Using your 401K or IRA to fund early retirement without penalty can be done under certain conditions. There is a method to take early withdrawals from your 401K based on a specific age related 401K penalty exception. For IRAs there is the IRS rule 72(t) to avoid paying the early withdrawal 10% penalty.
Using your 401K to fund early retirement without penalty
If you are 55 years old or older when you retire the federal government allows you to withdraw money from your 401K before age 59 ½ without incurring the 10% penalty. It is one of the little talked about 401K penalty exceptions. This is not mandatory of your 401K plan administrator to give for you. There also may be different rules about what and how often those withdrawals can be made. All, partial, or within time periods.
Obviously it would be ideal if you could withdrawal a yearly amount necessary to fund your early retirement. You can retire from age 55 to 59 1/2 and just withdraw what you need using the 401K penalty exception and only pay regular income taxes.
Most people roll their 401K over to an IRA. But once you do that you lose the 55-year-old 401K penalty exception. The money then falls under IRA withdrawal rules and IRA penalty guidelines.
If you are under age 55 when you retire, then go ahead and roll it over to an IRA. The IRA 59 ½ limitation isn’t a concern because it is the same as the 401K penalty.
If your 401K plan doesn’t allow for yearly withdrawals using the 401K penalty exception and instead insists on full withdrawal then don’t do it. You avoid the 401K penalty but pay full taxes on the entire 401K balance being distributed. That would probably put you in a higher tax bracket. You may also lose any chance to roll all of the 401K funds over to an IRA to keep tax deferred treatment.
Note: Only the 401K with the employer you are retiring from at age 55 or older qualifies for the 401K penalty exception. Previous employer 401Ks that you may have do not qualify.
Using your IRA to fund early retirement without penalty
There is a way to fund your early retirement with your IRA by utilizing the IRS Section 72(t) rules. The rules apply for early (pre age 59 ½) withdrawals from your IRA without penalty.
When interest rates are low as they have been it does need a large IRA balance to commit to the SEPP (Substantially Equal Periodic Payments) account. This SEPP is where your monthly payments will come from. Once you begin SEPP payments you cannot add to that SEPP IRA or take more money from it for 5 years or age 59 ½, whichever is longest. It is best not to commit all of your IRA funds to a SEPP. That way you have side emergency IRA money outside of the SEPP.
There are 3 different methods to calculate payment and the IRS has restrictive rules for the payment amount. The SEPP IRA amount is based on your age, gender, and the long-term bond rate at the time of establishing the 72(t) SEPP.
Work with a qualified tax professional or financial adviser to correctly set up the SEPP. If at any time you deviate from the substantially equal periodic payments within the IRS guidelines, you may have to pay the 10% early withdrawal penalty going all the way back to day one.
Use a 72t SEPP Calculator
(Note: if the link takes you to the 72t on the net site and it does not open the page, place your cursor in the url address box behind the url address and hit enter).
You can plug-in your IRA amounts and based on their researched IRS allowed interest rates you can see what you will generate from a SEPP IRA.
A tip that may help is where it asks for Total IRA Value. Go ahead and put a large number like $1M there. The SEPP calculation is based on what you put in the Amount to SEPP Plan amount box. But by having a larger number in the Total IRA box, you can go to the menu on the left of the page and click Reverse Calculator. This calculator allows you to put a desired payment amount and get the calculated SEPP Plan value required to generate that payment.
Using your 401K or IRA to fund early retirement without penalty- Last Comments
When long-term Bond rates are low, it may take much more money to be in the SEPP to generate the amount you want. If you believe interest rates will climb. Then you can set up one SEPP now and then using non-retirement accounts to supplement your retirement funding. Once interest rates increase set up a second SEPP with another separate SEPP IRA. More or less establishing a SEPP ladder. You will have to pay normal Federal and applicable State income taxes on all SEPP 72(t) payments that you receive.
Using your 401K or IRA to fund early retirement without penalty can be done but be aware of the restrictions detailed above.