Don’t Fear The “Penalty”!

Few concepts are as misunderstood in the FIRE community as the (ominous voice) “early withdrawal penalty.” More accurately described as section one of tax code §72(t)*, this is the additional 10% income tax that applies to withdrawals from tax deferred retirement accounts taken before age 59½. As I browse the various financial independence forums, I see statements like these way too often:

“I have 25 times my annual expenses in my 401(K), but I can't retire because I'm not 59½ yet.'”

“I don't want to pay large early withdrawal penalties, so I save most of my money in after-tax brokerage accounts.”

“I need to make sure my FU money is funded in penalty-free after-tax accounts, so I'll hold off funding my tax deferred accounts until later in my investing timeline.”

“I want the flexibility to withdraw my money at any time. That's why I invest in regular investment accounts instead of IRAs and 401(K)s that I can't touch until I'm 60.”

No, no, no, no. You absolutely CAN withdraw from these tax deferred accounts before 59½, as I discussed in detail in my post Investing Can Be Simple. Skipping these accounts to avoid a 10% tax can actually cost you hundreds of thousands of dollars over your investment timeline! Let's dig a little deeper to find out why.

The Mad FIentist Reveals All

Unlike the exciting topics of FU money and FI milestones, posts about tax code are… well… boring. How can I get you to dive deep into this important subject without falling asleep? The Mad Fientist does a better job of this than I can. Read his article, here. Get comfortable, grab a cup of coffee, and read it now. No, seriously, go read it. I'll wait…

Ready? Let's review it together:

  • You can withdraw your money before age 59½ if you pay an additional 10% income tax (the “penalty”)
  • This tax only applies on the amount you withdraw, NOT the entire account balance.
  • Penalty-free methods for early withdrawals do exist: these include Roth Conversion Ladders and Substantially Equal Periodic Payments (SEPP).
  • In MF's simulations, simply paying the penalty outperforms after-tax investing to the tune of six figures over the portfolio lifetime, and comes surprisingly close to the more complex penalty-free withdrawal methods!

To quote the Mad FIentist,

“Even if you don’t want to mess with things like Roth Conversion Ladders or SEPP distributions, it still makes sense to max out your pre-tax retirement accounts and then just pay the early-withdrawal penalty! The Penalty scenario (Scenario 2a) has over $200,000 more than the Taxable scenario (Scenario 1) by age 60 and will provide an additional decade of elevated income during standard retirement!”

SEPP, Ladder, and 'Paying the Penalty' on top; Roth and Taxable waaaay below!
SEPP, Ladder, and ‘Paying the Penalty' on top; Roth and Taxable waaaay below!

This is an amazing result! And this isn't even taking into account the very real tax savings those of us in higher tax brackets get each year due to the reduction in taxable income. As I've said before – pay yourself, or pay Uncle Sam – the choice is yours!

Keep in mind, the results above are most dramatic when you move down to a lower tax bracket in early retirement. While this may not always be true for traditional retirees, it is generally a safe bet for us FIRE types who have high savings rates and plan to live on 4% of our portfolios in retirement.


OK, so what's the takeaway from all this? That for the vast majority of those pursuing FIRE, you should max out your tax advantaged accounts before you put a single penny of your money into regular, taxable investment accounts. Even with the extra 10% on early withdrawals, the tax advantages of these buckets blow taxable investing out of the water. To the tune of hundreds of thousands of dollars over time!

Of course, it's still wise to diversify your investment dollars between different tax buckets (taxable, pre-tax 401(k), and post-tax Roth, for example) because you never know what future tax law changes will bring. But this happens automatically as your savings rate increases: there will come a point when you'll max out all available tax-deferred options and still have a surplus of cash available to invest. MMM echoes this concept as on his blog:

“While I still advise maxing out any tax-deferred savings accounts like the 401k, you’ll also need to invest elsewhere simultaneously. My own strategy was in Vanguard index funds, a paid-off house, and some rental properties, but you will surely find other places depending on your own interests.”

