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!”
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.
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!).
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.