How To Access Retirement Accounts Before 59 1/2

Since I am targeting early retirement I have been asked multiple times how I can make that happen because everyone knows you can’t retire until you are 59 1/2, or 62, or 67 (like there is some sort of law against it).  Because of this misinformation I have collected together all the ways I know of to access retirement accounts before hitting a magical age.  There’s no reason you can’t access retirement accounts before 59 1/2.

Option 1: Retire At 55 And Access Your 401K From Current Employer:

This is probably the most often used strategy, which can allow you to access retirement accounts 4 1/2 years earlier than normal. You can only access the 401K from the separating employer, so if you have an old 401K with a previous employer you would still be charged penalties for taking money out of this account.  This is an oddity to me in the retirement planning arena.

Option 2: Use An SEPP With A 401K/IRA:

SEPP stands for Substantially Equal Periodic Payments, this is the main way to withdrawal money from your retirement accounts without having to pay a penalty.  Once you start taking SEPP distributions you can not stop until you have reached age 59 1/2 or 5 full years of distributions, whichever comes last.  You also can not start an SEPP from an employer sponsored plan while still working for that employer.

There are 3 different calculations the IRS uses for decided how much money you can withdrawal from your account and you are free to choose whichever of these methods you desire.  Let’s look at setting up an SEPP using each of these 3 calculations, and compare them based on different ages of the account holder.  We will use a $500,000 balance across all these calculations. For reference the IRS uses The Uniform Life Table, Single Life Expectancy Table, and Joint Life and Last Survivor Table.  These are all located in IRS Publication 590 Appendix C.  The IRS also uses the mid term federal rate for interest calculations.  For November 2017 this is 2.38%

Required Minimum Distribution: With the RMD calculation you divide the previous year end balance by the current remaining life expectancy of the account owner.

  • Age 40:  $500,000 / Life expectancy of 43.6 years = $11,468
  • Age 45:  $500,000 / Life expectancy of 38.8 years = $12,887
  • Age 50: $500,000 / Life expectancy of 34.2 years = $14,620
  • Age 55: $500,000 / Life expectancy of 29.6 years = $16,892

Each year a new calculation has to be made for the new year end balance and the new age of the account owner. This method has an extremely conservative withdrawal rate, which essentially assumes that your account will never grow at all.

Fixed Amortization Method: This is my favorite method because it is simple, requiring no new calculations each year and it is slightly more generous in its withdrawal rate.  This method takes the ending balance of the account and amortizes it based on 120% of the midterm interest rate and the life expectancy of the account holder. When setting up the SEPP 120% of the midterm rate is the maximum interest rate that can be chosen, the account holder can choose to use a lower interest rate, and thus receive a lower payment if desired.

  • Age 40: A $500,000 balance amortized with a 2.38% rate over 43.6 years = $18,432 / year
  • Age 45: A $500,000 balance amortized with a 2.38% rate over 38.8 years = $19,740 / year
  • Age 50: A $500,000 balance amortized with a 2.38% rate over 34.2 years = $21,396 / year
  • Age 55: A $500,000 balance amortized with a 2.38% rate over 29.6 years = $23,556 / year

Fixed Annuitization Method: The Fixed Annuity Method takes the age of the account holder and applies an annuity factor to it, then uses the 120% of the midterm rate to figure out the payment.  The results for this method are very similar to the fixed amortization method.  Once again, this calculation is only done once and the same amount of money is withdrawn every year. Bankrate has an excellent calculator for this method here.

  •  Age 40 $500,000 balance = $18,553 per year
  • Age 45 $500,000 balance = $19,882 per year
  • Age 50 $500,000 balance = $21,532 per year
  • Age 55 $500,000 balance = $23,727 per year

Option 3: Roth Withdrawals Of Contributions:

Roth IRAs have the same rule as traditional IRAs in that you must be 59 1/2 to take withdrawals penalty free.  With a Roth however you can always take out contributions 100% tax and penalty free.  Let’s say over a 20 year career you contributed $100,000 to your Roth IRA,  that $100,000 of contributions can be taken out with no penalty or taxes owed.  You can’t just withdrawal the money straight out, you have to fill out IRS Form 8606 Part III, stating that you are withdrawing only previous contributions. Without filling out this form the IRS will most likely send you a friendly letter requesting you to pay 10% penalty plus your tax rate. In order to do this you need to know your basis, that is how much money in your Roth is currently contributions, so it is important to keep these records.

Option 4: HSA Distributions For Previous Medical Expenses:

I have personally not seen this in practice, but the tax code says it works.  Let’s say you established an HSA in 2014 and contributed the maximum amount to it.  Instead of using the HSA to pay for health care expenses, you paid for them out of pocket (and kept all receipts).  Fast forward 20 years and you want to withdrawal money from your HSA.  HSA withdrawals can be made to reimburse medical costs in previous years so long as the HSA had already been established in those years.  As an example, if over those 20 years you incurred $5,000 of medical expenses per year, then you could withdrawal $100,000 from your HSA tax and penalty free to reimburse yourself for those expenses. The burden is on you to prove that you didn’t receive a tax benefit on those medical costs already, so be prepared to keep HSA records and all tax returns as well as all medical receipts if this will be part of your plan.

An Ounce of Prevention Is Worth A Pound of Cure:

Ideally investments will be made across traditional 401k/IRA accounts, Roth accounts, and taxable brokerage accounts.

The taxable accounts can, and should be harvested first in early retirement, here’s why:  if you are in the 12% tax bracket or less, long term capital gains are taxed at 0%. For a married couple this represents income of up to $101,400.   If you have the option to pay no taxes on investment gains, then that is a pretty good starting point.  Also, a good chunk of the investments in your taxable account will be contributions and not gains, which have no taxes owed on them.  401K and IRAs don’t make those distinctions and all the money in those accounts is subject to taxation. For example if half the money in the account is contributions and half is gains, then you could take out $202,800 in 1 year and pay not tax because $101,400 was contributions made with after tax dollars, or basis, and $101,400 was gains.

Last Option: Pay The Penalty:

Paying a penalty isn’t the end of the world, in fact it can be a perfectly logical option.  The penalty on early withdrawal from your 401K or IRA is 10%.  For example, let’s say you have been an excellent saver and have $1 million in your account at age 50 and are ready to retire.  You have no money in other accounts.  The best SEPP option only allows you to take out $42,792 per year without penalty.  You would like to withdrawal at a higher rate and want an income of $60,000 per year.  Rather than living off of $42,792, withdrawal the extra $17,208 and pay $1,721 for the fee and live the life you want.  Under the new tax law a married couple who lives off of $60,000 from IRA withdrawals will have the following tax owed:

  • AGI: $60,000
  • Standard Deduction – $24,000
  • Taxable Income = $36,000
  • Tax Owed: $3,939 ($1,905 10% bracket, $2,034 12% bracket)
  • IRS Penalty: $1,721
  • Total Tax and Penalties: $5,660
  • Effective tax rate: 9.4%

An effective tax rate under 10% is certainly not a bad deal.  Just because a penalty exists, doesn’t mean it might not be in your best interest to pay it.  This makes sense for IRA and 401K accounts, however paying the penalty for an HSA account does not make sense, as the penalty is 20%. Most likely in the above scenario the married couple saved 15% or more on their 401K/IRA deduction when they added money to the account, so they still end up money ahead doing this.

What other ways do you know of to access retirement accounts early?

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John uses the free tool Personal Capital to track his net worth and posts quarterly updates on his finances. Check out the Action Economics archives section for all past posts.

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