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Generating Retirement Income Before Age 59-½

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You’ve saved diligently your entire working career. You’ve maxed out your retirement savings accounts. And it’s paid off. You’ve reached the point of financial independence, early. Or, maybe you were laid off, or took an early severance package.

Whatever the reason, like me, you got to retirement ahead of the usual schedule. Maybe in your 50’s. Maybe even younger.

But, you could still have a big problem, even if you have enough money saved in your retirement accounts….

Why? Because you can’t generally touch those tax-sheltered accounts without a penalty before age 59-½. If you take money out before then, you fork over 10% of it to the government, in addition to paying taxes on the income. That’s a huge potential drag on your retirement savings withdrawals and your retirement lifestyle.

So, even if you have enough savings to retire, in theory, how and where do you get the cash to live on until you reach that threshold age of 59-½?

In this article I’m going to explore your options for making ends meet until you can dip into your retirement accounts freely. Some of these techniques are simple and well known. Some are more obscure and complicated. But, taken together, they give you the means to finance an early retirement, long before the government allows unhindered access to your dedicated retirement accounts.

But, please beware: This topic is heavily impacted by tax considerations. And I’m not even close to being a tax professional. (I pride myself on avoiding our byzantine tax code as much as possible.) So, before taking any action based on something you read, always confirm the details against other sources, and/or review your personal situation with a tax pro….

Taxable Accounts

The simplest, most obvious, and most flexible way to avoid penalties when withdrawing your money before age 59-½ is this: Maintain substantial taxable/non-retirement accounts!

In my case, we were dedicated savers. Once we reached my high-income years in my 30’s and 40’s, we maxed out our retirement contributions nearly every year, and went right on saving thousands of additional dollars in taxable accounts.

That meant by the time my work income stopped when I retired at 50, about half of our net worth was parked in easily-accessible taxable accounts. We could, and do, withdraw that money now as needed for living expenses with no penalties. In fact, unless I’m selling appreciated assets and realizing capital gains, there are no tax implications whatsoever when withdrawing from those accounts.

Taxable accounts are the unsung heroes of retirement saving. Once you’ve maxed out saving to Traditional and Roth retirement accounts, saving into taxable accounts gives you superior flexibility for financing your retirement. And, surprisingly, if you’re able to keep more of your taxable investments in equities, and live modestly in lower tax brackets, the long-term performance of those taxable accounts can be nearly as good as tax-sheltered ones! That’s because you are exempt from paying tax on long-term capital gains in the lower tax brackets.

In an article I wrote last year, I reported on detailed simulations I ran to prove this point. My conclusion: “Remarkably, a taxable account with most of its growth coming from capital gains, if that growth is withdrawn in the lower two tax brackets, is essentially equivalent to a tax-free retirement account. That’s because, in either case, the growth is not taxed!”

Roth Accounts/Conversions

Roth retirement accounts contain a number of provisions that offer more flexibility than Traditional retirement accounts. The provision most relevant to this article on early retirement income governs your contributions as distinct from earnings in the account. “Contributions” are sums you deposited into the account as annual investments; “earnings” are the interest, dividends, and capital gains that have accrued in the account from your investments.

You can withdraw the contributions you made to your Roth at any time, and you pay neither taxes nor penalties. (As after-tax, non-deductible transactions, that money was already taxed.)

For example, say you have a Roth account with a $100K balance of which $75K represents your original contributions and $25K represents dividends and growth once the money was in the account. Well, before age 59-½, you can withdraw from that account for retirement living expenses up to $75K, with no additional taxes or penalties.

The logical next step, given this mechanism, is the possibility of converting Traditional retirement money to Roth accounts, so you can take advantage of penalty-free early withdrawals. However there are a number of caveats:

For starters, this procedure is less than simple in my view. See my previous article on Roths for details on how to do it and when it does, and doesn’t, make financial sense. Secondly, you will be required to pay tax up front on the converted money, so you need to budget for that expense, and be certain it makes sense given your current tax bracket.

Lastly, there is a 5-year waiting period before you can tap converted funds penalty-free. So this approach will require significant advance planning on your part. (See Michael Kitces for a detailed discussion of the 5-year rules for both Roth IRA contributions and conversions.)

Age 55 Rule

There is at least one simple rule for getting your retirement money before retirement age, but it applies only to certain employer-provided 401(k) plans. It works like this: You can withdraw penalty-free from a 401(k) plan, if you “separate from service” in or after the calendar year in which you reach age 55.

Depending on the timing, this rule could give you more than four years of penalty-free retirement income before reaching age 59-½.

