You’ve probably noticed that there’s a trend where some people choose not to contribute to a retirement account because of the perceived inability to withdraw the funds before you reach the age of 59½.
Unlike Social Security, where you simply can’t access it before you hit a certain retirement age, the government walks a fine line between convincing you that 401(k)s and other retirements accounts are YOUR money while also not wanting you to access this money “early”. To further this policy the government put in place a few penalties to discourage you.
These penalties are relatively successful in keeping people out of the cookie jar. Unfortunately, they also hurt poor planners that need to access the funds early for whatever reasons.
But what if you’re not a poor planner and you want to access your funds before you turn 59½? How would could get that money early?
Here’s how those who understand the rules circumnavigate this problem:
1. Withdraw from a taxable account
Taxable accounts get a bad rap. These are your regular brokerage accounts without the benefit of a retirement wrapper. You get no special benefit by contributing to a taxable account, as Uncle Sam wants to take a percentage of your capital gains and dividends, even if you’d prefer to defer that income the future because you have no need for it today. But taxable accounts open up a lot of opportunities as well. For one, it’s entirely your money. You can access it whenever you want and do with it whatever you want. Time to buy a Tesla? Sell some assets in your taxable account and now you own a Tesla. It’s the same for those that want to access retirement money before 59½. They simply leave the retirement accounts alone and withdraw from a taxable account, potentially draining it down to zero along the way. This buys them the time they need to reach 59½ when they will have unfettered access to retirement accounts.
2. Spend your health savings account
The Health Savings Account is there for a reason. It’s your triple-tax advantaged account that allows you to pay for medical expenses without paying any taxes whatsoever. If you have medical expenses today, you can go pay those expenses with cash on hand, save the receipts into the future and withdraw the money from the HSA later. Or you could just save yourself the trouble and use it as it was intended – for health expenses now! The money can be used at any time for health related expenses. Whatever is left over will turn into a Traditional IRA once you hit 65 anyway, which is why a lot of savers are using it as a Stealth IRA.
3. Avoid the penalty with a 457(b) account
Many government lawyers have access to a 457(b) account, sometimes in addition to a separate 401(k) or 403(b) account. One of the unique advantages of the 457(b) account is that you can withdraw the funds without paying the 10% penalty at any time before you are 59½. Of course, you’ll need to pay ordinary income tax on these withdrawals but being able to access it without penalty before you turn 59½ makes these accounts a favorite among the early retirement crowd.
The important distinction to keep in mind here is that there are technically two different types of 457(b) accounts: governmental and non-governmental. Governmental 457(b)s are the better option. If you work for a non-profit that has a 457(b), you’ll need to pay a little more attention. For one, these accounts are subject to your employer’s creditors which means they are technically at risk should your employer declare bankruptcy. Also, non-governmental 457(b)s do not have great rollover options as you typically must transfer them to another non-governmental 457(b).
On the other hand, governmental 457(b)s can be rolled over into traditional IRA accounts when you leave employment. Of course that will defeat the purpose of accessing the funds early as once they’re placed in an IRA you’ll have to wait until you turn 59½ to access the funds. But, with a little smart planning you can begin withdrawing the funds early before you leave your employment as long as you are willing to pay ordinary income taxes during on the amount you withdraw.
4. Exceptions to 59½ rule
Don’t forget that there are plenty of exceptions to the 59½ rule built up over time by Congress and explained in IRS Publication 590-B. Here are some of the common exceptions to the rule:
- Pay for medical insurance.
- Unreimbursed Medical Expenses, so long as those distributions are for expenses above 10% of your adjusted gross income (which could be easy to meet if you have no income).
- Qualified Higher Education Expenses (for yourself, your kids or your grandchildren).
- Purchasing a “first home”. The IRS considers any home your “first home” if you haven’t owned a home in the last two years. It also doesn’t have to be your first home. It can be a first home for yourself, your spouse, children, grandchildren or your parents. Could you withdraw $10,000 for your child’s first home and then receive a gift from your child for $10,000? Probably doesn’t meet the spirit of the law, but looks like it meets the letter of the law. Keep in mind that this is limited to $10,000 total.
- Inherited IRA. If you inherit an IRA, you can withdraw the money before you reach 59½ without being subject to the 10% penalty.
- A military reservist can withdraw money while on active duty without paying the 10% penalty.
5. Roth IRA contributions
You can withdraw Roth IRA contributions (but not the earnings) at any time without paying a 10% penalty. Keep in mind that if you’re making Backdoor Roth IRA contributions, those contributions are subject to the conversion rules so you need to wait five years before you can withdraw the funds. I would avoid these withdrawals if possible though as current laws make Roth IRAs very valuable to your heirs, but if you’re not planning on leaving them any money then Roth IRA contributions can be a great source for you to use today before you turn 59½.
6. Roth IRA conversion ladder
Are you a super planner? Then maybe you’ll set up a Roth IRA Conversion Ladder where you estimate your expenses five years out and slowly convert parts of a Traditional IRA account to a Roth IRA account. Once you do, and after you’ve let the contributions “season” for five years, you can withdraw the money without paying the penalty (or taxes either, since you’ll pay those the year you do the conversion).
7. SEPP (Rule 72(t) distributions)
The IRS offers another handy trick where you convert your retirement account into an annuity by agreeing to take substantially equal periodic payments based on your life expectancy. You’ll have to take these distributions for five years or until you reach 59½, whichever is longer, but in exchange you get access to all the money without having to pay the 10% penalty.
8. 401(k) loans
This is a bad idea but I didn’t say that all the ideas on the list would be good ones! If you want, you can take a loan against your 401(k). You’ll likely have to repay the loan once you leave your employer, so this option isn’t exactly helpful if you plan on retiring early. Not to mention it’s a bad deal for you as you’ll be taking your equity position out of the market and missing out on their ability to generate compound growth. However, it qualifies as a way to get access to money before you are 59½!
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He convinces the student loan refinancing companies to give you cashback bonuses for refinancing your student loans and looks forward to you discovering how easy it is to track your net worth with a free tool like Empower.