How to Access Your Retirement Stash

This article is a follow-up to an earlier series I wrote, which provides some advice on the basics of personal finance with the ultimate goal of achieving financial independence. If you haven’t read it already, I’d strongly encourage you to check it out first:

Financial Advice I Wish I Knew in My 20s

Photo by Japheth Mast

If you’ve read my previous posts on investing and tax minimization, you might be wondering about the most practical plan to approach saving for an early retirement. You might be among the precocious few who will manage to accumulate enough to retire in your 30s, or perhaps you are starting later and won’t have enough to do so until closer to 50.

Either way, the most efficient way to get there is by saving into tax-advantaged retirement accounts such as a 401(k) or an IRA, but they also come with a host of rules and penalties to discourage early withdrawals. So, how do you access your money in an early retirement scenario if most of it is tied up in these accounts?

The intended audience here is anyone relatively early in his or her career with the ambition of retiring before 59½. This typically means having the ability to save at least 20–30% of your income, which is more about your mindset than your means.

After reading this article, you can expect to:

• Feel 100% confident about investing primarily in your retirement accounts, knowing that money is not necessarily locked away until you’re 59½.
• Understand how to withdraw from your retirement accounts while incurring the least amount of taxes possible.

We’ll start by going over the regulations around the two main types of retirement accounts, get into some strategies for legally circumventing their restrictions, and wrap up with my recommendations on how to put everything together. If you’re the sort of person who prefers to eat the sausage before seeing how it’s made, feel free to skip to the end and come back up to read more about the why.

A quick note: This topic is fairly complex and this situation is not one that most people will find themselves in. As a result, there aren’t many other places where you can find these ideas clearly explained, and it’s why tax professionals continue to provide a valuable service. I promise the underlying concepts actually aren’t too hard to understand, but it’ll definitely require some extra attention since it’s one of the more advanced topics to unpack among the ones I’ve written about.

Ready? Let’s dive in.

A Quick Recap of the Different Account Types

While there are a bunch of different types of tax-sheltered retirement savings accounts out there, the two broad categories when it comes to how they handle taxes and withdrawals are:

• Traditional IRAs — These are funded with pre-tax money, and your contributions effectively reduce your income for the purpose of determining how much tax you’re supposed to pay each year. These allow you to save some money today but require you to pay taxes on those withdrawals once you retire.
• Roth IRAs — These are funded with after-tax dollars. By paying taxes on your contributions today, you get to pay no taxes at all when you take money out in the future.

All of the savings plans offered by your employer like a 401(k) can be rolled over to one of these two types of IRAs because they share the same underlying tax benefits. Doing so basically transfers the administration of these funds from your employer’s plan to you.

• A 401(k), 403(b), and SIMPLE IRA are all different types of pre-tax savings accounts and can be rolled over to a Traditional IRA, so they are all essentially equivalent.
• Some employers offer a Roth 401(k) plan, which can be rolled over to a Roth IRA, so they are interchangeable for our purposes.

One important principle to remember that will help everything make more sense is this: Income taxes are only paid once. If you’ve already paid income tax on a portion of money you’ve earned, you don’t need to pay tax on that portion again until it’s used (i.e. sales tax or gift tax).

With that in mind, let’s look at the details around how these accounts handle early withdrawals, defined as any withdrawals made before you turn 59½. (By the way, you may see “withdrawals” referred to elsewhere as “distributions,” which is just a fancy way of saying the same thing. It’s simply the opposite of contributions.)

Traditional IRAs — Convert, Don’t Withdraw Directly

The rules around Traditional IRAs are pretty simple: All withdrawals before you turn 59½ get hit with income tax plus an additional 10% penalty tax. Ouch. There are a some special situations that waive the penalty for early withdrawals, such as disability, education expenses, or buying your first home, but relying on those is not a good retirement withdrawal strategy.

Example: If you withdrew $50,000 early from your Traditional IRA in a year where you had no other income, you would pay $8,238.75 in ordinary income taxes (refer to my calculation in How Tax Brackets Work) and an additional $5,000 in penalties, for a total of $13,238.75. 😱

However, you can also convert funds in a Traditional IRA to a Roth IRA at any time without the 10% penalty, but you’ll still have to pay taxes on the amount you converted. These are also known as “Roth conversions.” Remember this because it will prove crucial to our early withdrawal strategy!