This is where you'll contribute to a standard after tax brokerage account, or perhaps, take advantage of the Mega Backdoor Roth and fund the after-tax portion of your 401(k). But in the beginning, when you are deciding which accounts to prioritize, choose tax advantaged accounts first.

The big picture is that you need to max out these tax advantaged accounts while you can. Once you miss a year, that opportunity is gone. F-O-R-E-V-E-R. The tax-free growth over time in these accounts is so incredibly powerful, I could have been FI years ago if I started contributing to them earlier. I'm still kicking myself for waiting so long to max out my 401(k), IRA, and HSA accounts.

OK, enough talk about what I should have done. The wife and I have a large portion of our money in 401(k)s now, so how should we access our money going forward? Let's compare options and see how they apply to our specific situation.

Roth Conversion Ladder

The Roth Conversion Ladder is the method that gets the most publicity in the FI community. While relatively straightforward to implement, this strategy requires a five-year pipeline before you can start withdrawing money penalty free. This means you need extra savings to cover your first five years of FI.

Had I known this the last time I switched employers, I would have rolled** my old 401(k) into a Vanguard IRA to have more control over when I get to start the five-year pipeline process. But I was so excited about my new employers' VIIIX fund, with its amazingly low 0.02 expense ratio, that I rolled all that money into my new 401(k) instead.

We've since saved up almost enough in other buckets to cover my first five years of retirement, so the conversion ladder is still an option for us. But I'm not sure it's the best option since there are rumors that it might be going away in the next few years. Bummer. Luckily there are other options to consider.

§72(t) SEPP

Substantially Equal Periodic Payments (SEPP) is the IRS approved method of withdrawing money from your tax advantaged retirement accounts penalty free before the age of 59½. Let's analyze the IRS guidance on this together:

“If distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary, the §72(t) tax does not apply.”

Sweet! We can avoid the penalty and access our money. What's the catch? Let's keep reading:

“If these distributions are from a qualified plan, not an IRA, you must separate from service with the employer maintaining the plan before the payments begin for this exception to apply.”

OK – no issue here. I just have to quit my job and roll over my 401(k) into an IRA before starting SEPP withdrawals. I was planning on doing that anyway, no worries here. Anything else?

“If the series of substantially equal periodic payments is subsequently modified (other than by reason of death or disability) within 5 years of the date of the first payment, or, if later, age 59½, the exception to the 10% tax does not apply. In that case, your tax for the modification year is increased by the amount that would have been imposed (but for the exception), plus interest for the deferral period.”

OUCH. This is the catch. Once you determine your periodic payment, you have to stick to withdrawing that specific amount, every year, for five years, or age 59½, whichever is later. This means if I have a tough year, and withdraw a little more from my IRA, I am back-taxed 10%, plus interest, on all distributions I've ever received (even from earlier years!).

If you want to play with SEPP numbers, there's a good calculator over on Bankrate, and a nice clear write-up on Vanguard, but I think I'm ready to see what other options are available.

Just Pay the 10%

The simplest option of all is to just treat our IRAs like any other financial accounts, withdraw the money we need, when we need it, and pay an additional 10% income tax (on those specific withdrawals) until age 59½. Mad FIentist already showed us how paying the penalty performs nearly as well as the other two options above, with none of the tricky hoops to jump through or dangerous pitfalls if we mess up. Even with this “penalty”, we still save much more than we would if we simply invested in a taxable brokerage instead. As Bryan from Smart Money, Better Life writes:

“If there are months or years where I don’t need the IRA income, it just keeps growing in my account, tax-free. So it’s like a faucet I can turn on or off as needed. On the other hand, after-tax income is ALWAYS taxed even if I don’t spend it. It’s ALWAYS taxed. Did you hear me? IRA income is ONLY taxed when I need it. This right here can be the difference (when you take into account compounding) of a HUGE SUM over 30 years.”

As we saw in the MF chart above, this sum was over SIX FIGURES! This concept of IRA + Penalty being superior to after tax investing for early retirees was also discussed at length on Radical Personal Finance in this episode. Think about it: every dollar you take home in your paycheck is ALWAYS taxed, regardless if you spend it or save it. Put this money into a 401(k), though, and we're ONLY taxed at withdrawal time, on the specific amount we withdrew. The rest of the money can keep on growing, tax-free. Add this to the fact that I should be in the lowest possible tax bracket in FIRE and you can see why this makes so much sense.


