Early Retirement w/ Tax Advantaged Accounts

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investor1
Posts: 1040
Joined: Thu Mar 15, 2012 8:15 pm

Early Retirement w/ Tax Advantaged Accounts

Post by investor1 » Mon Feb 01, 2016 1:12 pm

I came across this post on Reddit that explains a number of options for withdrawing money from a tax advantaged account prior to age 59.5 w/o penalty. Many people here likely already know this as much of it is covered on the wiki (https://www.bogleheads.org/wiki/Early_retirement), but I learned something new today :)

Source: https://www.reddit.com/r/personalfinanc ... /?sort=top
I often 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 (whichever is longer). 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 that requirement.

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. After leaving a job, 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.

Other exceptions

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.

chx
Posts: 429
Joined: Sat Jan 16, 2016 10:52 am

Re: Early Retirement w/ Tax Advantaged Accounts

Post by chx » Mon Feb 01, 2016 2:47 pm

Often, a person who retires early has sufficient funds in taxable accounts to not need tax-deferred withdrawals right away. In this case, it can be advantageous to do conversions from tax-deferred accounts to a Roth account during the years after retirement and before age 70.5. Several advantages occur:

1. You can choose how much to convert, hence you have control over the marginal tax rate.

2. You will reduce the required minimum withdrawals from the tax-deferred accounts after age 70.5, likely lowering taxes.

3. Your state might allow a limited amount of tax-free conversions (i.e., no state income tax) each year after a certain age.

4. If your heirs are in a high-tax bracket, then you'll reduce their tax burden by giving them a Roth instead of a tax-deferred account.

5. If you are lucky enough to have an estate that's large enough to be subject to federal or state death taxes, then the taxes you pay on the conversion will lower the net value of your estate, avoiding some percentage of the death tax. For the death taxes that I know about, the full value of a tax-deferred account is taken, not the after-tax value, in determining the amount of the death tax.

xxChip

Day9
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Joined: Mon Jun 11, 2012 6:22 pm

Re: Early Retirement w/ Tax Advantaged Accounts

Post by Day9 » Mon Feb 01, 2016 2:59 pm

Early retirement isn't talked about on this forum as much as other topics. It doesn't have to mean mimosas on the beach at 40 years old, it can mean switching to charity work, full time child rearing, part time consulting work, devoting yourself to a passion project, or anything really.

A young, healthy American woman might have something like a ~25% chance to make it to 100 years old! And it turns out planning for a 40 year retirement is not that much different from a 60 year retirement.

Starting with the famous Trinity study that showed 95% of historical 30-year scenarios avoided outliving your money with a 4% initial withdrawal rate of a standard 60/40 portfolio, and then adjusting that dollar amount for inflation in subsequent years, we can make adjustments to see how it works for early retirement.

Adjusting the scenarios to 50 years to account for early retirement and leaving everything else the same means the model would have worked in only 75% of historical scenarios.

But going down to a 3% withdrawal rate turns out to be overkill as this worked in 100% of historical 50-year scenarios with very many of them ending up with many times your initial amount.

A 3.6% withdrawal rate succeeds in 95% of historical 50-year scenarios. This is by no means the most sophisticated model but it at least at a glance it appears that you don't have to sacrifice that much in terms of SWR when you are faced with a 50 year retirement instead of 30 years.

In Larry Swedroe's very well received book The Only Guide You'll Ever Need for the Right Financial Plan he advises to have a "Plan B". For example, if the stock market crashes 30% or more within the first 5 years of retirement, I will commit to selling my vacation home and reducing my vacations to once every 2 years instead of every year. Only make a Plan B that you can actually stick to! This seems especially important for someone seeking early retirement.
I'm just a fan of the person I got my user name from

investor1
Posts: 1040
Joined: Thu Mar 15, 2012 8:15 pm

Re: Early Retirement w/ Tax Advantaged Accounts

Post by investor1 » Mon Feb 01, 2016 6:33 pm

chx wrote:Often, a person who retires early has sufficient funds in taxable accounts to not need tax-deferred withdrawals right away.
Yep, you've made good points, but given that the Mega Backdoor Roth is fairly new, I think there is a good chance this ^ could change. Granted that means having a lot more in tax exempt accounts, but I still think at least being aware of these options is a good thing.

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