Weeeeee. More nerdy finance talk. I’m literally gitty.

A common question that comes when we begin the discussion of retiring early, revolves around how to set up your investments so you can take money out for income in retirement.

Most people know that with certain accounts, you are not (technically) allowed to take money out of them before 59 1/2, or you could get a 10% penalty for doing so.

So, usually the question goes like this: “If I want to retire before 59 1/2, does that mean I need to invest almost all of my money in taxable (non-retirement specific) accounts so that I don’t get hit with the 10% penalty for withdrawal?”

This is a very good question, it means you are thinking ahead to the most efficient ways to invest for your future.

But there are actually a few ways to get around the 10% penalty if you withdraw funds before 59 1/2 years of age, from retirement specific accounts (Roth, 401ks, IRAs, etc.). And this post is here to share the secrets with you.

In particular, we are going to cover:

1. Roth IRA contributions
2. Roth Conversion Ladders
3. 72(t) withdrawals
4. Age 55 Rule Distributions

Before we jump into each of these categories, I do want to point out that the original question, of using a taxable account, does bring up another good option. That option is using a taxable brokerage account in some way or another to fund your retirement years.

Let’s review this topic quickly. You have two directions you can go with the taxable account:

1. You can plug all of your money into this account until you have enough invested to be financially independent from needing to work.
   • Though there is nothing wrong with this direction (as it still accomplishes the goal of you being financially free and you living off the investment income), the argument against it is that it is not very efficient or cost effective.
   • First off, you receive no tax savings up-front like you would with a traditional 401k/IRA contribution. So, you have less money getting invested up front because taxes get taken out of the money that would be invested into the taxable account. Less money invested means slower compounding returns over time. So it takes you longer to reach your wealth goal.
   • Second, you receive no tax deferment every year the money is invested like you would with every retirement type account (IRAs, 401ks, Annuities, and so on). So, you can lose money to taxes each year, reducing the amount you have invested further (compared to tax deferred options) and reducing the compounding further.
   • Third, you still pay taxes if you sell the funds during retirement, based on your capital gains from when you purchased the funds in the first place. You also pay taxes on dividends and interest income each year. Compare this to a Roth option, where you pay no taxes during withdrawal of any income.
   • There are still benefits with this account type. First your money is fully liquid, no dancing around IRS rules to take income out. Second, you can write off losses if you sell investments at a loss in a given year. This is called Tax Loss Harvesting – see link below to a post on more information on this. But, quick reminder, the flexibility of having the money liquid is still the primary benefit.

Or, the other option is you can pound all your money possible into retirement specific accounts until you get closer to retirement/financial independence, and then you switch to save five or so years of income in a taxable brokerage account.

• This option would allow you to still get tax savings with the other accounts (both in tax deferral and in either tax deductions up front or tax free withdrawal), but build yourself a 5 year runway of fully liquid money to pull from, without dancing around IRS rules with that initial 5-year money. A best of both words scenario (tax efficiency with most of your money, but liquidity for your next few years). And an option that I personally am striving for.

But, if we go with option 2, above, we still come to the question of how to be able to pull money from our retirement accounts during our financially independent years (and after the liquid, taxable funds are used).

So, let’s jump into the nerdy nuts and bolts.

In the example above, you have built yourself a short runway where you are planning on liquidating funds to cover the first number of years you are early retired. But how do we replenish those liquid funds from our non-liquid, retirement accounts prior to 59 1/2 years of age. Many of you will have invested your money in a combination of traditional 401ks/403bs and traditional IRAs, and Roth accounts (Roth 401ks or Roth IRAs). Plus, you could have dabbled in some real estate and other investments. So, let’s start by breaking down the options that you already have within your current tools.

