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Personal Finance FAQ

How Do You Bridge the Gap Between Early Retirement and Age 59 1/2?

Camelback Bridge
Can this get you to your retirement accounts?

“I retired early for health reasons — my company was sick of me and I was sick of them.”
–Unknown

The U.S. government does a great job of making tax-advantaged retirement accounts available to everyone who earns an income. Through IRAs, 401ks, 403bs, TSPs, 457s, and other tax deferment or tax free retirement savings plans, we’re able to save up money now and either pay taxes on what we withdraw later in life – increasing the amount we can contribute now since it’s pre-tax – or we can pay taxes now and withdraw tax-free later in life – giving us certainty of knowing that we won’t have to deal with whatever tax rates have become by that point.

There’s a problem for that slice of us who either have or will quit working before the government mandated retirement deferral age of 59 ½. We can’t just tap into those retirement accounts like a checkbook without paying a 10% early withdrawal penalty.

Thus, we’re faced with a dilemma. What to do?

There are a few answers to help us bridge the gap until we can access those retirement plans.

  • If you retire between ages 55 and 59/12, then if you have a 401k or 403b plan, you may withdraw from those plans without incurring a 10% penalty.
  • If you have a 457 account, you can withdraw any contributions and earnings at any point, but if you rolled funds over from another plan into a 457, you may incur a penalty for early withdrawal.
  • If you have a Roth IRA, you can withdraw any contributions to the IRA without penalty. If you withdraw earnings before age 59 1/2, you may incur a penalty for early withdrawal.
  • For any plan, you are also allowed to take Substantially Equal Periodic Payments (SEPP), sometimes called 72(t) withdrawals for IRAs. This allows you to, in basic terms, divide the balance in your retirement account by your expected mortality to determine an amount to withdraw without paying a penalty. There are several rules concerning SEPPs and the strategies differ depending on what you’re trying to accomplish. You can check the IRS’s guidelines for more information.

    Tapping into your retirement accounts early has its own set of issues, though. You’re defeating the purpose of having the tax advantages in the first place if you withdraw early (one of the reasons I advocate against funding your startup with a ROBS self-directed IRA). Plus, many people don’t have a substantial amount built up in their IRAs and retirement accounts, so the amount that they can withdraw might not be enough to sustain them in their retirement.

    Thus, some, if not all, of your living expenses will need to come from taxable accounts. If you’re in a situation where you have enough in assets to retire early, then chances are pretty good that you have a reasonable amount set aside in taxable accounts as well. There are a few approaches you can take in funding your living expenses, both traditional and non-traditional.

    • Pension or retirement income. Unless you were in the military or worked for the government, this is becoming increasingly rare. Still, if you retired after 20 years in the Armed Forces, thanks for your service, and you could certainly cover at least a portion of your living expenses with the money you receive from your retirement check.
    • Periodically withdraw from market investments. Ideally, dividends and capital gains will provide you with enough to live on. Just as I recommend value cost averaging during your wealth accumulation phase, I recommend the same in reverse for withdrawing. You will need some extra cash in liquid reserves, as the amount you withdraw each month will vary. Also, don’t take 4% as a safe withdrawal rate. That number was derived using 30 years as the length of retirement. If you’re retiring early, you’re likely to be needing money for much longer.
    • Use funds to buy rental real estate. With rental properties, you’re effectively buying an asset for the cash flow that it can produce. Rents tend to rise with inflation, so the purchasing power that your rental income provides should remain constant. I buy rental properties for the cash flow and don’t count on appreciation; however, since real estate is both an illiquid and irrational market, there are opportunities to take advantage of mispricing. Furthermore, there are tax advantages to rental real estate.
    • Buy single premium immediate annuities. Here you truly are converting assets into income, as once you buy an annuity, you pretty much can’t get the money back except through the income stream that it provides. If you’re really young, you’re probably going to get a really low rate of return on the annuities that you’d buy, but you can lock in purchasing power, and if you dollar cost average annuities, you can take advantage of rising interest rates. There are also tax advantages to annuities, as there is an exclusion ratio that determines how much of each payment is a return of your capital and how much is actually income, so, until you reach the age of your actuarial life expectancy from the time you bought the annuity, you will pay taxes on only a fraction of the money you get from the annuity. If you have estate plans or just can’t get over the annuity puzzle, then annuities might not be appropriate for you.

    You could always work or start your own side gig for a little scratch, but doesn’t that defeat the purpose of retiring early?

    It is possible for you to find yourself in a situation where you have enough money to retire, but don’t have enough accessible money to retire. There are no easy choices beyond what I’ve outline above to get around some of the restrictions of retirement accounts.

    The lesson is that if you’re planning on retiring early, you need to have a financial plan to be able to retire early when the time comes. Sure, if you sell the next Tumblr or Waze, then money won’t be a problem. However, if you get there by being wise with your investments and living reasonably and not jumping on the hedonic treadmill, you could still find yourself needing to work because of the early withdrawal penalties. Planning asset allocation and asset location are required if you plan on kicking back before you reach an age when the government says you can do so without paying a penalty.

    If you enjoyed this article, please share it with your friends!

    Around a year ago, I wrote about whether or not you’d die sooner if you retired early. Want to know if early retirement is linked to early mortality? Check the article out!

    By

    Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

    You can read more about him in the About Page.

    2 replies on “How Do You Bridge the Gap Between Early Retirement and Age 59 1/2?”

    Hi Stefanie! Thanks for commenting!

    If you don’t plan ahead, then you may not have the means to support yourself via non-penalized avenues.

    I’ll take a purely numerical example to show this.

    Let’s say that you have a person who is age 25. She makes $75k a year. She saves 41% of her income (if you don’t believe this is possible, check out Paula Pant or Mr. Money Mustache for examples. Each year, she earns 7% on her investments, maxes out her IRA, maxes out her 401k (3% of which is matched by her employer), and receives a 3% pay raise. IRA and 401k contribution limits increase by inflation.

    She decides she wants to retire when she has 28.57x of her annual expenses saved up (it’s a 3.5% withdrawal rate, possibly safe for an early retirement).

    At that rate, it will take 20 years for her to reach that point.

    Without adjusting her lifestyle downwards, she runs out of penalty-free money at age 54. She has a year and change to go until she can tap into her 401k. If she rolled her 401k into an IRA, she has to wait 5+ years.

    How many people get convinced to do rollovers when they leave an employer? Read all of the press about the high fees in 401k funds. I can name two financial planners who have billboards in the Fort Worth area that have “DO A 401K ROLLOVER WITH US” (or similar wording) emblazoned in big letters for all passersby to see.

    Another example is military retirees. If you enlisted in the military at age 18, right out of high school, and retired at age 38, having served the 20 years necessary to earn a retirement, you’ll have a pension, but it’ll probably be 40% of your last paycheck. If you were contributing to an IRA and a TSP, you probably have very little in taxable accounts. You could have saved and invested wisely yet have no taxable money to draw upon and be forced to go back to work. I can’t tell you how many military retirees I saw in just that position because, while they had the assets, they didn’t have the accessible assets to cover the difference.

    I’ll throw in a final category – a self-directed IRA. If someone put his real estate investments or small business in a self-directed IRA and then was very successful, that money may not be accessible.

    Asset location is just as important as asset allocation, particularly if you plan on retiring early. Even if you plan on retiring at normal retirement age, asset location is critical for tax minimization strategies.

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