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Today, in part three, I’ll expand on the last of three topics that hang people up and make them think that early retirement is impossible to achieve.

• Part 1: Health Insurance
• Part 2: College
• Part 3: How to access your retirement money early

We’re taking on the topic of how to access your retirement accounts early without penalty and excessive taxes.

The third most frequently asked question we get is how we will access our retirement savings during our early retirement. It’s true that, generally, there are rules, restrictions, and penalties for withdrawing your 401K, 403(b) or IRA funds before you reach the “Retirement Age” of 59 1/2. Mostly it’s the 10% early withdrawal penalty plus taxes on the withdrawals that people are concerned about. 

Nerd Alert Warning

If you’re here for the short answer, it’s that there are ways to access your retirement savings penalty free and with a low tax burden, so you don’t have to worry about it. If you want more info on how this works, keep reading as we dig deeper.

Some of this depends on the type of account you have (Traditional vs. Roth).  Thankfully, we have a mix and would suggest a mix for others as well. Generally, contribute as much as you can to Roths when you are young and in low-ish income tax brackets and then move to traditional accounts later when the tax savings is more significant for you. See your CPA for the balance that’s right for you.

Roth Contributions

You can always take out your Roth contributions without paying a penalty or taxes (you’ve already paid taxes on that money before you put it in your Roth). What you can’t touch is the amount of earnings within that Roth. You’d think the IRS would keep track of how much in the account is contributions vs. earnings, but (as we recently found out) they don’t. Keep good records about how much you’ve contributed to, rolled over into, or converted from traditional accounts in your Roth. That will make accessing this money less of a headache. For us, we went back through a dozen years of account statements to reconstruct this to find out how much of our account balance we’d be able to withdraw without tax or penalty.

NOTE: It should be mentioned that when you take away from the principal in your Roth account, you’re sort of killing the goose that’s laying the golden eggs. Due to the wonders of compound interest, the principal in your Roth account is growing tax free and can be an excellent source of wealth later in your retirement. It doesn’t mean that you shouldn’t use it, just make wise choices.

Roth Conversion Ladder

We’ve talked about the ability to withdraw your Roth contributions before 59 ½ without taxes or penalties, but what if you don’t have a ton of money in Roths and instead have it in traditional retirement accounts? Wouldn’t it be nice to somehow convert traditional retirement funds in 401K or IRA into Roth money through some magic financial wizardry? Enter the Roth Conversion Ladder. Perhaps the best resource is the Mad Fientist:  https://www.madfientist.com/how-to-access-retirement-funds-early/

Here’s how it works:

1. Start With a Traditional IRA

First, if your money isn’t already in an IRA, roll over your traditional retirement money into a traditional IRA, if it’s in a 401(k). This is easy to do once you leave your job.

2. Convert to Roth and Pay Taxes

The “magic financial wizardry” I refer to above kicks in here. What you can do is CONVERT a portion of your balance from Traditional IRA to a Roth IRA. To do this, you will have to pay taxes on the amount you convert as if it were income. Therefore, it’s best to do these conversions in years where your income puts you in a low tax bracket (maybe during early retirement instead of your last working years).

Remember that the money you have in there was pre-tax so this is the first time you are being taxed on it and you would have been taxed upon withdrawal after 59 ½ anyway, so it doesn’t seem that bad, right?. 

3. Wait 5 Years (Really)

Here’s the catch: you can’t touch the converted money for 5 years. But the good news is that after that 5 years, you can withdraw the converted amount as if it were a Roth contribution (see above) without paying any penalties or taxes.

To optimize for taxes while you’re doing conversions, you only want to convert the amount you expect to withdraw to live on 5 years from your conversion. Otherwise, you may unnecessarily bump yourself up into a higher tax bracket by converting a higher amount.

4. Repeat

Then you simply repeat this conversion (for one years’ living expenses) once per year until you have enough to get to age 59 ½ when you can start regular withdrawals on your traditional accounts (and just paying the taxes as normal).