1. Roth IRAs Contributions– Whether you contributed to a Roth IRA, you roll your Roth 401k into a Roth IRA, or both, you have some nice flexibility with this option. Remember, any money that is in your Roth account as money you contributed, has already been taxed (the money you contributed to the Roth options were post-tax dollars). This means that there is no taxes due on this money in the future and the government does not care if you use this money (contributions) at this point. So, if you would like to take contributions you made into your Roth IRA back out for any reason, you can. And, therefore, you can use that money to help fund your early retirement without penalty.
   • Quick notes –
     • Any money that that was a match by your employer from your contributions into your Roth 401k, has gone into a traditional 401k bucket. So, your employer contributions do not fit the mold of money you can take out of retirement accounts, willy-nilly.
     • Any gains that you made on the investments in your Roth, cannot be taken out prior to 59 1/2, without penalty (traditionally). So you need to make sure you keep track of the contributions and focus on using those.
2. Roth Conversion Ladders – If you did not use a Roth IRA or Roth 401k, which many won’t, you can still use Roth funds for your early retirement income. The way this is done is by converting money from an IRA to a Roth IRA. There are many rules around this, so make sure you consult your tax professional to get things right, but in essence, here is how it works.
   • Once you have moved your traditional 401k money into an IRA (one you already had or a new one) from your employer, you can elect to convert some of that money each year over to a Roth IRA.
   • You will pay tax on the amount you convert (because you have paid no taxes on the money yet), so pre-planning these moves during times you show low income is always best. Especially showing lower income than you did during your employment years so you save yourself money in tax compared to the tax you would have paid while working.
   • Then, in order to use your new Roth funds without penalty, the IRS will require you wait 5 years from the time of conversion before you can withdraw the funds, tax and penalty free.
   • Therefore, if you started this conversion process the first year after retirement, you could live on your taxable investments for the first five years (like mentioned above), and switch over to using these Roth conversion funds after. You would just want to continue converting some of your IRA over to a Roth IRA, each year so your Roth conversion funds continue.
   • For a nice infographic of this process, check out this one by the Mad FIentist, who is a very well known finance blogger in the F.I.R.E community.

72(t) distributions, or Substantially Equal Periodic Payments –

Another tool that is available is the 72(t), Substantially Equal Periodic Payments. This is also condensed down to “SEPP” for simplicity. I, frankly, find it does not simplify much for people because it is still not easy to remember what (SEPP) stands for. But I will use 72(t) and SEPP interchangeably (if needed) and hopefully it makes sense while you are reading this.

How does a SEPP program work? When you transfer your 401k/403b assets over from your employer to an IRA account, you can choose to start taking withdrawals right away from your IRA, even under 59 1/2 years of age. The kicker is that in order to do it before 59 1/2 (outside of converting to Roth and paying the tax) you have to designate a specific amount you will be withdrawing each year (based on IRS options), it has to be the exact same amount withdrawn each year, and you have to stick to it for at least 5 years (or until you are 59 1/2 – whichever is longer). Hence the Equal Periodic Payments part. You can choose to make a change on the calculation you use one time, for a small amount of flexibility.

The pros to this option are you get to access your money without penalty prior to 59 1/2. The cons could be that you still have to withdraw the funds from your IRA even in years where you may not need to, based on other income you create. The funds are taxable (like all IRA fund withdrawals), so some years that may not be beneficial.

This option would likely be best used as you get closer to 59 1/2, just to make sure you can keep some flexibility in your withdrawals over longer periods of time. In theory, if you are retiring early (say 40), the Roth conversion ladder option would put you in more control over the tax brackets you are in and the funds you want to withdraw for use/income. But this SEPP is another tool in the tool-belt for you. Maybe we could say another utility in the utility belt, to make you sound like Batman. If you did want to pursue this option, make sure you deep dive with a tax professional before choosing the withdrawal amount option you go with.

Rule of 55 Distributions –

The final direction we will jump into here is the Rule of 55 Distributions. In essence, if you separate from an employer after the age of 55 (technically no sooner than the beginning of the year that you turn 55), and you leave your funds with your employer in their 401k/qualified retirement plan, you can withdraw distributions from that employer retirement account without the 10% penalty.

The requirements are that the funds must be in the employer retirement plan (cannot roll them over to an IRA or personal account), you must be 55 or older (exact age terms I mention above), and you must have separated from your employer that has the account (no earlier than the year you turn 55). Make sense?

Alright, hopefully that was not too daunting to read through and I kept everything pretty simple/basic. If any of these directions may be something you use, please make sure you review with an accountant/CPA before beginning. Tax codes change, and making mistakes can be costly.

The final note revolves around the obvious (hopefully). You can use multiple of these approaches once you reach your early retirement years. Maybe you take some funds out of your taxable investments, some out of Roth contributions, some out each year to do a Roth conversion, and at some point you combine the 72(t) and Rule of 55 Distributions as you get closer to your age 59 1/2.

I totally just solved your problem, so your welcome.

Oh boy, and now a random cool picture from space to end the post. Just because.