Accessing retirement accounts without penalties
Mrs. Grizzly and I are going to face a problem.On the day we leave our jobs sometime in 2018 our various pots of money should look something like this ($k):
About $1M in investable assets, plus any extra that comes our of our house in San Francisco when we sell it. Sounds great! However, the problem is that a significant portion of that $1M is going to be locked in IRAs, 401ks, and Roth IRAs. Tax-advantaged retirement accounts are great! But they have one significant problem for early retirees like ourselves, they are for traditional retirement and can carry hefty penalties if you try to use them before you turn 59.5. However, there are a few simple steps to access your retirement accounts without penalty.
Technically, taxable accounts have nothing to do with tax-deferred retirement savings, but it is important to start with this first step. Mrs. Grizzly and I are lucky here, we’re going to have a sizeable amount of savings in taxable accounts when we leave. This is the result of earning the salaries of a couple insufferable one-percenters for a few years before retirement without enough tax-advantaged options to cover everything. With our current portfolio of taxable accounts, even with very conservative return assumptions of only 4% we could last for almost 20 years pulling out $40k per year. The best part of this is that during those 20 or so years, we will not pay a dime in taxes. The full picture of after-retirement tax burdens will have to wait for a much longer post, but the important thing to remember is that if you stay in the 10-15% tax bracket you pay no tax on qualified dividends or long-term capital gains (you can find a great reference here). While we burn through our after tax savings a large portion of our income will come through these channels. It’s good to be retired.
For more traditional portfolios composed of a higher portion of tax-deferred accounts, keep in mind that you do not need to have as much in taxable accounts as us. The key number to keep in mind is 5 years. We’ll come back to why that number is so important in a bit.
Roth contributions are the next step in our plan to access our retirement accounts. The important point to remember is that any contribution made with after-tax dollars can be withdrawn from your account at any time. Over the years, Mrs. Grizzly and I contributed about $20k to Roth accounts. Those accounts are now worth a bit north of $42k now. We can’t access all of that $42k without penalty, the gains are stuck until we reach normal retirement age. But we can pull $20k out at penalty free. This is not a very significant amount now, but there are a couple tricks that will increase this over the next two years.
After-Tax 401k and IRA contributions
My company just announced that next year we are finally allowing after-tax contributions to our 401k plans. This is HUGE news for us. 401k Plans are capped at $18k of deductible contributions, but the FULL amount that can be contributed is $53k. My employer also chips in $9k, so we have an extra $26k that we can put into tax-advantaged accounts each year for the next two years.
The best part of these after-tax contributions is that they can eventually be rolled over into a Roth IRA when I leave. If your company offers in-service distributions, meaning while you still work there, you can do this even earlier. Here is the IRS ruling on this if you’re curious. It means that when we retire we will have another $52k of after-tax contributions in our Roth plans to utilize. Finally, we have another $20k in after tax contributions in our traditional IRAs. As a result, our total after-tax contributions across 401ks, IRAs, and Roth IRAs that we can immediately access without penalty will be north of $90k. That ends up being about $700k (taxable accounts + after-tax contributions) that are immediately available for us to withdrawal without penalty.
Everything split between taxable accounts and after-tax contributions to IRAs and 401ks are the foundation we will draw down from the rest of our retirement savings are ready to access. That happens slowly, but it can start taking place in as little as five years.
Roth IRA conversion ladder
Something called the Roth IRA conversion ladder is the next step and the reason for the five-year time frame. The Roth IRA conversion ladder is something that sounds very complicated at first, but once you understand, it’s really very simple.
Essentially, the contributions to your normal 401ks and IRA have never been taxed. The contributions to your Roth IRA have been taxed. The government allows you to convert from one to the other by just taking one simple step – paying income tax on whatever you transfer. Making any conversions from traditional IRAs to Roth IRAs triggers income tax on whatever you move. This is a problem if you’re still making a high salary and sitting in a high tax bracket. No one wants to lop off 25% of their portfolio and hand it to the government by transferring from a traditional IRA to a Roth IRA.
However, the key lies in those beautiful low taxes of early retirement. In our situation, married filing jointly with two kids, with no other considerations we could move up to $48k each year and owe zero income tax. We could have an additional $55k in qualified dividends and capital gains and still be sitting at $0 income tax.*
The next caveat is that those conversions have to ferment for five years before you can access them penalty free. Try to pull them out before then and the 10% penalty trap snaps shut. However, as long as you have a sufficient cushion from taxable accounts and after-tax contributions you can successfully avoid this. Every year you simply convert one more tranche of you pre-tax IRAs and 401ks and five years down the line you can start withdrawing those conversions penalty free.
If you’re looking for details on how all this works, I’ve pulled together a quick calculator to show exactly how all of the various accounts function as you pull this off. You can the basics of how that calculator works here.
* Note on the Affordable Care Act – the affordable care act makes this tax picture more complicated as within this range your subsidies start to phase out based on your MAGI income, which includes capital gains, dividends, and conversions. I’ll be going into this in much more detail in a couple later posts on health care post early-retirement. But the gist is that you will pay an additional ‘tax’ on this income in the form of reduced subsidies. It’s technically not income tax, but it’s lowering the amount you would have received from the government which is in effect a marginal tax on this income.
* Note on Substantially Equal Periodic Payment (SEPP) – There is one additional way to gain access to your retirement plans without incurring the normal 10% penalty. The SEPP program essentially enables you to withdraw a small fixed amount every year from your plans. You can find a good breakdown of the details here and there is a good calculator here. I did not include this method because I cannot recommend it for several reasons:
- Complicated – the calculations are rather arcane to determine the correct distribution you can take every year, for most of the methods you will probably need a good tax advisor to help you
- Penalties – If you screw up the calculations at any point you are hit with the 10% penalty on ALL of the payment you have ever taken plus interest
- Loss of flexibility – once you start SEPP you cannot shut them off, ever. Additionally, once you start taking SEPP payment you lose the ability to contribute to your IRA or make conversions into it. So if you ever decide to go back to work or make some money in a side business you won’t be able to use your IRA anymore to shield income from taxes
- Insignificant amount – for all these hassles the amount you are actually able to withdraw is somewhat insignificant, a few thousand dollars each year.