Saturday Selection: How to Get to Your Money Before Age 59 1/2
This classic post from Dr. Jim Dahle originally appeared on The White Coat Investor. It is of particular value to the aspiring early retiree. Yes, Virginia, there is a way to get to that retirement money.
But what if you want to retire before age 59 1/2? How can you get to your money without that pesky 10% penalty that comes with taking money out before age 59 1/2? Here’s a few tips the pros use:
# 1 Burn Your Taxable Account First
Your taxable account is your least tax-efficient way to invest. Yes, it has its tax benefits, but these pale in comparison to IRAs and 401Ks, especially when you consider the additional estate planning and asset protection benefits of a true retirement account. Most experts agree that an early retiree ought to hit up his taxable account before diving into his tax-protected ones for a number of reasons. First, you don’t pay any tax on your basis, which might be quite high. Second, long-term capital gains are only taxed at 5-15%, likely much less than your IRA withdrawals. Last, it leaves your IRA money to continue to compound at tax-free rates.
[PoF: Long-term capital gains are typically subject ot state tax, as well, but federal tax can be as low as zero under the current tax code as long as your taxable income is under about $75,000 for a married couple filing jointly.]
# 2 Drain that 457
A 457(b) is a tax-protected account available to many docs who work for university hospitals. If you have a 403B you ought to look and see if you have a 457 too. It allows you to squirrel away another $16,500 a year into a tax-protected account. It’s biggest downside is that the money is technically subject to your employer’s creditors. But that comes with several upsides.
First, it gives you a tax-break just like a 401K or 403B. Second, it isn’t subject to YOUR creditors. Lastly, you can raid it as soon as you separate from your employer without having to worry about the age 59 1/2 rule. In fact, you probably should since it isn’t quite as separate from your employer’s money as your 403B account is. If you don’t want to spend the money, you can also roll it into an IRA. That, of course, makes it subject to the Age 59 1/2 rule, so don’t do it if you want to spend the money before then.
[PoF: WCI is referring to a governmental 457(b), which can be rolled over into an IRA. If, like me, you work for a non-governmental non-profit hospital, you may have a non-governmental 457(b), which can also be accessed at any age after you leave the employer, but cannot be rolled over into an IRA.
You often can roll over money in a non-governmental 457(b) to another non-governmental 457(b).]
# 3 Take Advantage of the SEPP Rule
The Substantially Equal Periodic Payments (SEPP) rule is the little-known exception to get into your IRA as soon as you retire. You basically “annuitize” your IRA from the time you retire until 59 1/2. Your life expectancy is calculated, and you then must take out an equal amount each year equal to the balance of the IRA divided by your life expectancy. Once started, you must continue to take these withdrawals for at least 5 years, or until age 59 1/2. When you do this, you DO NOT have to pay the penalty (but of course do have to pay taxes due on a tax-deferred account.)
# 4 Don’t Forget the Exceptions to the Age 59 1/2 Rule
Per IRS Publication 590, you can take out the money without paying the 10% penalty for the following reasons:
- Unreimbursed medical expenses > 7.5% of your adjusted gross income (which may not be that high if you’re retired)
- Pay for medical insurance
- Inherited IRAs. (if your father leaves you his IRA, you can take out the money before you get to 59 1/2)
- Qualified Higher Education Expenses- for you, your kids, or your grandkids
- A First Home. Keep in mind the IRS definition of a “first home” is that you haven’t owned one for the last 2 years. Also, it doesn’t have to be YOUR first home, it can be your kid’s or grandkid’s first home too. See how this works? You pull out $10K from your IRA to pay toward their home, and they gift you $10K for Christmas. No 10% due. Ethical? Perhaps not. Legal? Certainly. Keep in mind there is a $10K limit.
- IRS Levy
- Reservist Distribution. A military reservist can withdraw money while activated without paying the 10% penalty.
[PoF: I’ll add another. Your 401(k) can be accessed penalty free anytime during or after the year in which you turn 55 if you separate from your employer. You lose that benefit if you roll the 401(k) money over into an IRA.]
# 5 Don’t Forget the Stealth IRA (Your HSA)
Although after age 65, an HSA can serve as just another IRA, withdrawals for qualified medical expenses are always tax and penalty free.
# 6 Roth IRA Contributions
Unlike traditional IRA contributions, and earnings on either type of IRA, all contributions to a Roth IRA can always be taken out tax and penalty-free. In fact, some people even use their Roth IRA as an emergency fund initially because of this. This applies even to Backdoor Roth IRAs, which is the only way most practicing physicians can make these contributions.
However, I would be hesitant to touch a Roth IRA any earlier than you have to. Those tax and penalty free distributions are tempting, but keep in mind that in terms of maximizing your estate, the Roth IRA is the LAST account you would want to touch. A stretch IRA is super valuable to your heirs.
# 7 401K Loans
All right, I can’t really recommend this one. The problem with a 401K loan is that you have to pay it back immediately if you separate from your employer, which is kind of the point of retirement. But it does allow you access to your money before age 59 1/2…as long as you keep working at least part-time.
# 8 Cash Value Life Insurance
This is another one I can’t recommend. If you were suckered into a cash value life insurance policy years ago, and it now makes sense to keep it (as it often does AFTER 10-20 years), the cash value can be accessed to pay for early retirement expenses without any concern about taxes or penalties. Life insurance salesmen LOVE to point out this benefit of their policies.
Despite this benefit, life insurance is still a lousy investment due to the high fees, poor returns, and overly expensive insurance components so don’t go buy a policy to fund your early retirement. You’re likely far better off with a plain old taxable account invested in index funds. Don’t mix insurance and investing.
What do you think? When do you plan to retire? What resources will you use first in retirement? Comment below!