First things are firstI did the work for you, and you can trust what you are reading. That said, I am anesthesiologist who lives by the “Trust but verify” way of life. My sources for the information included in this post are included. The consequence for taking money out of a 401K/403B early is a 10% penalty on whatever you take out. That is not an insignificant amount of money. However, the real number for early retirement is not age 59.5, but age 55. If you retire during or after the calendar year you turn age 55, then you can receive distributions without paying the 10% penalty for taking the money out. That’s all well and good, but what if I retire at age 40 or 45 like the original poster from ESI Money’s interview? Let’s dive in.
Exceptions to the 10% Rule: The Good, The Bad, and The UglyThere are many exceptions to the 10% Rule. I am going to lay them out for you. Some are good, some are bad, and some are ugly. Everyone always want’s the bad news first. So, let’s discuss this in reverse order: the ugly and bad choices (to be thorough) before getting to the good stuff at the end.
The ugly choicesIf the benefit is paid to a beneficiary on or after the death of the person participating in the 401K, the 10% penalty does not apply. So, option number 1 is to die. That’s an ugly option. Ugly option number 2 is that you can also avoid the 10% penalty if you are facing hardships such as disability, natural disasters that the IRS has given permission to use it for, or medical payments. Not ideal, but good to know in case this happens to you. Qualified Domestic Relations Orders (QDRO) also avoid the penalty. These aren’t good as they are the result of court mandated payments (alimony, child support, etc). Not a good spot to be in.
The bad choicesIf the IRS levies a tax/fine against you, this can be taken from your 401K without penalty. Not a great situation, but better to pay it out of a 401K than your taxable account if it’s got tax benefits to it and you are retired.
The (possibly) good choicesSo, those are some less than stellar options to access your 401k/403b early. Let’s discuss some potentially better options: Loans and SEPPs.
LoansYou can take a loan out of your 401K for another investment. The loan amount can be up to 50% of your account balance or a maximum of $50,000 whichever is less. You must pay it back in five years after taking the loan and it must be paid back in equal quarterly payments. This one almost made it into the “bad” section, but I can see where it could be used for good. Say, if you were using it to diversify your account with real estate. This would allow you to access the money prior to age 59.5. Generally speaking, though, I would not encourage you to do this. I just wanted to point out that it is technically an option.
The best choices?
Roth Ladder ConversionFull Time Finance pointed out an extremely important omission on my part, which is to mention Roth Ladder Conversions as an option to access your 401K early. This is true (with a catch). You can convert your 401K to an IRA upon retirement. Then you can convert your traditional (pre-tax) IRA to a Roth IRA. The catch is that you cannot touch the money for five years after you convert because the government doesn’t want you dodging the 10% penalty in early retirement so easily. For this reason, it may not work for you unless you have enough money to span that 5 year gap prior to accessing the money. However, if you have the dough, then this is a great option. If you want to read more about Roth Ladder Conversions you can check out posts by Route to Retire, Money Under 30, or Big Law Investor.
Substantially Equal Periodic Payments (SEPP)The IRS states that if you take payments “as part of a series of substantially equal periodic payments beginning after separation from service” that you can avoid the 10% penalty. The stipulations are the following:
- The payments must be “substantially equal” and occur after leaving your employer.
- They must not be altered or stopped for five years after payments begin or 59.5 (whichever is later).
- You can determine your payment in three ways: By calculating RMD’s for your age, using it as an annuity, or via amortization.
SEPP 1 Million Dollar Thought ExperimentLet’s break down these three different methods to show what they might look like. Here are the assumptions. $1,000,000 in a 401K. Retire at age 45. Here is what the annual “equal payments” would be by each of the above calculators.
Required Minimum DistributionsAfter looking at the table to determine life expectancy from Age 45 (38.8), I then divide my total amount 1,000,000/38.8 = $25,773…. this is the annual amount. So, each month I have to take $2,147. I can access this money without getting hit by the 10% penalty. This number is calculated each year. For example, at age 58 the annual amount becomes $37,037 (or $3,086 monthly). This allows me to pull this amount from my 401K each month until the age of 59 1/2 plus however much I need from my taxable account for early retirement without having to worry about the 10% penalty. At age 59 1/2 I could use however much I wanted, because I’ve reached the age determined by the IRS.
Amortization/Annuitization MethodWith either of these methods your total annual “equal payment” will be around $41,000 with the above assumptions. This comes out to a monthly payment of $3,417. Generally speaking, this would be the better option if I needed more monthly income that wasn’t coming from somewhere else. Unlike the RMD, these payments stay the same over the years and do not change. It only has to be calculated once. You are allowed to change from one option to another (say from RMD’s to amortization), but you are limited to the number of times you can do this.
Take HomeSo, if you want to access your money from your 401K/403B, retiring after the year in which you turn 55 works. If you want access earlier than that, then you’ll likely have to either plan on saving enough money in your taxable or 457 account that you won’t need your 401K til 59.5 years old. (More on this in a post coming later this week). Otherwise, you are left with a SEPP as the best option. The take home point for the SEPP payments is that if you want to be able to access your 401K prior to age 59.5 (and want to retire before age 55), then the RMD method is the best method to keep your payments down so that you don’t deplete your accounts too quickly. It’ll extend the amount of time that your taxable account lasts as well. If this isn’t a concern to you, then the amortization/annuity methods provide a slightly higher amount of money each year. This will, again, extend your taxable account so that it lasts longer. After the age of 59.5 you can take however much you want from it. At the end of the day, this post serves to say that you can access your 401K before the age of 55/59.5, but you have to think about it and have a plan in place to do so. Otherwise, you’ll have to either depend on other sources to bridge the gap or succumb to the 10% penalty. If you would like to read more on this, others who have also written on this topic include White Coat Investor, Physian On Fire, Mad Fientist, and DoctorofFinanceMD.
If you plan to FIRE, what’s your distribution plan? Are you going to rely on a massive taxable account? Roth money? Is a SEPP part of your plan? Leave a comment below.TPP