This guest post is brought to you by Eddie Wills.
For those of us who have had to put together War Plans/OPLANs on a military staff, we all know the importance of an Exit Strategy. The late great author Dr. Steven R Covey, author of “The Seven Habits of Highly Effective People” knew this as well. His first (and likely most important) of the Seven Habits is:
Begin with the End in mind.
There’s so much focus in the financial services industry on how to save for retirement, and yet so little on the best strategies to get your money out. Sure, Fidelity, Schwab, or Vanguard will be happy to compute your Required Minimum Distribution for you when you turn 70½, but wouldn’t it be nice if you knew the most tax-efficient tactics over the long run to draw your retirement income? Maybe if you knew the most rapid strategies to access Retirement Account money penalty-free you could make a better-informed decision in choosing between Roth, Traditional IRA, or 401k/TSP accounts during your working years.
My best guess is that the financial services industry makes the lion’s share of its revenue (commissions and fees) when our retirement accounts are accumulating money, and that they have very little financial incentive in helping us choose the most efficient path to draw our account values down to zero at the optimal actuarial time (the moment our earthly bodies assume room temperature).
From reading some comments on this page and the Early Retirement forum, it’s clear to me that the vast majority of people don’t know some of the key rules about accessing money penalty-free from tax-deferred plans such as IRAs, 401ks, and Roth accounts. Sorry to paraphrase G.I. Joe, but knowing is half the battle:
Locking your money up in a Retirement Account for too long can cost you big bucks. Avoid the Red Lasers!
There are plenty of books on how to get out of debt, start saving for your immediate needs, and save for retirement. My favorite is Beth Kobliner’s book , “Get a Financial Life”. Start there if your only familiarity with CDs is you believe it is how people listened to music before the iPod.
For the rest of us on our way to saving for retirement, Begin with the End in Mind. The best book I’ve read is Dr. Twila Slesnick’s book “IRAs, 401(k)s & other Retirement Plans : Taking your money out”. Go grab a copy at your library or here. Now. Her book gives you vital information on how to retrieve retirement money penalty-free for health, home, education, leisure, and early retirement reasons. Knowing what Exit Strategies are available will help you choose the best Retirement Account vehicle for your goals.
Here are some of the key points regarding Retirement Accounts:
Retirement Account Misconception #1: I see post after post lamenting, “I guess I’ll just hang on with my employer until I can start drawing down my 401k at age 60”. This statement makes me grind my gears, because most people (falsely) believe that money in their 401k plan is stuck there until you turn 59½. Largely true, but if you terminate employment (for ANY reason- quit, fired, or retired) in the calendar year of your 55th birthday, you can start taking withdrawals from your employer’s 401k plan without penalty (you’ll still owe the IRS income tax, just not the 10 percent penalty). Caveat: While the tax code permits 401k withdrawals at age 55, you must check with your employer’s 401k plan administrator to ensure they have the accounting “hooks” in place to permit withdrawals at age 55. Most do.
Retirement Account Misconception #2: Another misunderstanding I frequently see is that people think their IRA money is stuck there until they are 59½. Also largely true, but there is a “Texas Two Step” you can take if you want your IRA money penalty-free at age 55. Here’s how it works- When you are 54 years old, apply for seasonal full-time employment at your favorite retail store (we’ll call it ‘CostMart’) during the Holidays. Roll some or all of your traditional IRA money (does not matter where it originally came from) in to the CostMart 401k as soon as you are eligible for employee participation in the CostMart 401k. Come January 1st, quit your job at CostMart and begin making penalty-free 401k withdrawals as discussed above. You’ve just made your IRA accessible without penalty- 4½ years early!
If a few extra months working for the Man turns your stomach, you could get really frisky with this option and start a solo-401k for your ‘consulting’ business… but I’d certainly enlist the help of an accountant before attempting this.
Retirement Account Misconception #3: Possibly the biggest misunderstanding is about Roth IRA contributions. Folks, you’ve already paid taxes on the cash you put in to your Roth account. It’s yours for the taking at any time for any reason. Example: You and your spouse want to set aside $10,000 for a trip to Hawaii to celebrate your anniversary in three years. You and your spouse each plunk $5,000 in to Roth accounts, choosing a 3-year CD paying 1.35% as the investment vehicle. At the end of the three years, each CD is worth $5,543. You and your spouse each pull out your original $5,000 and leave the $543 of earnings in each of the Roth accounts.