Example: Instead of withdrawing $50,000, you convert that amount to your Roth IRA. You still lose $8,238.75 to income taxes, so the amount that makes it into your Roth IRA is $41,761.25.

Roth IRAs — What Goes In, Comes Out Tax-Free

This account type is a bit more nuanced when it comes to early withdrawals because it treats your original contributions differently from any earnings (or gains) that you make from your investments in the account. If you had put in $10,000 and that grew to $30,000 over time, the $10,000 represents your original contributions and the $20,000 on top of that represents your earnings.

The IRS also requires that you withdraw your Roth IRA funds in specific, predefined sequence:

1. Your original contributions must be withdrawn before anything else.
2. Any conversions from Traditional IRAs must come out next.
3. Any earnings your investments make can only be withdrawn once 1 & 2 are depleted.

Let’s take a closer look at how taxes and penalties on each of these three pools are handled:

Your Original Contributions

Because you’ve already paid taxes on this money before you deposit it to a Roth IRA, your contributions can be taken out any time, with no penalties or taxes, much like you could with a regular savings account.

Conversions from Traditional IRAs

Since you pay taxes on any amount converted from a Traditional IRA to a Roth IRA when you convert it, you won’t need to pay taxes again once you withdraw these converted amounts.

However, you will get hit with a 10% penalty on these withdrawals unless you wait five years to withdraw it. That five-year period may actually be shorter, because the countdown starts on January 1st of the year in which you made the conversion. For example, a conversion of $50,000 you made at the end of 2017 can be withdrawn penalty-free anytime after January 1, 2022. If you make another conversion of $50,000 in 2018, you’ll have to wait until January 1, 2023 to withdraw it.

Earnings Your Investments Make

This is the most complicated pool of money in your Roth IRA. These may be taxed and/or penalized based on two factors:

• Whether your Roth IRA has been open for at least 5 years. In this case, the countdown starts from January 1st of the tax year that you first funded the account. For example, if you made your first Roth IRA deposit ever while doing your taxes for 2017 (which can be as late as April 2018), the five-year period starts January 1, 2017 and is fulfilled by January 1, 2022.
• Whether you are 59½ when you make the withdrawal.

In general, if you are under 59½ you will always pay both income tax and the 10% penalty on an early withdrawal of Roth IRA earnings. If you are 59½ or over, you will only pay income taxes on the earnings if your Roth IRA has been open for less than 5 years. Here’s what this looks like represented as a matrix:

How withdrawals of earnings are treated in a Roth IRA (you should really try to be in the lower right quadrant)

Since this was a lot of detail, let’s recap with a hypothetical example where you contributed $60,000 originally, converted $40,000 from your Traditional IRA, and the total account value is now $150,000.

How each portion of your Roth IRA account is affected by taxes or penalties

Putting the Two Together

Now that you’ve seen that A) you can always convert funds in your Traditional IRA to a Roth IRA and B) you can withdraw those conversions for free after 5 years, let’s look at a plan for how this all fits together.

1. When you stop working, make sure you have at least 5 years of expenses that can be covered by freely accessible money. This can be from your savings/checking accounts, non-IRA investments, or even the contributions portion of your Roth IRA. You’ll need this money to tide you over before you can start accessing your Roth conversions.
2. Roll over the funds in your employer-sponsored savings plan to your Traditional IRA so that you have all of your pre-tax money in your Traditional IRA, ready to be converted.
3. Each year, convert however much you expect your annual expenses will be five years from now from your Traditional IRA to your Roth IRA. Keep in mind you’ll need to pay taxes at the time of the conversion, so the amount that makes it into your Roth IRA will be less than what you take out of your Traditional IRA.
4. Five years later, you can withdraw the conversion you made five years ago without paying taxes or penalties.

Why Not Just Use a Roth to Begin With?

You might be thinking: “Hang on, if I’m gonna have to pay taxes on those conversions anyway, why not just skip the hassle and contribute to a Roth IRA or Roth 401(k) in the first place?”