To be honest, I haven't really added much to this conversation: Mad FIentist said it all! But after seeing so much confusion in the community on this topic, I felt the need to reiterate the importance of funding these tax advantaged accounts first and foremost so they have time to grow. You should have NO FEAR about accessing these funds in early retirement!

It doesn't really matter all that much if you choose the conversion ladder, the SEPP, or pay the additional 10% tax on withdrawals. What matters is that you max out your tax advantaged accounts while saving for FI, so you can save WAY MORE MONEY and retire even earlier. THIS is the point I want to emphasize: If you're not maxing out all tax advantaged accounts available to you, but are still investing after tax dollars, you need to stop what you are doing, right this second, and fix this!

I've seen many people bend over backwards and make crazy decisions to avoid this 10% early withdrawal tax. To me, this is silly… It's significantly more important to max out your tax deferred buckets early, before funding a taxable brokerage account. It's also important not to hoard a ton of cash (more than an adequate emergency fund). The natural consequence of these two heuristics is that you might find yourself in a position, at least in the first few years of your FI journey, where part of your FU money requires a 10% tax to access. This is not the end of the world – believe me, when I'm ready to say FU to a job, it's going to take a lot more than a small tax to stop me!

So what withdrawal strategy will the wife and I choose for our own situation? Perhaps we'll tinker with the conversion ladder first, and see how that goes. If laws change and this option disappears, we might talk with a tax professional about SEPP. Perhaps, to mitigate the risk of having completely fixed withdrawal amounts every year, I'll try out SEPP on my IRA, and then just pay the penalty on early withdrawals from my wife's IRA. The SEPP IRA would provide a fixed income, and the wife's could provide variable, supplemental funds, as needed.

The wife and I really like the simplicity of just paying the extra tax on withdrawals as we need it, however, so we may wind up just paying the penalty. We've saved a few years of expenses in other buckets*** like our Roth IRAs (whose principal can be withdrawn penalty free at any age), so we don't have to rush into a decision today.

As I start implementing some of these withdrawal strategies, I'll blog about it here so we can all learn as we go. The important thing to remember right now is that the money you contribute to tax advantaged accounts is all yours. It's not trapped until you are 59½. It's completely accessible at any time. It lowers your taxable income today. It grows tax-free. It's only taxed when you withdraw it, on the amount you withdraw. And for most of us pursuing FIRE, it blows after tax investing out of the water.

It's simply too good to pass up!


*Bonus reading: Tax code §72(t) is about halfway down the page here.

**Be careful when rolling over 401(k) or similar accounts to ensure you don't accidentally withdraw the money by mistake. While this is usually an automated electronic process, sometimes a paper check is involved. If you wait more than 60 days to deposit that check into an account of like kind, it's considered a withdrawal. While I say not to fear the penalty in this article… I'm referring to the additional 10% tax on small monthly or annual cost of living withdrawals… you definitely don't want to pay it on your entire portfolio balance!!

***If you're like me and your portfolio spans many different account types, I recommend reading chapter 30 of The Simple Path To Wealth, titled “How Do I Pull My 4%?”. Here, Collins goes through some great examples of the mechanics behind withdrawing money from numerous accounts and makes sense of what would be an otherwise tricky problem.

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23 thoughts on “Don’t Fear The “Penalty”!”

  1. Joel, just to be clear, I would recommend the conversion ladder until it is actually gone. All I want people to understand is that the strategy is on the minds of members of Congress and they are sharping their ax. It may never happen as many tax proposals never see the light of day.

    I also agree with the Mad Fientist. He is the smartest tax guy I know not inside the tax industry. Max out retirement accounts. The Mad guy put it into a chart so it is easy to visualize.