There’s some caveats here. In addition to being married to each other, you and your spouse are now also married to IRS form 8606 for life (it tracks your contribution basis to Roth accounts). It’s not that big a deal- tax prep software will keep track of this for you. Also, there are some tax land mines that have to do with Roth CONVERSIONS (a five-year holding period) and transfer/withdrawals from a Roth 401k. Consult your tax professional if either of these apply to you.
There are some rather esoteric methods I’m not covering here (like the 72(t) exemption) to get at your money early, but I’m just covering some of the most direct methods of accessing your Retirement Account money without penalty. If you want to read a bit more about 72(t) methods and Roth Conversions, Mr. Money Mustache has a quick summary. If you are really interested in converting your IRA or 401k to a 72(t) “self-annuity”, early-retirement pioneer John Greaney provides an excellent summary of 72(t) nuts-and-bolts.
For further reading, get Dr. Slesnick’s book for specific examples of advanced Retirement Account withdrawal strategies. Here’s a quick summary (remember to consult your tax professional before engaging):
Qualified Plan, IRA, and Roth IRA early withdrawal gouge sheet.
401(k)s, ESOPS, Money Purchase Pensions, Stock Bonus Plans, Keoghs.
Contributory/Traditional IRAs, SEP IRAs, SIMPLE IRAs, Rollover IRAs.
See IRC Section 408(a),
|Know this:||- Below are IRS rules on “Qualified” Retirement Plans; your employer plan rules/documents may vary.- Exceptions listed below are 10% penalty-tax free, but you will still be taxed on all distributions as income.||Exceptions listed below are 10% penalty-tax free, but you will still be taxed on all distributions as income.||- “Contributions” to Roth IRAs are yours. You may withdraw contributions (not investmentreturns) at anytime for any reason, penalty and income tax free.- Exceptions listed below are both penalty-free and income tax-free.- 5-year holding/waiting period for the entirety of a ‘converted’ Roth IRA.|
|5-Year minimum holding period before withdrawing investment returns.||N/A||N/A||Yes|
|Withdrawals taken after age 59 ½||Yes||Yes||Yes|
|Withdrawals after quitting your job in the calendar year of your 55th birthday||Yes||N/A||N/A|
|Immediate Annuity: IRC 72(t) SEPP – Substantially Equal Periodic Payments||Yes, but you must terminate employment first.||Yes, anytime. Penalty-free but subject to income tax.||Yes, anytime. Penalty-free but subject to income tax.|
|Payments on Death||Yes||Yes||Yes|
|Disability||Yes, if “Permanent” (consult a tax lawyer).||Same||Same|
|Medical Expenses||Medical expenses paid beyond 7.5% of your AGI||Same||Same|
|Health Care Premiums||N/A||Health Care Premium payments, if:1) Distributions taken no sooner than 12wks after unemployment and terminating no later than 60 days after starting a new job.2) Allowed in the Calendar Year of unemployment to follow-on CY only.||Same as “traditional” IRA|
|One-time tax-free transfer to Health Savings Acct.||N/A||Up to $5800 (family)/$2900 (self)(See IRB 2008-25).||N/A|
|“Qualified” Education Expenses||N/A||Tuition, fees, supplies, equipment.- Room&Board if >1/2 time student.- Withdrawals can be for self, spouse, children, or grandchildren.||Penalty free (IRS Notice 97-60).|
|1st time home purchase, or first ever plan withdrawal after not owning a home for two years.||N/A||Yes. $10K lifetime limit for home purchase per person (not per retirement account).||Same as “traditional” IRA|
|Mandatory Distributions as a part of a QDRO (divorce) settlement.||Yes||N/A||N/A|
IRC Section 72(t).
IRC Section 401.
IRC Section 401(k).
IRC Section 408.
IRS Regulation 1.408A, Roth IRA Regulations
Slesnick, Twila. IRAs, 401(k)s & other retirement plans : Taking your money out. 10th ed. Berkeley: Nolo Press, 2011.
IRS Notice 97-60.
Eddie served seven years on active duty as a Submariner and holds a Master’s Degree in Personal Finance from the College for Financial Planning. He earned his commission from the Naval Academy in 1993 and is looking forward to earning his retirement both as a Naval Reservist and Federal Employee. He can be reached at ejwills AT 1993 dot USNA dot com.
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