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6 Tips and Investing Strategies to Retire Early (and Without Penalty)

Ready to quit work or begin a financially independent lifestyle? Laura covers six tips and strategies to help you amass enough money to retire early and on your terms.

By
Laura Adams, MBA,
Episode #561
6 Tips and Investing Strategies to Retire Early (and Without Penalty)

5. Know the retirement withdrawal rules.

This takes us back to Megan’s question about using a retirement account when you plan to retire early. After all, you’ve probably heard that taking money out of a retirement account before age 59½ typically means paying a 10% early withdrawal penalty, on top of income tax. The good news is that there are legit ways to avoid the penalty.

The first option is to use a Roth retirement plan at work or a Roth IRA, which you open on your own. As I previously mentioned, a Roth requires you to pay tax upfront on your contributions. Therefore, you’re allowed to withdraw your contributions at any time without paying a penalty or additional tax. This makes it a great option for early retirees.

However, your investment gains in the account haven’t been taxed. So, if you choose to withdraw earnings from a Roth before age 59½, those amounts would be subject to tax, plus the 10% penalty.

The only hiccup is that high earners aren’t eligible for a Roth IRA. But that rule doesn’t apply to a Roth at work. You can contribute to a Roth 401(k) or a Roth 403(b), regardless of how much money you make.

Here are the Roth IRA eligibility rules for 2018:

If you file taxes as a single and your modified adjusted gross income is higher than $135,000, you cannot contribute to a Roth IRA. When you earn from $120,000 to $135,000, your contribution total is reduced.

If you’re married and file taxes jointly, you cannot contribute to a Roth IRA when your household’s joint modified adjusted gross income exceeds $199,000. And when you earn from $189,000 to $199,000, your contribution total is reduced.

Megan didn’t mention how she and her husband file taxes. But if they file jointly with $170,000 of total household income, they each qualify for a Roth IRA. Additionally, they can also max out a retirement account at work or one for the self-employed in the same year.

But what if you earn too much to qualify for a Roth IRA or don’t have an employer that offers a Roth retirement plan? You can still retire early using a traditional 401(k) or a traditional IRA and avoid the early withdrawal penalty using a couple of workarounds.

The first exception applies if you have a workplace retirement plan and decide to retire at age 55 or later. If you are no longer employed, you can use the “rule of 55” to take penalty-free withdrawals from your 401(k) or 403(b).

For certain government workers, this exception can apply as early as age 50. But note that this rule doesn’t apply to any type of IRA or SEP-IRA, only to workplace plans and solo 401(k)s.

In the next tip, I’ll cover the second key way to avoid an early withdrawal penalty if you’re an early retiree younger than age 55.

See also: 7 Simple Reasons to Invest in a Roth 401(k) or Roth IRA

6. Understand 72(t) payment plans.

There’s also a little-known rule you can use to avoid the early withdrawal penalty no matter your age. This exception goes by a few different names, including:

  • 72(t) payment plan
  • 72(t) distribution
  • substantially equal periodic payments (SEPP)
  • SEPP plan

The name 72(t) comes from its numbered section of the IRS tax code. This regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) distribution for a workplace plan, such as a 401(k) or 403(b) if you no longer work for your employer.

The amount you can withdraw using a 72(t) plan is calculated using one of three accounting methods approved by the IRS. They use factors such as your account balance, age, and life expectancy. The payment calculation can be based on the amount in a single retirement account or on the aggregate of all your retirement accounts.

Problem is, a 72(t) comes with restrictions and some risky consequences if you don’t use it the right way. It’s important to understand that once you begin taking 72(t) distributions, you can’t stop taking them for a certain period of time.

Once the plan is put in place you must take the periodic payments for a minimum of five years or until you turn 59½, whichever is longer. In other words, if you started a 72(t) at age 30, you’d have to continue payments for 29½ years.

After you complete a series of 5-year distributions or reach the age of 59½, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 70½, you generally must take annual required minimum distributions, no matter if you used a 72(t) plan or not.

Another issue with a 72(t) plan is that you can’t make new contributions to your retirement account or add rollovers while you take payments. And, of course, all distributions that weren’t previously taxed will be subject to ordinary income tax.

When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early without penalty. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount. Always get help from a tax professional who has experience setting up a 72(t).

Taking too little, too much, or missing a distribution deadline can result in expensive consequences. In addition to owing income tax, messing up your 72(t) payments means that all your distributions will be subject to the 10% early withdrawal penalty—plus, interest on unpaid tax and penalties calculated from the original date you made an error.

Megan and every early retiree should weigh options carefully and never enter a 72(t) plan lightly. Make sure you can afford to trade your nest egg for an immediate cash flow. Taking payments now means that you drain the resources that would be available to you later in retirement.

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