How to Retire Early with No Penalty

Retirement accounts like 401(k)s and traditional IRAs offer significant tax benefits, but in exchange, the IRS expects you to leave the money untouched until you reach your 60s. To discourage early withdrawals, the IRS imposes a 10% penalty on the taxable portion of any distributions taken before age 59½.

However, there are exceptions to this rule that can help you avoid the penalty. Some common options include:

1. Using Non-Qualified Funds First: Tap into accounts that don’t have early withdrawal penalties before using your retirement funds.
2. Utilizing the Rule of 55: If you leave your job in or after the year you turn 55, you can take penalty-free distributions from your 401(k).
3. Roth IRA Plan: Contributions to Roth IRAs can be withdrawn penalty-free at any time, and earnings can be withdrawn penalty-free after age 59½, provided the account has been open for at least five years.
4. Leveraging SEPPs: Substantially Equal Periodic Payments (SEPPs) allow penalty-free withdrawals if you commit to a specific schedule of withdrawals for at least five years or until you turn 59 1⁄2, whichever is longer.

If you’re considering early retirement, it’s crucial to understand these exceptions and identify alternative sources for penalty-free cash. This article serves as a comprehensive guide to help you navigate these options effectively and make informed choices based on your individual circumstances.

1. Use non-qualified funds first

If you retire early, it’s best to start by using funds from a “non-qualified” account. These accounts do not get the special tax treatment that retirement accounts do. Here’s why this can be beneficial:

What Are Non-Qualified Accounts?

Non-qualified accounts include brokerage accounts where you can invest in assets like stocks, mutual funds, and exchange-traded funds (ETFs). Unlike retirement accounts, withdrawals from these accounts are not taxed as ordinary income.

Tax Advantages of Non-Qualified Accounts

1. Qualified Dividends: Income generated from investments like mutual funds and ETFs is often classified as qualified dividends. Qualified dividends are taxed at a lower rate than ordinary income.
2. Capital Gains: When you sell investments that have appreciated in value and have been held for more than a year, you pay long-term capital gains tax, which is also typically lower than the tax on ordinary income.

Tax Rates and Thresholds

• Qualified Dividends and Long-Term Capital Gains: If your income is below certain thresholds, you benefit from lower tax rates on qualified dividends and long-term capital gains.
• 2022 Income Thresholds: For single filers, the threshold is $41,675, and for married couples filing jointly, it’s $83,350. If your income is below these amounts, you won’t pay any federal taxes on your qualified dividends and long-term capital gains.
• 2023 Income Thresholds: These thresholds increase to $44,625 for single filers and $89,250 for married couples filing jointly.

If your income is above the 0% threshold, you will pay 15% or 20% on qualified dividends and long-term capital gains, depending on your income level.

However, if you withdraw from retirement accounts, the amount will be taxed at your ordinary income tax rate. This rate could be significantly higher than the capital gains rate, especially if you are in a high-income bracket (22% or higher if you are single).

Example:

If you retire early and need to withdraw money, tapping into your brokerage account first can save you money in taxes. You will likely pay lower tax rates on qualified dividends and long-term capital gains compared to the ordinary income tax rates applied to withdrawals from retirement accounts like IRAs or 401(k)s.

2. 55 or older? Consider your 401(k) or 403(b)

If you leave your employer in or after the year you turn 55, you won’t be subject to the 10 percent penalty on early 401(k) distributions, which is known as Rule of 55.

To qualify for penalty-free withdrawals under the Rule of 55, specific eligibility criteria must be met:

a. Age and Separation Timing

• You must leave your job within the calendar year you turn 55 or later. For certain public safety employees, such as police officers, firefighters, and emergency medical technicians, this age is reduced to 50.
• The rule does not apply if you left your job before the calendar year you turned 55 and waited until 55 to take withdrawals.

b. Employer-Sponsored Plan

• The provision applies only to the 401(k) plan of the employer from which you separate in the qualifying year. It does not apply to plans from previous employers or to IRAs.

c. Employment Status

• Separation from service must occur. This means you must have fully terminated your employment with the qualifying employer. Partial retirements or reductions in hours do not qualify.

