How to fund an early retirement without paying penalties?

Hi there! How has it been getting back to routine after your vacation?

Helloooo…it has been challenging to get back to my previous routine because I have sort of forgotten what my life was before I went for a vacation! Jokes aside, it has been difficult but I seem to have more energy than I had before. You also seem to be refreshed after yours with that glow on your face!

 I definitely am feeling refreshed and thank you for noticing! Even my first week back from vacation was difficult but it feels good to be reenergized for the work left in the rest of the year. I also had a follow up question from our last discussion on funding retirement accounts. There are penalties for early withdrawal from a lot of the retirement accounts, so in the dream scenario where I get to retire early, how can I access the funds in these accounts without getting penalized?

That is an excellent question given that you are already very financially savvy and I have no doubt that you will be financially independent very soon to retire early. The strategy to use funds before the age of 59.5 is a bit tricky because a lot of the retirement accounts where you are saving now, charge a 10% penalty for withdrawing funds earlier than the age of 59.5. Also, a lot of benefits like social security kick in after the age of 60. So, let’s say you retire at the age of 50, then there is a good 10 year period that you need to plan for meeting your living expenses without paying penalties. There are a lot of rules and regulations around the retirement accounts that will factor into this plan so it is always best to check with a professional about your plan before you make a major decision. Having said that, we can today go over some general guidelines that you can keep in mind and use that as a starting point for future discussion with a professional when the time comes.

That would be amazing! I understand that there are a lot of nitty gritties involved related to withdrawals from retirement accounts that can change over time, so it will be good to review my financial plan with a professional. I will treat today’s discussion as a starting point and general information on how to think about planning for early retirement. I feel that even in the best case scenario, an early retirement is at least a decade or more away for me, so there is plenty of time for me to dive into the details and consult a financial advisor down the line. 

Excellent! It is good that we recently talked about the different types of retirement accounts [Check out this blog on the different types of retirement accounts] as things will be fresh in your mind. We can talk about how to treat each of these accounts in case of early retirement.

1. Taxable brokerage account – These are the accounts that you fund with after-tax money. When we discussed the “Three Bucket Strategy” for saving for retirement [Check out this blog to learn more about the Three Bucket Strategy for retirement planning], we talked about this account as the last bucket to fill after maximizing contributions to the tax-free and tax-deferred retirement accounts, which are tax-advantaged. Even though there are no tax advantages for putting money in this account, it is probably the most important account if you plan to withdraw money before the age of 59.5 because there is no early withdrawal penalty here. You can withdraw money from this account whenever you want and you would have to pay taxes only on the profits from selling investments in this account. The taxes on the profits fall under capital gains tax, where the tax rates are much lower than the ordinary income taxes. [Check out this blog to learn more about the Capital Gains tax

For example, if you fall under Married Filing Jointly, you do not have to pay any taxes on long-term capital gains and qualified dividends if your taxable income is below $96,700. This means considering a standard deduction of $30,000, your taxable income including the long term capital gains and qualified dividends can be $126,700 (=$96,700+$30,000) and still you would not have to pay any taxes. Therefore, to avoid paying any taxes you can strategically plan to sell investments that are held more than a year, while accounting for the dividends that the other investments in the account are generating.

For example, if you sell investments that you have held more than a year in this account and make a profit of let’s say $20,000 while you are also earning $20,000 in qualified dividends from the other investments in the account. Therefore, the total amount that will be considered under capital gains tax brackets would be $40,000. As long as the sum of your other income stays below $126,700 – $40,000 =$86,700, you will not owe any taxes on the gains and the dividend earned from this account.

If you can save 10 to 15 years worth of living expenses in this account then you do not have to touch your retirement accounts till you reach the age of 59.5 and avoid the withdrawal penalty. The only downside of using this account is that you might have to pay taxes if you exceed the 0% tax bracket threshold but at least there will not be any penalties.

I remember our talk about how the tax brackets for capital gains and qualified dividends are so much lower and forgiving than the ordinary income tax brackets. It made me realize how profitable generating income from investments is from a taxation point of view. I like the flexibility of withdrawing money from this account anytime I want and ideally I would like my dividend income to cover all my living expenses. How can I use the tax-free retirement accounts?

It would be amazing if your investments in dividend paying stocks or ETFs get so large that they cover all your living expenses. This way you do not need to sell any investments to cover your expenses. Let’s talk about the Tax-free retirement accounts.

