3035: [Part 1] Generating Retirement Income Before Age 59 by Darrow Kirkpatrick of Can I Retire Yet

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[00:00:25] This is Optimal Finance Daily, Generating Retirement Income Before Age 59 and a Half, Part 1, by Darrow Kirkpatrick of CanIRetireYet.com. You've saved diligently your entire working career. You've maxed out your retirement savings accounts and it's paid off. You've reached the point of financial independence early, or maybe you were laid off or took an early severance package.

[00:00:51] Whatever the reason, like me, you got to retirement ahead of the usual schedule. Maybe in your 50s, maybe even younger. But you could still have a big problem, even if you have enough money saved in your retirement accounts. Why? Because you can't generally touch those tax-sheltered accounts without a penalty before age 59 and a Half. If you take money out before then, you fork over 10% of it to the government, in addition to paying taxes on the income.

[00:01:19] That's a huge potential drag on your retirement savings withdrawals and your retirement lifestyle. So even if you have enough savings to retire, in theory, how and where do you get the cash to live on until you reach that threshold age of 59 and a Half? In this article, I'm going to explore your options for making ends meet until you can dip into your retirement accounts freely. Some of these techniques are simple and well-known. Some are more obscure and complicated.

[00:01:48] But taken together, they give you the means to finance an early retirement long before the government allows unhindered access to your dedicated retirement accounts. But please beware, this topic is heavily impacted by tax considerations, and I'm not even close to being a tax professional. I pride myself on avoiding our Byzantine tax code as much as possible.

[00:02:10] So before taking any action based on something you read, always confirm the details against other sources and or review your personal situation with a tax pro. Taxable accounts. The simplest, most obvious, and most flexible way to avoid penalties when withdrawing your money before age 59 and a Half is this. Maintain substantial taxable non-retirement accounts. In my case, we were dedicated savers.

[00:02:37] Once we reached my high income years in my 30s and 40s, we maxed out our retirement contributions nearly every year and went right on saving thousands of additional dollars in taxable accounts. That meant by the time my work income stopped when I retired at 50, about half of our net worth was parked in easy, accessible, taxable accounts. We could and do withdraw that money now as needed for living expenses with no penalties.

[00:03:02] In fact, unless I'm selling appreciated assets and realizing capital gains, there are no tax implications whatsoever when withdrawing from those accounts. Taxable accounts are the unsung heroes of retirement saving. While you're maxing out saving to traditional and Roth retirement accounts, saving into taxable accounts gives you superior flexibility for financing your retirement.

[00:03:25] And surprisingly, if you're able to keep more of your taxable investments in equities and live modestly in lower tax brackets, the long-term performance of those taxable accounts can be nearly as good as tax-sheltered ones. That's because you're exempt from paying tax on long-term capital gains in the lower tax brackets. In an article I wrote last year, I reported on detailed simulations I ran to prove this point. My conclusion?

[00:03:52] Remarkably, a taxable account with most of its growth coming from capital gains, if that growth is withdrawn in the lower two tax brackets, is essentially equivalent to a tax-free retirement account. That's because, in either case, the growth is not taxed. Roth accounts and conversions Roth retirement accounts contain a number of provisions that offer more flexibility than traditional retirement accounts.

[00:04:17] The provision most relevant to this article on early retirement income governs your contributions as distinct from earnings in the account. Contributions are sums you deposited into the account as annual investments. Earnings are the interest, dividends, and capital gains that have accrued in the account from your investments. You can withdraw the contributions you made to your Roth at any time, and you pay neither taxes nor penalties, as after-tax, non-deductible transactions, that money was already taxed.

[00:04:47] For example, say you have a Roth account with a $100,000 balance, of which $75,000 represents your original contributions, and $25,000 represents dividends and growth once the money was in the account. Well, before age 59 and a half, you can withdraw from that account for retirement living expenses up to $75,000 with no additional taxes or penalties.

[00:05:11] The logical next step, given this mechanism, is the ability of converting traditional retirement money to Roth accounts so you can take advantage of penalty-free early withdrawals. However, there are a number of caveats. For starters, this procedure is less than simple in my view. See my previous article on Roths for details on how to do it and when it does and doesn't make financial sense.

[00:05:35] Secondly, you'll be required to pay tax up front on the converted money, so you need to budget for that expense, and be certain it makes sense given your current tax bracket. Lastly, there's a five-year waiting period before you can tap converted funds penalty-free, so this approach will require significant advanced planning on your part. The age 55 rule.

[00:05:57] There is at least one simple rule for getting your retirement money before retirement age, but it applies only to certain employer-provided 401k plans. It works like this. You can withdraw penalty-free from a 401k plan if you separate from service in or after the calendar year in which you reach age 55. Depending on the timing, this rule could give you more than four years of penalty-free retirement income before reaching age 59 and a half.

[00:06:26] An excellent post at Oblivious Investor lays out all the fine points of this rule. For one thing, it doesn't matter why the separation from service occurred. It might be a layoff, or you can just simply quit and retire early. But you don't have to be fully retired to qualify. You can also take a part-time retirement job and still qualify to withdraw retirement funds from an employer you previously left at or after age 55.

[00:06:51] But also note that this exception does not apply to IRA accounts, only to 401ks, and that could be one reason to wait on rolling over any employer plans into IRAs. By keeping your money in your previous employer's 401k, you are also retaining some flexibility for withdrawing funds before you turn 59 and a half. 72-T rule. Hear that in tomorrow's episode.

[00:07:21] You just listened to part one of the post titled Generating Retirement Income Before Age 59 and a Half by Daryl Kirkpatrick of CanIRetireYet.com. Did you know that only 8% of people will stick with their New Year's resolutions all year long? Well, there's one financial resolution you could actually stick to because it happens automatically. Today's episode is sponsored by Acorns.

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[00:09:58] But it appears there's also an assumption here that a 10% penalty on withdrawing from your retirement accounts early should be avoided at all costs. What if the tax benefits from retirement vehicles far outweigh taxable accounts even with the penalty? That might very well be the case and shouldn't be ruled out as an option. We really need to run the numbers here. So I'd really encourage you to read the article, How to Access Retirement Funds Early by the Mad Scientist,

[00:10:28] who debunks this idea that if you want to retire early, you should prioritize investing in taxable accounts over fully funding your retirement vehicles. He provides in this article a hypothetical early retiree drawdown strategy. And the surprising conclusion is that even if you don't want to mess with things like a Roth conversion ladder or SEP distributions, it still makes sense to fully fund your pre-tax retirement accounts.

[00:10:53] Let me be clear, this isn't financial advice, and you may have some nuances to your situation where it really doesn't make sense to fully fund your retirement vehicles. However, I would like to encourage all of us to make sure we're not sacrificing dollars to save pennies. Well, that should do it for today. Have a happy rest of your day and great weekend. And I'll be back tomorrow where we'll finish up this post and where your optimal life awaits.