In addition to 401(k) plans, the same exception also applies to: 

1. Employees of public schools and charitable organizations with a 403(b) plan.
2. State and local government employees who participate in a 457(b) plan. Employees with these plans can take early withdrawals without penalty at any age after separating from service. However, they will be required to pay regular income tax on the withdrawals, as the contributions are made with pretax dollars.

While some individuals who separate from service at 55 may want to roll their 401(k) balance into an IRA to access more investment options and greater control, doing so immediately may not be in your best interest. By keeping the funds in your 401(k), you can take penalty-free distributions at 55. If you roll the 401(k) funds into an IRA, you would lose the ability to withdraw those funds penalty-free at 55.

Once you reach age 59 1/2 and no longer have to concern yourself with early withdrawal penalties, you may consider rolling the balance into your IRA, suggested financial planner Byron Ellis of Goldman Sachs Personal Financial Management in The Woodlands, Texas. This way, you can benefit from penalty-free withdrawals from your 401(k) at age 55 and still take advantage of an IRA’s flexibility and investment options once you’re older.

3. Younger than 55 or no 401(k)? Perhaps your Roth IRA

Correct, a qualified distribution from a Roth IRA is not taxable, and you are not required to report this amount as part of your gross income when filing your tax return. To qualify, the distribution must occur after the five-year period beginning with the taxable year of your first Roth IRA contribution and meet one of the following conditions: Made on or after the taxpayer turns 59 ½.

1. Made to a beneficiary or the taxpayer’s estate on or after the death of the taxpayer.
2. Attributable to the taxpayer being disabled.
3. It is a “qualified first-time homebuyer distribution, up to a maximum lifetime limit of $10,000.”

Non-qualified distributions of earnings from a Roth IRA are treated as income. If these distributions are taken before reaching age 59 1/2, a 10 percent penalty is typically applied to the taxable portion of the distribution. However, certain exceptions may waive this penalty.

Additional tax regulations could impact funds in your Roth IRA that originated from a traditional IRA or 401(k) rollover. If a non-qualified distribution comprises these funds, the 10 percent penalty would be enforced, irrespective of the distribution’s taxability. To bypass this penalty, at least five years must have elapsed since the conversion or rollover date. Notably, after-tax IRA contributions rolled over do not face taxation at the time of rollover (as they are already after-tax), and thus are not subject to this rule.

If a Roth account contains both regular contributions and conversion amounts, any distributions follow this categorization:

1. Withdrawals are initially attributed to regular contributions, which is advantageous as no penalty is incurred.
2. Subsequently, any conversion or rollover contributions are accessed.
3. Lastly, any distribution exceeding the sum of all contributions is considered earnings, potentially subject to the 10 percent penalty and taxation. Conversions or rollovers may also face penalties, as previously outlined. The IRS consolidates all Roth IRAs when determining taxes and penalties. For detailed guidelines on Roth IRA distributions, consult IRS publication 590-B.

While the Roth IRA allows penalty-free early withdrawals, utilizing this option can negate a significant benefit of the Roth account. Roth balances grow tax-free and are not subject to required distributions during your lifetime at any age, enabling your nest egg to grow indefinitely—a feature not shared by traditional IRAs or 401(k)s, both mandating minimum distributions (RMDs) starting at age 73. The age for RMDs increases to 75 as of January 1, 2033. Moreover, you can leave the Roth account to your heirs if you don’t exhaust it yourself (although RMDs apply to Roth beneficiaries).

4. Another option before 59 1/2: Substantially equal periodic payments

One strategy for accessing early distributions from a traditional IRA or making non-qualified Roth IRA distributions involves leveraging the IRS’s section 72(t)(2) rule.

This rule permits retirement account holders to circumvent the 10 percent penalty by initiating a series of substantially equal periodic payments (SEPPs). 

Eligibility Criteria

To qualify for SEPP, the following criteria must be met:

a. Access to Qualified Accounts

• You must have an IRA or 401(k) account. SEPP does not apply to other retirement accounts such as Roth IRAs or employer-sponsored pension plans.

b. Commitment to Payment Duration

• You are required to take periodic payments for at least five years or until you turn 59½, whichever is longer. This ensures the IRS views the withdrawals as part of a systematic plan rather than early withdrawals.