This annual process of converting retirement funds from traditional to Roth and waiting 5 years to withdraw it tax and penalty free, is referred to as the “Roth Conversion Ladder.” If you’re not a super nerd, get help from a fee-based certified financial planner (CFP) and your tax accountant.

SEPP (Substantially Equal Periodic Payments)

If the Roth Conversion Ladder is not for you, there is another way to access your retirement accounts before traditional retirement age known as SEPP (Substantially Equal Periodic Payments) or a 72(t). 72(t) refers to IRS code 72(t), section two, which “allows IRA owners to access their retirement savings before they reach age 59½ without incurring the typical 10% penalty for early distributions.” Your withdrawals are still taxed as regular income.

Here is how this works:

1. Start With a Traditional IRA

As with the Roth Conversion Ladder, roll your workplace retirement accounts over into a Traditional IRA when you leave. 

2. Get Out Your Crystal Ball

This is the hard part about the SEPP method for me: to execute a SEPP, you have to figure out how much you want to withdraw every year (equal payments) until you are age 59 ½. Depending on when you are going to retire early, this could be a decision that follows you for a very long time.

If the Roth Conversion Ladder needed your CFP and CPA onboard, the SEPP math most certainly will. IRS Rev. Rul. 2002-62 lists three methods you may use in determining what are substantially equal periodic payments:

• the required minimum distribution method
• the amortization method
• the annuitization method

All three methods require the use of a life expectancy or mortality table. The second and third methods require you to specify an acceptable interest rate.

It’s super dorky and complex and if your eyes gloss over at the thought, you’re not alone. What you need to know is that each of these three methods will yield a different annual (periodic) payment, avoiding the 10% early withdrawal penalty. 

3. Choose a Method

What you need to do is have your CFP and/or CPA calculate the payment amounts with each of the three techniques and then pick the one that is closest to your crystal ball prediction of what you want to withdraw each year until you turn 59 1/2.

4. Withdraw

Once you have that selected, withdraw that amount each year (some methods are a constant dollar amount and others change each year so be careful and consult your CPA). You’ll still pay income tax on the amount you withdraw, but you’ll avoid that 10% early withdrawal penalty. 

SEPP Tips

1. Multiple IRAs

One nuance that I only recently discovered is that the 72(t) SEPP is not an all or nothing thing for the entirety of your traditional retirement accounts. You can select this for each account. This means that if you roll over your traditional workplace account, do it into a new (separate) IRA apart from the one that you may already have.

It also seems possible to split off funds from one IRA to another, giving you maximum flexibility in accessing these funds in different increments. For instance, my wife has an IRA in her name and I have one in my name and I’m still currently working and contributing to my workplace 401(k). When I retire early, I’ll roll that 401(k) over into a brand new IRA so that if I choose to go the SEPP route, we can select which account or combination of accounts (and which methods) for each we will use to tap to live on.

2. Do Over

The IRS does give you one “do over” for selecting which of the three techniques you will use to calculate your payments. But other than that, it is very inflexible, and you have to live with that choice until you’re 59 ½. If you’re retiring pretty early, you’ll be living with those decisions for quite a while.

3. Don’t Screw It Up – Get help

Be careful and don’t screw this up. Get professional help. The stakes are high for taxes and penalties if you withdraw the wrong amount.

What’s our plan?

1. Retire with three years’ worth of living expenses saved in cash
2. Spend one year doing our grand Great Loop adventure
3. Use our two-year buffer, combined with tax and penalty free withdrawals of our Roth contributions, to live on
4. Execute a Roth Conversion Ladder, SEPP, or a creative combination of the two, to access the rest of our retirement funds early to live on until we turn 59 ½

There you have it. Thanks for sticking with me through a pretty nerdy post. I hope you got the value you were looking for in our brief (non-expert) overview of free withdrawals of Roth Contributions, what the Roth conversion ladder is and how you can use it, a simplified look at the complex topic of SEPP to access your retirement accounts early, and what our current plan is for accessing our funds in early retirement.

The bottom line is that you need not be scared of having access to your retirement accounts in early retirement. There are tips and tricks you can use to be able to get at your money without taxes and penalties. So don’t let the fear of penalties stop you from saving aggressively and retiring early.