The answer? Your tax bracket. When you are working and saving, you’re making a bunch of money so that you can not only cover your expenses, but also save as much as possible for the future. For example, let’s say in a typical working year you save 30% of your income while the remaining 70% covers your expenses.

Once you can afford to stop working, you no longer need to save. That means you only need 70% of the income you had during your working years to enjoy the same lifestyle. The less income you have, the less taxes you pay.

Therefore, while you do pay some taxes on those Roth conversions, you’ll typically pay fewer taxes than what you would have had to pay to contribute to a Roth account directly while you were still working.

Here’s an example to drive this point home:

• Let’s say you were making $70,000 a year when you were working, and you decide to save the maximum of $18,000 in your 401(k).
• Your salary puts your in the 25% tax bracket. By using the 401(k) you avoid paying $4,500 in taxes, because you don’t get taxed on the $18,000 that gets contributed.
• After the 401(k) contribution and taxes, you’ll end up taking home around $40,000, which you use to cover your expenses. Let’s assume you need about the same amount each year once you retire.
• Since you no longer need to save in retirement, you only need an after-tax income of around $40K, putting you in the 15% tax bracket. By waiting until then to convert the same $18,000, you will only pay $2,700 in taxes.
• Therefore, by not contributing directly to a Roth account while you were working, you’ve effectively saved $1,800. Add this up over 10–20 years and it becomes a pretty sizable pool of money.

What About Non-deductible Contributions in a Traditional IRA?

You might recall in my taxes article that I mentioned you can still contribute to a Traditional IRA once you reach the Roth IRA income limit. The only catch is that these contributions are no longer tax-deductible, so they are made with after-tax money (like contributions to a Roth IRA).

Withdrawals/conversions of these types of Traditional IRA contributions differ slightly in how they’re handled and is worth a quick mention to make sure we’ve covered all the bases.

Since these contributions are made with after-tax money, you won’t have to pay taxes again when you withdraw or convert them. You also don’t have to pay the 10% penalty on these contributions if you withdraw them before you turn 59½. In this sense, it works pretty similarly to a Roth IRA.

However, where they differ is that Traditional IRA withdrawals don’t cleanly separate contributions and earnings like Roth IRA withdrawals do, so the taxes and penalties on early withdrawals are calculated based on the ratio between after-tax contributions and pre-tax contributions in your account.

Here’s an example to explain: Let’s say you have $500,000 in your Traditional IRA by the time you retire, and $50,000, or 10%, of that money consists of after-tax contributions you had made.

If you make an early withdrawal of $50,000, you unfortunately can’t take that all out from your after-tax contributions like you would be able to with a Roth IRA. Instead, only $5,000, or 10% of the withdrawal, would be tax- and penalty-free. You’d be on the hook for the taxes and penalty on the remaining $45,000.

Taxes on conversions are calculated using the same ratio between after-tax and pre-tax contributions. The only difference is you wouldn’t have to pay the 10% penalty.

This whole mess makes mixing pre-tax and after-tax contributions in a Traditional IRA problematic. I’ll show you how to avoid getting into this scenario in a future article on what’s often known as the “backdoor” Roth contribution.

Another Option for Early Withdrawals: SEPP

The IRS provides another option for accessing your IRA money early known as Substantially Equal Period Payments (SEPP). These are also referred to as “72(t) distributions” but that’s not important unless you need to Google it or wish to impress early-retirement nerds at a party.

As the name suggests, these plans commit you to withdrawing a consistent amount of money each year until you turn 59½ in exchange for waiving the 10% early withdrawal penalty. You’ll still have to pay taxes on the withdrawals each year, of course.

There are three IRS-approved methods to calculate the amount you can withdraw annually. They are all esoteric and not important to understand, so all you need to know is that each formula produces a slightly different amount. Just use an online calculator and take the number that most closely matches your income needs.