Calculation Methods

The IRS provides three approved methods to calculate SEPP. Each method uses different calculations based on your account balance, life expectancy, and interest rates:

a. Fixed Amortization Method: Your account balance is amortized over your life expectancy using an interest rate of not more than 120% of the federal mid-term rate. This results in a fixed annual payment.

b. Required Minimum Distribution Method: Your payment amount is recalculated annually by dividing your account balance by an appropriate life expectancy factor derived from IRS life expectancy tables. This method offers the most flexibility, as it adjusts the payout each year based on the account balance and life expectancy, thus less likely to deplete the account prematurely.

c. Fixed Annuitization Method: This method uses an annuity factor derived from IRS mortality tables and an interest rate of not more than 120% of the federal mid-term rate to determine a fixed annual payment. This method results in fixed annual payments.

Example: 

This is how SEPPs would operate for a 50-year-old individual with a $1 million account balance under each of the three calculation methods:

Required Minimum Distribution Method: To compute the distribution amount using the Required Minimum Distribution method, divide the $1 million account balance by the account holder’s life expectancy based on an IRS-approved life expectancy table. For instance, applying one of the authorized tables for single life expectancy, a 50-year-old’s life expectancy is 34.2 years. Dividing $1 million by 34.2 results in an initial distribution amount of $29,239.77. Subsequent amounts will vary accordingly.

Fixed Amortization Method: You can utilize an online 72(t) calculator to construct an amortization schedule and determine the annual withdrawal amount. As of January 2023, the maximum interest rate permissible is 4.62 percent, which is 120 percent of the federal mid-term rate. Given a life expectancy of 34.2 based on the single life table and an account balance of $1 million, the calculation at January 2023 rates produces an annual amount of $51,202.

Fixed Annuitization Method: For the annuitization method, the calculation involves determining an annuity rate from an IRS-provided table that generates a factor considering the prevailing interest rate and the client’s age. Financial planner Dressel suggests that this computation is most effectively handled by a computer. The process entails dividing the account balance by the calculated annuity rate to derive the distribution amount.

Caveat

When taking SEPPs from a 401(k), 403(b), or traditional IRA, ordinary income tax applies to the taxable portion of those distributions. However, there is a significant caveat tied to taking SEPPs. 

If SEPP payments cease before the required duration, a retroactive 10 percent penalty is enforced on all prior distributions. In simpler terms, suppose you start withdrawing $1,000 per month through SEPPs at age 50 and discontinue at age 54. In such a scenario, you would be subject to a 10 percent penalty on the $48,000 total withdrawn over the years, resulting in a $4,800 penalty plus interest.

Modifying the SEPP arrangement also incurs a retroactive penalty. For instance, opting to contribute more to your IRA due to part-time work or executing a rollover triggers penalties. Likewise, withdrawing a lump sum in addition to the scheduled annual payments due to financial constraints leads to penalties. In this case, penalties are levied on all prior SEPP withdrawals along with an additional penalty on the lump sum withdrawal. 

Therefore, Section 72(t)(2) distributions are more effective when they supplement other income sources, like part-time work, rather than serving as the primary income stream.

When paying the 10 percent penalty might make sense:

Financial planner Richard E. Reyes from Wealth & Business Planning Group in Maitland, Florida, explained that if your taxable income, after deductions and exemptions, is zero, the only tax due on an early withdrawal is the 10 percent penalty. 

Reyes presented a simplified example to demonstrate this concept, acknowledging that real-life scenarios are likely more intricate: For a single 55-year-old individual who received a $10,000 traditional IRA distribution in 2023, with a standard deduction of $13,850 (considering no other income sources), the taxable income on the distribution would be zero. Therefore, the penalty on the distribution would amount to $1,000. This principle applies similarly for a single 55-year-old who took a $50,000 traditional IRA distribution and possessed $50,000 in itemized deductions. In this scenario, with no other income sources, the penalty on the distribution would equate to $5,000.

The bottom line

Navigating the rules and exceptions for early withdrawals from retirement accounts can be complex, but understanding these options can significantly impact your financial well-being. By using non-qualified funds first, leveraging the Rule of 55, considering a Roth IRA, or implementing SEPPs, you can access the funds you need while minimizing penalties. Careful planning and informed decision-making are essential to maximizing your retirement savings and ensuring financial stability in your early retirement years. Use this guide to help you make the best choices for your unique situation and secure a comfortable and stress-free retirement.