By Dr. James M. Dahle, WCI Founder
Here's a question I've received.
“I am tired of practicing. I want to retire early. I have done a good job saving and investing and am stepping that up so I can have enough by age 55 to support my needed retirement income. How can I get to my money without paying the 10% penalty for withdrawing before age 59½?”
Many doctors dream of retiring from the workforce before the traditional retirement age of 60-70. Most of them cannot do it because they spend too much, did not save enough, and did not invest wisely. They simply do not have the resources to retire at their desired standard of living without additional savings, a few more years of compound interest on their investments, and perhaps even the additional income from Social Security.
Don't Let the Age 59 ½ Rule Keep You from an Early Retirement
The select few who do have the resources to retire earlier than that worry about the age 59½ rule. This is a rule that applies to retirement accounts like traditional IRAs and Roth IRAs. At its most basic level, the rule says that if you withdraw money from an IRA prior to age 59½, you will owe any taxes due and also face a 10% penalty. However, this rule should never prevent someone who is otherwise able to retire prior to age 59½ from actually doing so—for a number of reasons.
#1 Withdraw from Taxable First
Anyone who saved enough money to retire before age 59½ probably could not fit all of their savings into their available retirement accounts. They likely also have a sizable taxable account from which money can be withdrawn without any penalty, simply by paying any long-term capital gains taxes that are due. Those taxes, of course, only apply to the gains; the principal comes out tax-free.
Generally, the earlier you retire, the larger the ratio of your taxable accounts to your retirement accounts will be. So, you can simply live off the taxable assets until you turn 59½ and then tap into the retirement accounts. Spending taxable assets first is generally the best move anyway, as it allows your retirement accounts to continue to benefit from the tax and asset protection offered by retirement accounts for a longer period of time. Taxable assets also create their own income, whether it's qualified dividends from mutual funds, interest from certificates of deposit or bank accounts, or rents from income property. These sources of income can be used to cover your retirement expenses instead of being reinvested.
#2 457(b)s, 401(k)s and 403(b)s
Many types of retirement accounts are not subject to the age 59½ rule. For example, many doctors are eligible for a 457(b) account, a type of deferred compensation. While the distribution rules in every 457(b) are different, you can often access this money penalty-free as soon as you stop working. Meanwhile, 401(k)s and 403(b)s have an age 55 rule where you can withdraw from them penalty-free once you are 55 and have stopped working. If you plan to do this, be sure not to roll your 401(k) into an IRA as soon as you separate from the employer.
#3 HSAs
Withdrawals from HSAs to pay for healthcare are not subject to the age 59½ rule. Those withdrawals come out tax- and penalty-free at any age. While an HSA generally cannot be used to pay for health insurance premiums, it can be used to pay premiums for COBRA (the federal program that allows workers to continue benefits provided by their group health plan for a limited time following a job loss or certain other life events). After age 65, all withdrawals from an HSA are penalty-free, although they're only tax-free when used for healthcare.
#4 Roth IRAs
Roth IRA contributions can always be withdrawn tax- and penalty-free. Only the earnings are subject to the 10% penalty. Note that if you have funded your Roth IRA via Roth conversions (such as through the Backdoor Roth IRA process), that principal is subject to a five-year waiting period before it can be withdrawn tax- and penalty-free. If Roth IRA principal withdrawals are your plan to cover living expenses between ages 55 and 60, then you need to make sure you’ve started doing any necessary Roth conversions by age 50.
#5 The SEPP Rule
Consider the substantially equal periodic payment (SEPP) rule. This allows you to start withdrawing from retirement accounts at any age penalty-free. Once you start SEPP withdrawals, you must continue them for at least five years or until age 59½, whichever time is longer. The amount you can withdraw is limited but is approximately equal to the amount you should be withdrawing anyway if you want your money to last for a long period of retirement. There are three different methods you can use to calculate these withdrawals, but all of them would allow a 50-year-old to withdraw 3%-4% of the portfolio per year penalty-free and a 55-year-old to withdraw 3%-4.5%
#6 Other Exceptions
There are many exceptions to the age 59½ IRA withdrawal rule. These include paying for medical insurance, disability, qualified higher education expenses for you or your children, a first home for you or your children ($10,000 limit), a new child or adoption ($5,000 limit), an IRS levy, and a military reservist distribution if on active duty.
#7 An IRA
Finally, IRA money is never locked up. It is your money, and you can access and spend it any time you like. The age 59½ rule only applies a 10% penalty to otherwise unqualified withdrawals. Few early retirees ever have to pay that penalty, but it is always an option to just pay it.
Congratulations on saving up enough money to retire early. Knowledge of IRS rules and careful management of withdrawals should allow you to cover your expenses without ever paying the 10% early withdrawal penalty on IRAs.
How have you accessed money for retirement before age 59½? Did you ever have to pay a penalty? Comment below!
An excellent summary, Jim.
One point of clarification on the “age of 55 rule” for a 401(k) or 403(b). You can make penalty-free withdrawals when you separate from your employer (e.g. retire) in the calendar year in which you turn 55.
So, unless your birthday is January 1st, you can get those penalty-free withdrawals at age 54. If you have a December birthday, you would qualify within a month of turning 54.
Cheers!
-PoF
Thanks for the clarification.
Home equity or cash out refi to release limited portion of your equity from appreciated home.
If you have decent/large sized portfolio (Brokerage) – you can take limited amount of Margin/Portfolio loan.
Not necessarily advocating Debt — especially the ones which can harm /ding you “badly” – but you may be better off taking such loans — to minimize income in certain years — ACA Subsidies, minimize IRMAA costs etc. or at extreme – optimize toward FAFSA.
At some point you still have to pay off these loans, but you may be able to withdraw large capital gains — and have one sub-optimal optimistic high tax year — to optimize multiple low- tax and ACA subsidy years.. with ACA cliff gone for some years — this strategy may not be impactful, but you may have to calculate yourself based on your financial situation.
Via email:
To Clarify: Federal tax law exempts 457(b) participants from the 10% penalty tax.
Thank you for the great summary! There’s one more option that comes to mind. If the After-Tax source is available in the 401(k) plan, the individual can do in-service withdrawals and rollover after tax dollars to a Roth IRA and access it in five years (a/k/a mega backdoor roth conversion).
You have the SEPP rule backwards. Once you start SEPP withdrawals, you must continue them for at least five years or until age 59½, whichever time is *longer*.
Thanks for the correction. You’re obviously correct. No idea why I typed shorter instead of longer.
Non-taxable Roth conversions do not incur the 10% early withdrawal penalty in the first 5 years. So for example, if your Roth IRA consists entirely of backdoor contributions, converted before any earnings, you could withdraw those contributions immediately without tax or penalty.
Re: the rule that you can take distributions from employer qualified plans like 401ks and profit sharing plans without a 10% penalty, starting in the calendar year you turn 55:
—This applies only to the assets you leave in your employer qualified plan. Anything rolled over into IRAs does not benefit from this rule.
—This method – leave funds in your qualified plan instead of rolling it over to an IRA – is almost NEVER mentioned in “retirement planning seminars/dinners” hosted by financial advisors who hope to manage your retirement money for a fee.
Good point.
Can you save your medical bills from pre-retirement and claim them in retirement to avoid taxes? If so, is there a limit to how old the bills need to be before you can’t claim them any more?
You can certainly make HSA withdrawals for them in retirement with saved receipts, but I think that’s it.