Retirement Accounts, Part 4 – Early Withdrawal Strategies   1 comment

While I do want to be financially independent by 40, I don’t think I’ll retire at 40. Though it’s still a possibility. And to prepare for that possibility, I looked into early withdrawal strategies.

Normally, unless you have some kind of hardship, you will pay a penalty to withdraw from a retirement account before 59.5 (or before 55 from the 401k of an employer from which you terminated employment in the calendar year you turn 55, or later). But, there are two ways around such penalties: the substantially equal periodic payments (SEPP) or 72t, and the Roth conversion pipeline.

SEPP

The SEPP explicitly allows you to withdraw money from an IRA (and I think you can do this from workplace retirement plans also. If not, you can always roll over your 401k/403b/governmental 457b to an IRA) before 59.5 without penalty. There are three formulas you can use to calculate the amount of money you can withdraw each year.

However, there are several disadvantages to the SEPP.

  • Once you start the SEPP, you must continue to withdraw money according to the formula for five years or until you are 59.5, whichever is later
  • Once you start the SEPP, you must withdraw exactly as the formula you’ve chosen states–no more, no less. If the amount calculated is too much or too little, well, too bad. You are subject to a 10% withdrawal penalty on all previous withdrawals if you do not withdraw the correct amount at the right time.
  • The formulas are apparently headache inducing (I’ve never actually looked into the details). But if this is the only thing between you and early retirement, you shouldn’t let that stop you
  • Once you start a SEPP, you cannot take lump sum withdrawals. For example, if you started a SEPP at 57, your SEPP has to continue until 62. While the SEPP is still in effect, you cannot take a lump sum withdrawal, even after 59.5, without incurring the SEPP penalty of 10% on all previous withdrawals (even though if you didn’t start taking the SEPP, you’d normally be able to take lump sum withdrawals without penalty starting at 59.5).

Because of bullet one, I do not plan on using the SEPP for the major source of income before 59.5 However, it is important to note that unlike the IRS’s pro-rata rule for conversion of traditional IRAs to Roth IRAs, where all IRAs are viewed as one IRA, you can start a SEPP with one iRA, and none of your other iRAs will be subject to SEPP rules. So, I may end up creating a new IRA, transferring some funds to it, and starting a SEPP on that to bridge the five year gap in the Roth conversion pipeline, explained next.

Roth Conversion Pipeline

This method is the preferred method of early retirees. Recall that you can convert some or all of your Traditional IRA money to a Roth IRA. When you do this, the conversion amount is treated as normal income and taxed as such.

A retiree shouldn’t have much income, so the conversion should be taxed at a low rate. However, unlike direct contributions which can be withdrawn anytime without penalty, “contributions” from a conversion cannot be withdrawn penalty free for five years. So, the strategy would look something like this:

  • Year 1 – Convert some traditional IRA money to a Roth. Draw down on savings and/or capital gains from a taxable account.
  • Year 2 – Convert some traditional IRA money to a Roth. Draw down on savings and/or capital gains from a taxable account.
  • Year 3 – Convert some traditional IRA money to a Roth. Draw down on savings and/or capital gains from a taxable account.
  • Year 4 – Convert some traditional IRA money to a Roth. Draw down on savings and/or capital gains from a taxable account.
  • Year 5 – Convert some traditional IRA money to a Roth. Some day of the year after year 1’s conversion occurred, withdraw up to the conversion amount from year 1. Supplement that income with savings and/or capital gains from a taxable account if need be.
  • Year 6 – Convert some traditional IRA money to a Roth. Some day of the year after year 2’s conversion occurred, withdraw up to the conversion amount from year 2. Supplement that income with savings and/or capital gains from a taxable account if need be.
  • etc.

Now how much you want to convert will depend on your living expenses, how much you have in a taxable account, and how much you are willing to pay in taxes to do the Roth conversion. You have to keep in mind that because the tax system is progressive, it is more advantageous to convert smaller amounts over five years than one large amount in one year.

The key to making this strategy work, of course, is being able to have enough money for the first five years. It would be feasible to set up a separate IRA to draw from using SEPP to supplement income for the first five years. But remember, if you do this, the SEPP must continue for five years or until 59.5, whichever comes later.

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Posted January 18, 2015 by Fiby in Uncategorized

One response to “Retirement Accounts, Part 4 – Early Withdrawal Strategies

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  1. Pingback: Obamacare, the Thorn in the Roth Pipeline Strategy | Financial Independence by 40

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