    Reminder, distributions using SEPP must continue 5 years or until age 59 1/2, whichever is longer. If for some reason you don’t follow through on the SEPP a penalty will be due for all prior distributions. If you have 25x your spending all tied up in retirement accounts and assume no Roth IRAs for basis to tap you probably can live off the 72(t) (SEPP) distribution. A 35 year old, single life expectancy, with $800,000 can withdraw ~$26,455. This is ~3.3% of the balance. Any side gig or other small income source and you are still all clear. The older you are the easier it is to reach an allowed 4% withdrawal rate.

    The calculator is here:

    Excellent article, Joel.

    1. Thanks, Keith- that feedback means a lot coming from you! Great clarification above as well – you certainly don’t want to screw up the 72(t) withdrawals. Mad FIentist did an amazing job with his article, I’m just reminding everyone they have many options and don’t need to fear maxing out these amazing accounts.

      1. They would have to be, Church. As I see it, if the law changes it will be something disallowed in the following year. Otherwise you would have to remove the money from the account, plus any gains, by the due date.

    2. I have strong doubts on the backdoor Roth being closed anytime in the next 7 to 8 years and here is why. A simple Google search will show that this rumor has been around for years and has not come to pass, even under the democrats. The social security loop hole that was closed was closed by a Democratic president. I can still remember the rumors a few years ago that the democrats were considering nationalizing 401k plans to the point that they had to come out and publicly deny it. The U.S. would not be the first country to do that by the way.

      Times have changed and for the most part Republicans don’t punish savers the same way democrats seem inclined to want to do. Just last month Republicans were trying to double the size of HSA’s. I for one would be shocked if the backdoor Roth was closed anytime in the next decade. Great article and great website, really enjoy it.

    3. If I had substantial tax deferred assets and was considering a SEPP, I’d definitely be utiliizing BAMFMoney’s services to do the analysis and do it right. I definitely wouldn’t settle for paying the penalty just because that’s superior to not taking the tax deductions during my career.

      I highly recommend anyone curious about the 72(t) to read his post.

      As he mentions in the post, there are multiple methods to determine the SEPP, and you are given a one time option to change certain methods. (So you actually can bump up your withdrawal to the terms of the other method- but that would be a permanent increase until age 59.5 )

  2. Can you elaborate on:
    “Had I known this the last time I switched employers, I would have rolled** my old 401(k) into a Vanguard IRA and started the five-year pipeline process.”

    This would have been a significant taxable event (assuming your 401k is traditional and you roll into a Roth IRA to start the 5-year clock on that money), so I’m not able to see the benefit that would have had. Most recommendations have the Roth Conversion Ladder starting after leaving work (specifically in the first year of little to no regular income), so the tax hit on the conversion is very low or even $0.

    Any reason I’m missing that would make it beneficial to start the ladder when switching jobs?


    1. Sure, Noah. With perfect hindsight, instead of rolling my previous 401(k) into my current 401(k), I would have rolled it into a traditional IRA at Vanguard. Then, at any time I wanted, I could have started a conversion ladder by withdrawing small annual amounts and converting those to a Roth IRA each year.

      Agreed, taxes on conversion amounts would be higher during my working years, and the ideal strategy is to wait until RE and aim for the lowest bracket. But my withdrawals would be relatively small, and this plan could have provided additional options. For example, starting a small ladder while I retire and the wife continues work, or vice versa.

      Not too worried about it though. As the article states, if the ladder doesn’t work out for the wife and I, we can simply pay the penalty and still be in great shape. 🙂

      1. But even in small amounts, you would be paying taxes at the marginal rate on that money. Assuming you’re still working and contributing money to tax-deferred accounts in the same year, you’re literally canceling out the tax savings of those contributions by converting money from Traditional to Roth at the same time. Why not just put money directly in Roth at that point and avoid the 5-year thing altogether?

        As you’ve covered, it would be better to pay the 10% penalty while you’re in an overall lower tax bracket in retirement than to forego putting money in tax-deferred accounts while working. By converting money from Traditional to Roth at your present marginal tax rate (in any amount), you would be doing the same thing you’re recommending against!