An excellent post at ObliviousInvestor lays out all the fine points of this rule. For one thing, it doesn’t matter why the separation from service occurred. It might be a layoff, or you can simply quit and early retire. But you don’t have to be fully retired to qualify: You can also take a part-time retirement job and still qualify to withdraw retirement funds from an employer you previously left at or after age 55.

But also note that this exception does not apply to IRA accounts, only to 401(k)s. And that could be one reason to wait on rolling over any employer plans into IRAs. By keeping your money in your previous employer’s 401(k) you are also retaining some flexibility for withdrawing funds before you turn 59-½.

72(t) Rule

Potentially the most accessible mechanism for an early retiree to tap retirement accounts without penalty is the IRS “72(t) Rule” governing “substantially equal periodic payments.” Basically it lays out an accounting mechanism to distribute your entire IRA balance over your remaining life expectancy.

I am again going to lean on CPA Mike at ObliviousInvestor to summarize the technical details. And even he strongly recommends working with a professional tax/financial adviser if you actually want to implement the rule. There is some potentially complex math involved, and if you make an error you could complicate your financial life and set yourself up for tax penalties.

Also, once you start down the 72(t) road you are essentially locked in for a period of time. You must continue taking 72(t) distributions for 5 years or until you reach 59-½, whichever comes later. Your options for changing the payment amount before that period is over are very limited. So you need to be quite certain about your cash flow needs, because it will be hard to change your payments without penalty.

And remember that the 72(t) mechanism eliminates the 10% penalty, but you must still pay ordinary income taxes on the withdrawn sums.

The IRS offers three methods for calculating the amount of your annual 72(t) distribution. You can run the calculations for each method and use whichever amount best fits your financial needs. I won’t get into the actual details here because there are good resources online for performing those calculations:

Some methods produce a fixed amount each year; some fluctuate. Some give more; some give less. Some are simpler; some more complex. Some you do once; some you do every year.

For example, given a $100K nest egg and a couple both age 50, using a “reasonable interest rate” of 2.45%, the calculators currently show a range of allowed annual withdrawals from about $2,100 on the low side to about $4,300 on the high side. You could choose any of the calculated amounts within this range.

Borrowing

I’m generally against borrowing, in retirement or before. I haven’t made a debt payment — consumer, mortgage or otherwise — in about 20 years. There are so many aspects of being in debt that I dislike: the feeling of obligation to somebody else, getting hit by fees, the burden of paying interest costs, and losing time and focus to added paperwork each month and at tax time.

That said, there are times when taking on debt is acceptable.

In the context of early retirement, when your job income is about to stop or become unreliable or occur part-time at best, a conventional loan would be nonsensical, even if you could get one. How would you repay it?

But, another type of loan, one that isn’t really a loan, but is actually a form of borrowing from yourself, made necessary by cash flow, tax, or regulatory considerations, could be acceptable.

Later in retirement this could take the form of a reverse mortgage, which is essentially borrowing from your home equity to finance an annuity coupled to a life insurance policy. But a reverse mortgage is a non-starter for early retirement: Most reverse mortgage programs require that you be a homeowner 62 years of age or older.

But there is a rough approximation to a reverse mortgage available to early retirees with substantial equity in their homes. That’s a Home Equity Line of Credit (HELOC) or home-equity loan. Borrowing in either of these forms to finance living expenses for a few years before reaching age 59-½ might make sense, if you plan carefully.

But great caution is advised. If you take out any kind of loan in early retirement, you are assuming that you will have the cash flow later in retirement to easily pay off the loan. If that turns out not to be the case, you might be putting your home or remaining wealth at serious risk!

For that reason, I’d classify borrowing to generate early retirement income as a measure of last resort only.

(Unfortunately, borrowing from a 401(k) is not a viable way to generate early retirement income, because you are usually obligated to pay back the entire outstanding balance of any such loans within 60 days of leaving a job, or else trigger a penalty.)

Special Situations

Above I’ve explored the primary techniques for financing retirement before age 59-½. We’ve looked at Taxable accounts, Roth Accounts, the Age 55 Rule, the 72(t) Rule, and limited borrowing.

In addition to those primary mechanisms, there are a number of additional mechanisms that might help you generate income in early retirement. Most of them, unfortunately, apply only in specialized situations or to certain kinds of accounts.

One example would be high unreimbursed medical expenses, for yourself, a spouse, or qualified dependent. You can withdraw some money from retirement accounts penalty-free in such situations. However, the amount you are allowed is limited to the actual expenses minus 7.5% of your AGI.

In the end, the very best way to save for early retirement is probably to max out your tax-sheltered account contributions and then keep on saving into taxable accounts during your working years. Those taxable accounts generally offer you the simplest, cheapest, and most flexible way to generate retirement income.

However, if circumstances limit penalty-free access to your money in your early retirement years, the options discussed above could still be your ticket to financial freedom….