If you’ve been saving for years and your retirement dreams look like they might come true earlier than you expected, review your financial strategy and retirement accounts carefully before you quit your job and take off in your Winnebago.
First, make sure you have enough money set aside to support you for the rest of your days, and second, make sure you understand 401k withdrawal rules so you can minimize any penalties associated with 401k early withdrawal activity.
Generally, if you make an early withdrawal — other than a hardship withdrawal — from your 401k before you hit the 401k withdrawal age, that money is subject to a 10-percent penalty fee. Before you plan a withdrawal, review the IRS guidelines or talk to a financial or tax advisor beforehand, or else you might face a hefty penalty. Here are seven suggestions to keep in mind if you’re planning to retire early and use the money in your 401k.
How Early Retirement Affects 401k Withdrawals
If you withdraw funds from your 401k prior to age 59.5, you’ll be charged an early withdrawal penalty of 10 percent in addition to federal and state taxes, according to the IRS. Several exceptions apply, however, to the early withdrawal penalty. If you’ve become permanently disabled or have particular medical expenses, you might qualify for a penalty-free early 401k withdrawal. Additionally, if you left your employer the same year you turned 55, you might not have to pay the 10 percent penalty.
Here are seven tips to mitigate your losses when it comes to early 401k withdrawal:
1. Use the 4-Percent Rule
If you’ve been researching how to retire early or how you should be saving for retirement, you might have come across something called “the 4-percent rule.” This financial planning strategy suggests you make a withdrawal of 4 percent from your retirement savings during the first year of your retirement. The theory states that by maintaining a steady withdrawal rate of 4 percent — plus inflation — during each year of your retirement, your savings should last for about 30 years.
Take a look at your own total retirement savings. If you retire before age 59.5 — the magic number at which you don’t incur a 10 percent tax for early withdrawal — and you withdraw 4 percent of your non-401k savings annually, might not even need to touch your 401k. If this is the case, avoid the 10-percent early withdrawal penalty by living on your non-401k retirement savings. If possible, let your 401k savings grow tax-free until you have to make a required minimum distribution, or RMD, withdrawal at age 70.5.
2. Reinvest Your Withdrawal in an Annuity
If you plan on taking money from your 401k, consider reinvesting it in an annuity. The key benefit to this strategy is that it will give you guaranteed income for the rest of your days without requiring you to make any decisions about how that money is invested.
In addition, if your annuity has survivor benefits, your spouse will enjoy an income stream if he survives you. However, the income payments will not be inflation-adjusted.
3. Retire at 55 With Your Current 401k
When it comes to withdrawing from a 401k, age matters. You might not want to wait until your full retirement age to leave your job, but waiting until you’re at least 55 can decrease the cost of withdrawing from your 401k associated with that job. If you leave your place of employment during or after the calendar year you turn 55, you can take money from your 401k without paying that early 401k withdrawal tax penalty.
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4. Roll Other 401ks Into Your Current 401k
Whether you’ve worked for several companies in the same field or changed careers during your working years, look into withdrawing and rolling your previous 401k into your current 401k. This way, if you leave your job during or after the calendar year in which you turn 55, you can avoid the early withdrawal tax penalty on all of that money.
5. Roll Your 401k Into an IRA for SEPP Withdrawals
Another strategy you can use to minimize paying penalty taxes if you need to access your 401k for early retirement is to roll your account balance into an IRA. This allows you to make what the IRS calls 72(t) distributions — also known as a Series of Substantially Equal Periodic Payments — without paying the 10-percent tax for early withdrawal.
However, bear in mind that you’ll have to keep withdrawing from your IRA for at least five years or until you are 59.5, whichever is longer. This strategy can be quite complicated, so make sure you run it by a tax expert before you commit to it
6. Roll Your 401k Into an IRA and Attend College
If getting a college degree or helping your spouse or child obtain one is part of your early retirement plan, you can avoid that withdrawal tax by rolling your 401k into an IRA. You can take a penalty-free IRA distribution for qualified higher education expenses, such as tuition and books, according to the IRS. That said, you will likely still have to pay income tax on that withdrawal.
7. Try Tax-Loss Harvesting to Lower Taxes
If you’re determined to retire early and planning to tap into your 401k and your non-tax sheltered investments anyway, consider tax-loss harvesting to reduce your overall tax. Tax-loss harvesting involves selling off a security that has experienced a loss to offset capital gains and income taxes.
Beware: The IRS wash sale rule can put a damper on your tax-loss harvesting plan. This mandate prohibits you from claiming a loss on the sale of a security if you buy a “substantially identical” security within 30 days before or after the sale.
Find Out: What Is Tax-Loss Harvesting?
Do Your Early Retirement Due Diligence
If you’re planning to retire early, first look for other ways to generate income. Consider making withdrawals from your taxable investments and IRAs to minimize your taxes and penalties.
Your 401k is a valuable financial asset but that 10-percent early withdrawal penalty can make it expensive to access early. If you do find you have to make a 401k withdrawal for early retirement, seek expert advice to ensure you make the wisest decision for your financial situation.
Laira Martin contributed to the reporting for this article.