• Required minimum distribution (needs to be recalculated each year)
• Fixed amortization (calculated once for the whole period)
• Fixed annuity (calculated once for the whole period)

While this plan produces a predictable stream of income, it’s also very inflexible. Keep in mind the following restrictions once you start a SEPP plan:

• You have to make the same withdrawals each year whether you need them or not.
• The plan stays in place at least until you turn 59½. If you started the plan within five years of turning 59½, then it needs to be in place for a full five years.
• While taking withdrawals on a SEPP plan, you cannot add any funds to your IRA or withdraw any additional money beyond the SEPP payment.
• If you’ve started the plan using either the “fixed amortization” or “fixed annuity” calculations, you can only change it once, and only to the “required minimum distribution” calculation. This calculation tends to result in a lower payout amount, so it’s a decent option if you realize the plan is withdrawing more than you need.
• Any deviation from the plan beyond the one-time allowed change will invalidate the plan, causing all the payments you’ve already received to be subject to a 10% penalty and retroactive interest on the penalty. Not good!

Since both the SEPP plan and Roth IRA conversions ultimately involve paying the same taxes, the only real advantage from the SEPP plan is that it allows you to access your Traditional IRA funds immediately, whereas the Roth IRA conversion involves a 5-year waiting period.

My Recommended Approach

Here’s the general strategy I recommend for most people to diversify their sources of retirement income. It’s not necessarily the hyper-optimized, perfect-in-theory approach that many early retirement blogs preach, but I’m willing to bet that most people are willing to make a slight tradeoff in tax-efficiency for overall simplicity.

During Your Working Years

1. Contribute as much as you can each year to your 401(k) or equivalent employer-sponsored savings plan to take advantage of any company match and save thousands on your taxes. Max it out each year if possible. Don’t bother with a Roth 401(k) if your company offers one — it’ll be less expensive tax-wise to do a Roth conversion later.
2. If you have money left over, contribute as much as you can to a Roth IRA while you’re under the income limit for eligible contributions. This will allow you to build up a pool of contributions that you can withdraw from at any time.
3. Take any remaining savings you have each year and contribute them to a regular, non-IRA investment account. You don’t want that money sitting in a bank account because it’ll lose value to inflation over time.

You can start a Roth IRA as well as a non-IRA investment account with pretty much any investment management service. I suggest using a robo-advisor like Wealthfront if you don’t mind paying a small fee for convenience, or Vanguard if you prefer to have more hands-on control.

Once You Stop Working

1. Make sure you have at least five years of living expenses covered by your non-IRA investments and your Roth IRA contributions. For the first five years, withdraw from these sources to pay for your living expenses since this money can be taken out without penalty.
2. While doing so, convert enough to support your living expenses five years from now from your Traditional IRA to your Roth IRA each year.
3. In five years, withdraw the amount you converted five years ago from your Roth IRA, tax- and penalty-free.
4. Repeat steps 2 and 3 each year until you reach 59½.

Everyone’s situation is different, so before you take the plunge, make sure to consult a tax professional to make sure all of this advice is sound. This merely lays out the general principles and framework for withdrawing funds early from your retirement accounts, but the amount of money you have in each type of account (Traditional IRA, Roth IRA, non-IRA) will obviously affect your overall withdrawal strategy.

Also, be sure to read my guide to paying zero taxes in retirement to help figure out the optimal balance of withdrawals from each of your various accounts to minimize your tax burden and stretch your savings.

As always, if anything was confusing or unclear, please leave a comment! Anything involving taxes tends to be pretty esoteric, and I want to make sure I’ve written this in a way that’s approachable and understandable for everyone — not just finance geeks and tax professionals.

If you have any questions feel free to leave a note or hit me up on Twitter (@dekaliber) and I’ll try to help as much as I can.

I’m always interested in opportunities to explain complex personal finance topics to people who are interested in learning about them. Questions about this subject are often uncomfortable to bring up in social settings, and the majority of resources online tends to assume a level of knowledge that few of us have. If there’s something you’d like me to write about, let me know and I’ll be happy to take stab at it.

Cheers,
Tai

Version History

Because I’m a bit of a perfectionist, it’s likely that I’ll revisit this article once in a while to make updates for the sake of improving clarity, correcting outdated or incorrect information, or adjusting recommendations based on new things I’ve learned. I’ll do my best to annotate the changes here.

10.17.2017

• Pretty significant rewrite of most of this article for clarity, adding a few examples along the way (thanks to my editor — my wife — for always providing pointed and helpful feedback)
• Removed the section on backdoor Roth contributions as it was slightly out of context here and frankly deserves its own article anyway

10.13.2017

• Initial version

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