but I also didn’t always contribute the maximum amount each year. And just to make things even more fun, I also changed brokerage companies once and have made one conversion and one back door Roth contribution so far. I assume the back door Roth contribution will be treated as a conversion and therefore subject to the five year rule?
Would the IRS be able to answer the question of how much I have in contributions versus conversions versus earnings?
The IRS should have this number already, as your brokerage will have sent you and the IRS a Form 5498 for each year you contributed. I don’t know of a way to get it from them though. There are ways to get a transcript or copy of your old tax returns (up to seven years back), but you don’t generally need to report Roth contributions on your tax return and I don’t know of a way to get them to provide other forms to you. Your best bet, if you didn’t keep these records yourself, might be to contact your old and new brokerage to see if they have these on file.
The first time you withdraw from your Roth IRA you will have to report your total contributions on Form 8606 to determine how much (if any) early withdrawal penalty you will owe. As long as you don’t report a number that’s higher than what the IRS knows already, it seems unlikely you would be audited over that part of your tax return, but anytime you report something without the records to back it up you’re taking a risk. This is why good recordkeeping is so important! To be totally safe, only report contribution amounts that you have documentation for.
Backdoor Roth contributions are indeed counted as conversions. Be aware that the 10% penalty for amounts withdrawn within five years only applies to amounts that were subject to tax when you made the conversion, which in the case of backdoor contributions would only be any earnings between the time of contribution to the traditional IRA and the conversion to Roth. The conversion ordering rules do still apply, so if you made a fully taxable conversion in 2012 and a backdoor contribution in 2013, a withdrawal would include the 2012 conversion first (and require a 10% penalty) before the penalty-free 2013 backdoor contribution could come out.
Thank you, that information is helpful.
Regarding the records, I was not contemplating retiring in my 40s when I was in my 20s, and I only recently came to understand that taking the money out of my Roth before age 59.5 was even a possibility. So there was not a great urgency regarding keeping these records in the late 1990s and early 2000s, because I thought I would have to wait until I was in my 60s to start withdrawing the money. Also, Roth accounts were brand new at that time with no internet sites like this in existence yet to teach young people how to properly manage them. But this is an important point for those in the millenial generation to understand so they don’t repeat my mistake with not keeping records. You never know when you might need that information. I obviously think very differently about retirement now than I did in my early 20s.
I think your suggestion to contact the first brokerage company is best. It is not an urgent matter. Right now I am still working and still contributing to the Roth. I have other funds I can use for early retirement (mainly taxable account and I bonds), and I expect to work part time for a while even after officially retiring. So I may still leave the Roth alone until I am in my 60s, which will avoid the issue regarding the penalty on earnings. But if I do take some out earlier, I will be careful to take less than I can prove was contributed as you said. I do have good records going back for the past ten years or so.
One more question: I did the conversion in 2014. Let’s say it is now 2019 and I want to take that money out. How does that get reported to the IRS as being available to withdraw? (In other words, I want to know how to report that money as a conversion >5 years old as opposed to a contribution.)
When you withdraw from your Roth IRA, you’ll report the amount withdrawn on Part III of Form 8606. There are lines to report the amount you withdrew early, as well as the amount of contributions and conversions that you hadn’t already withdrawn in prior years. So long as the amount you take out is less than the sum of contributions and conversions, this form shows that none of the withdrawal counts as income subject to your marginal tax rate.
If you do happen to withdraw conversions less than five years old, you’ll calculate the early withdrawal penalty on Part I of Form 5329. You’ll have to report the amount you withdrew that is subject to the penalty on Line 1, and you’ll end up adding 10% of that to your total tax. See the instructions for more info.
I think you left out one important option for tapping into a 401k. If you’re 55 or older and decide to retire, you can immediately pull money out of your employer’s 401k without penalty. It’s not mentioned much, but is one good reason to leave money in a 401k vs. rolling to an IRA.
Option 1 question: If I contribute and convert $20,000 in 2010, and $40,000 in 2011 via backdoor Roth, those amounts will be tax-free in 2015 and 2016 respectively.
My question is, do I HAVE to take the $20,000 from 2010 out of the account in 2015? Or, can I pull it out next year (or any time after that)? Is converting Roth money sentencing yourself to a scheduled future withdrawal?
There’s no requirement to withdraw the Roth money at any particular time. The ordering rules define which money you’re taking out if you happen to make a withdrawal. Direct (non-backdoor) contributions come out first, then conversions (oldest conversions first), then earnings. Just because you can withdraw penalty-free funds from your IRA doesn’t mean you must do so. You could save those tax-free withdrawals for any future year when you need the money.
Awesome, thanks so much. In general, people less than 55 have $23,000 tax sheltered contribution per year, correct? ($17,500 from 401k, $5,500 from IRA)
Are there any exceptions that have no/very little restrictions? (HSA has a restriction because it has to be used for health reasons)
You’re awesome! Thanks for the post/blog.
The maximum really depends on what workplace options you have available. If you have a 401(k), you can contribute $18k to that. If you work for a government organization that has a 457 plan, you can contribute another $18k to that. If you work for yourself you can contribute as much as $53k pre-tax to a solo 401(k), depending on your income.
I think the withdrawal option that has the fewest “restrictions” would be direct contributions to a Roth IRA. You can take those out at any time for any reason with no tax due.
Everything else has some strings attached. There are special rules for withdrawing from IRAs without penalty for a first-time home purchase or education or disability, but I think those would be “restrictions” just the same as the rule that HSA withdrawals must be backed by medical expenses to be tax-free.
How would this work for funds that are in a Roth 401k subaccount?