2. Tax-free retirement accounts – This would be your Roth IRA or Roth 401k accounts. Here, there is a penalty for withdrawing money from this account in two scenarios:

1. If the account has not been open for more than 5 years and/or the money you are withdrawing has not been in the account for at least 5 years.
2. If you withdraw the gains or the earnings on the money invested before the age of 59.5 years  

When we talked about the Three Bucket Strategy, we chose to fill this bucket or account first since the investments could grow tax free and you can also withdraw this money tax-free. Since this is the first account you need to start building for retirement, there is a good chance you would have opened this account pretty early in your financial journey and the account therefore would be more than 5 years old by the time you decide to retire early. Also, the contributions made in the account would have been for more than 5 years if you followed the Three Bucket Strategy. Therefore, you can negate the first point related to penalties. In this scenario, the only thing to be mindful of is withdrawing the amount of money that you contributed and not the amount you earned from investing the contributed money. This will help avoiding the point 2 of penalties before the age of 59.5.

Now, let’s say you do not have enough money in this account when you decide to retire and instead you have a lot of money in the Traditional IRA or 401k accounts. In this case, you can choose to transfer money from the Traditional accounts to Roth accounts and stagger the transfers such that you factor the 5 year waiting period before withdrawing the money you transferred. For example, you need $25,000 every year from the Roth account when you are 45 years old. You would have to then start making a $25,000 annual transfer from the traditional retirement accounts starting the age of 40. So, by the time you are 45, this contribution has been in the account for at least 5 years. Remember that it is only the $25,000 you transferred that can be withdrawn without penalty and not any earnings on this $25,000 that you might have had from investing it into equities or bonds. Also, it is important to note that you would have to pay taxes on the money transferred from the traditional to Roth accounts. To minimize the amount of taxes you pay on the transferred amount, try to time the transfers when your ordinary income from other sources is lower so that you do not go into a higher tax bracket when you add the transferred amount.

Besides Roth accounts, HSA can also be used to get funds during your retirement. You can always use HSA for paying for medical expenses and there are a bunch of items that are HSA eligible that you can buy from this account. You can also pay for non medical expenses with your HSA account and not incur any penalties or taxes, if you follow the strategy of paying for your medical bills from your checking or savings account, then save all the receipts for these bills and later withdraw money equivalent to these medical bills later from the HSA account. This way you have let the money contributed to the HSA account grow tax-free and are also able to use it tax-free and penalty-free.

Wow! This conversion strategy from Traditional to Roth is amazing. It needs some foresight and planning but can be very powerful to convert from tax-deferred to tax-free accounts. I am glad you mentioned the strategy related to the HSA accounts because I will from now on save all my medical expenses related receipts that I pay from my checking/savings account. I believe the last, but not the least, type of retirement account is the tax-deferred account.

Yes, this is an interesting account to talk about.

3. Tax-deferred accounts – These are the accounts that have been funded through pre-tax money so regardless of when you withdraw it, one thing for certain is that you will have to pay taxes as this withdrawal will be added to your gross income. If your taxable income is low even after adding this withdrawal amount then you may be able to avoid paying taxes or pay lower taxes based on the tax brackets at that time. 

Now, to avoid paying penalties before the age of 59.5, there are two options that you can use depending on what is allowed in your plan.

1. If you leave your job in the year you turn 55 or later, then you can take distributions from your current employer’s 401k or 403b without paying any penalties. For public sector employees, this age limit is lower i.e. 50. It is important that you need to be in the current employer’s plan which you left at or after the age of 55. Also, this may not be offered by all employers so you would need to check with yours if this option is available.
2. You could also decide to take equal annual distributions from the IRA or 401k or 403b accounts for the longer of 5 years or until the age of 59.5 years. This falls under the rule 72(t) in IRS code and is called Substantially Equal Periodic Payments. It is critical to ensure that the amount stays the same every single year and you cannot pause or modify them midway. Let’s say you decide to use one of IRS approved methods to calculate an annual distribution of $25,000 and you choose to start at the age of 50. Then till the age of 59.5 years, you would receive this $25,000 every year. If you withdraw $30,000 then you would be charged the 10% penalty on that withdrawal and all the distributions that have been made up to that point. So, it is very important that you think carefully and consult a professional before doing this route as there is no flexibility in this option. 

Let’s summarize the overall strategy for financial planning in early retirement if you have the three types of retirement accounts. I would say you should rely on using the funds in the taxable brokerage first. Next, start converting money from the Traditional retirement accounts to Roth accounts at least 5 years before you need the money from that account. You can start using this contributed money till the age of 59.5. You can continue using the money contributed to the Roth and this could include  the funds you had originally contributed to the Roth account. Remember, it is worthwhile to consult a professional financial advisor for this retirement planning as they can optimize your strategy to minimize paying taxes, avoid penalties and maximize the time your wealth lasts.

This has been an amazing discussion and thank you for summarizing it so well! There is still some time to go before I get to apply all these strategies but I am glad I learnt things that I can start practicing now like paying for medical expenses using my regular accounts while preserving money in my HSA account. Also, just realizing the intricacies of different accounts has been very interesting which had made me respect the amount of planning that would be required to create a solid retirement plan, especially if I plan to retire early.