        The “additional options” you mention is the same kind of statement you called out at the top of your post. People making non-optimal decisions like avoiding tax-advantaged accounts for “flexibility” or “additional options”. The math just doesn’t support it.

        1. Not sure if I fully agree, Noah. Suppose I know I’ll only have three years of expenses saved before starting the ladder, instead of the necessary five.

          Rolling over into a traditional IRA, to have the option of starting a ladder early doesn’t cost anything. Starting the ladder two years earlier while still employed does, but this cost is a small number over a small time scale.

          I’m willing to spend a small number of dollars in the name of flexibility. Skipping these tax advantaged accounts altogether, however, can cost six figures. I’m not willing to spend that in the name of flexibility. THAT is the big picture.

          The more we dive into the minutia, the more I like the option of just paying the penalty. It’s simple, performs nearly as well as these significantly more complex strategies, and it’s hard to screw up. I think that’s the real value here!

          1. The only “cost” I can see with rolling a 401k into a Traditional IRA is potentially limiting future contributions via the Backdoor Roth IRA, but that will be situational.

            I suppose my main argument is that starting the Roth Conversion Ladder while still employed will lose out to the alternatives. As I said, contributing to tax-deferred accounts in the same year you do a conversion cancels out the tax benefit and adds additional restrictions (like the 5-year waiting period).

            I think you’d be hard pressed to find any person/couple saving a high % of their income benefiting mathematically (or gaining any extra flexibilty) from starting the Roth Ladder while still fully employed. There should always be a better way to cover the 5-year gap than converting while still fully employed whether that be cash reserves, old Roth contributions, taxable accounts, paying the 10% penalty or otherwise.

            Btw, I agree with almost everything you wrote above and the overall message is clear: Contribute to Tax-Deferred Accounts (100% agree with that). It’s just that one line I quoted that seemed out of place because I can’t come up with any situation where it would be beneficial.

  3. The silver lining with almost any of these approaches is that most people approaching FI end up having a ton in taxable accounts already. This means they’ll have not only the 5 years of living expenses in those accounts, but often so much in these taxable accounts that the amount they need to put in the 5 year pipeline (taxable event) or via SEPP, or just taking the 10% penalty on, is smaller than you’d probably anticipate.

    A good take on the subject, and any reminder to go back to Mad Fientist’s greatest hits is a good one.

    Found your site on the Choose FI podcast, btw. Great episode!

    1. Yeah, my goal for this article was to bring more attention to the wonderful Mad FIentist article, and focus on the surprising result that the ‘penalty’ is actually better than many of the alternatives.

      Thanks for the feedback! I had a blast on ChooseFI; Brad and Jonathan are the best.

  4. Shoot, I’m late to the discussion because somehow I got unsubscribed maybe? I don’t know.

    Anyway, Keith beat me to the punch. I was gonna say that just because there are rumors of a change to the roth conversion ladder doesn’t mean they’ll come about and even if they did, it’s still probably a great option until it gets taken away. I imagine the worst that would happen is that those withdrawals suddenly start being taxed, just like they would have been if they’d stayed in your traditional IRA in the first place. So, you wouldn’t really miss out on anything and you benefit in the meantime before congress takes it away (again, if they actually end up doing that).

    For me, I think that’s the route I’ll pursue, assuming it’s still in place. I’ll be a few years later than you, so who knows where we’ll stand at that point. (Here’s hoping that healthcare is covered or at least not exorbitant…)

  5. Am I missing something here, or can it be as simple as considering it an additional 10% tax on money that you saved 15% or more tax on in the year you earned it, depending on tax bracket? If that’s true, I think more people would see the benefit of maxing out their tax-deferred accounts and considering “paying the penalty,” especially if the conversion ladder and/or SEPP are too confusing to them.

  6. I know I’m late to commenting on this, but once again, great recap!

    I wouldn’t personally be too concerned about changes to the tax code. Its been virtually the same since the mid 1980s and every time they monkey with it, net taxes paid or net taxes owed changes by 1-2%. Taxation also continues to get more progressive, so an early retiree realizing $40,000 in income while likely being married and maybe with kids will continue to be in the clear.

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