If you plan to retire early, you may be wondering whether it makes sense to invest in traditional retirement accounts, such as employer-sponsored 401(k)s/403(b)s and IRAs/Roth IRAs. The speculation comes into play because there’s an early withdrawal penalty when you take money out of these accounts before age 59 ½.
I argue that it’s still a good idea to invest in traditional retirement accounts if you plan to retire early. This is because there are tax benefits that come with these retirement plans. Money contributed to employer sponsored 401(k)s/403(b)s are pre-tax and reduce your taxable income for the year. Money contributed to Roth IRAs isn’t pre-tax but the money grows tax-free.
The best scenario is to have enough money outside of these retirement accounts so that you can live off other investments before age 59 ½ and then tap into your retirement accounts after turning 59 ½. Here are a few tips to aid you in your early retirement planning.
Avoid Early Withdrawal Penalties
Generally, the money withdrawn from a retirement plan before the age of 59 ½ is considered “early” or “premature.” When this happens, you must pay an additional 10% early withdrawal tax. For most, that 10% penalty is a big deal. It will likely result in enough money lost that you’ll want to avoid making early withdrawals.
One thing you can do to avoid early withdrawal penalties from retirement plans is to have other investments. We’ll get to that in a moment.
Another way to avoid early withdrawal penalties is via the IRS rule 72(t). This rule permits penalty-free withdrawals from an individual retirement account (IRA), provided that you take “substantially equal periodic payments (SEPPs)” for at least five years or until you reach 59 ½, whichever period of time is longer. The payment amount will depend on your life expectancy as calculated by IRS-approved methods.
The withdrawals will still be taxed at your normal income tax rate. You can roll over a portion of your 401(k) into an IRA to take advantage of this rule as well. A good guide for IRA conversion can be found here on Dough Roller.
The IRS rule 72(t) is a bit complicated. You may want to work with a financial advisor to make sure you are complying by the rule’s stipulations. If you stop payments too early, you’ll have to pay the early withdrawal penalty on the previously withdrawn amounts.
It’s good to know there’s a way to access your retirement plan funds without the early withdrawal penalty. But, that doesn’t have to be the only option if you plan to retire early. Another option is to have other investments that you can liquidate before you turn 59 ½.
Plan on Other Investments
The best thing you can do is not touch your retirement plan funds until you reach age 59 ½. It’s best to have other investments that you can use as income until you reach IRS retirement age. This means you’ll have to do even more saving during your early years. But it’s worth it for the sake of early retirement.
Here are some options for where to save the rest of your money:
- Savings accounts and certificates of deposit (CDs) – These accounts offer lower interest rates but guaranteed returns. Your money is also FDIC insured up to at least $250,000.
- Peer to peer lending – Companies like LendingClub and Prosper let you build an investment portfolio of personal loans. This gives you monthly cash flow.
- Rental properties – This investment takes some time and skill. But it also offers monthly cash flow as long as you have tenants.
- Dividend stocks – You’ll gain money in two ways. First, you’ll earn as the value of the stocks appreciate. Second, you’ll gain money from distributions paid out to shareholders by the dividend-paying companies.
You can use these investments to fund your lifestyle until you reach IRS retirement age. Depending on the age you plan to retire, you may not even need that much to sustain you until you reach 59 ½. It’s all about planning ahead of time.
Consider Phased Retirement
Most people work a long career and then jump right into retirement and stop working altogether. If you plan to retire early, though, that doesn’t necessarily have to be the path for you. Consider phased retirement as an alternative, in order to make early retirement work for you.
For example, if you work an office job now and want to retire at age 40, you can leave that day job and then start another career. You could start an online business that doesn’t require you to go into an office. Use the time between when you leave your first career and when you reach age 59 ½ to explore another one of your interests. Have you always wanted to write books? Do you have a passion for working with animals? The possibilities are endless.
Finding a new career to embark on during the first few years of early retirement will not only give you extra money to live on, but it’ll also keep you mobile and energized. Make sure it’s something you enjoy so you can still consider yourself “retired.”
Yes, you should invest in traditional retirement accounts if you plan to retire early. They have many tax benefits that make them good investments. What you want to avoid is early withdrawal penalties. You can avoid this by taking advantage of the IRS rule 72(t) as explained above. Or, you could have other investments that fund your lifestyle until you reach age 59 ½ and can withdraw money from your retirement plans penalty-free.
Another consideration to keep in mind is phased retirement. Although you retire from your day job at an early age, that doesn’t mean you don’t have to work at all. Consider starting a new career based on another one of your interests or passions. This way, you’ll keep some money coming in until you reach age 59 ½ — and can withdraw from the traditional accounts — but you’ll still enjoy your early retirement.
Updated December 2, 2016 and originally published November 28, 2016.