Fear of the 401(k)

59.5 Is a Long Way Away

This was my first and only thought, five years ago, as I looked upon my retirement account options. What if I wanted that money sooner? What if I didn’t want to wait until I was 60 to retire? What if I don’t even make it that far? (Seriously, I could get hit by a bus!).

With my head full of doubt, I did what any other rational human being would do. I contributed the bear minimum to receive my employer’s match. Whatever’s left of my salary, I would stash in my savings and brokerage accounts. Genius! I can have that money whenever I need it; surely, before age 59.5.

Oh, what I wouldn’t give now to protect that money from Uncle Sam’s greedy fingers. Instead of unbridled tax-free growth, I now owe taxes on that money come April 15th. Every. Single. Year. But my argument still holds, right? I have access to that money whenever I need it. No need to wait until I am 60. That’s true.

What I didn’t realize at the time was this: there are ways to withdraw penalty-free from a 401(k) (and other tax-deferred accounts) before age 59.5. How is this possible?! Well, let’s dive in.

Avoiding Early Withdrawal Penalties

There are numerous ways this can be done. Not all are easy. Not all are fool proof. But here they are:

1. Early-Withdrawal Penalty Exceptions

Some expenses are exempt from the IRS early withdrawal penalty tax. These include distributions to pay medical bills, a down payment on a house, college expenses, and more. Ideally, you will have planned for these expenses with a well-funded savings account, as withdrawing from your 401(k) because you didn’t save up enough for a down payment is usually not a great idea. But hey, it’s comforting to know that it’s possible!

2. 72(t) Distributions

IRS Code 72(t) allows for early and penalty-free withdrawals from tax-deferred accounts. The rules are fairly complicated, but here’s the gist: you can withdrawal penalty-free "Substantially Equal Periodic Payments" (SEPP) for a minimum of five years or until age 59.5, whichever comes later.

The amount of each withdrawal is based on your account balance and life expectancy, and is strictly enforced. Any deviation from the prescribed amount may lead to a retroactive early withdrawal penalty on all prior distributions. Ouch! Used properly, however, 72(t) distributions can help you make early and penalty-free withdrawals.

3. Roth Conversion Latter

By far my favorite of the bunch! At just about any time, you can convert pre-tax money stored in a 401(k) to post-tax money in a Roth IRA. The catch: you have to pay income taxes. Okay, great. So I just swapped one retirement account for another, and now I have to pay income taxes. What’s the point?

Well, after five years, any conversions made into a Roth IRA count as contributions. And if you’re savvy with retirement accounts, you know that Roth IRA contributions (not earnings) can be withdrawn any time, tax and penalty-free.

So what does all of this mean? I’ll explain with an example. Say you plan to retire at age 50 instead of 59.5. You have ten years until you can begin making withdrawals from your traditional 401(k). How are you going to bridge the gap?

With adequate planning, you can save enough money to last five years in non-retirement accounts. At age 50, you retire. Now your income is $0. This means that you can convert tens of thousands of dollars from your 401(k) into a Roth IRA and owe little to no taxes. How? The standard deduction & child tax credits go a long way. And beyond that, the 10% and 12% tax brackets are in effect up to $40,000+ in taxable income. Each year, you make these conversions based on your predicted future annual expenses.

Now, five years have passed. You are 55, and your first Roth IRA conversions now legally count as contributions. Perfect! Withdraw the contributions to live off of in that year, do the same the next year, etc. etc. This strategy can effectively fund an early retirement at any age (given you have enough saved).

Easing My Concerns

So there you have it. Three strategies that can be used to make early penalty-free withdrawals from tax-deferred retirement accounts. This list is not comprehensive, and there will always be exceptions. Will I end up employing any of these strategies myself? Who knows. For me, all that matters is knowing they exist. I now contribute freely to every tax-deferred account I have access to, up to whatever point my budget allows.

Now I know that money does not disappear into the abyss when I invest it in my 401(k). There are ways to access it, penalty-free, long before I turn 59.5. So, even if you’re like me with an irrational fear of the future, do yourself a favor and don’t sleep on your 401(k)!

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