Worried that maxing out your retirement accounts will not leave you enough on before 59 1/2? Here are all the penalty-free ways to draw money from your IRA that make it almost always the right move to still max out your retirement accounts.
Over the past year and a half, I’ve gotten all sorts of personal finance questions. While I’ve gotten plenty of extremely specific questions, there are a bucket of questions that seem to get asked again and again, and it tells me it’s on a lot of reader’s minds. One of these is how to think about allocating one’s dollars between tax-advantaged retirement accounts and the more accessible, regular savings and brokerage accounts which are taxable.
The obvious advantage to putting your dollars in a retirement account is that the money can grow tax-free for many years. But the IRS has put in place restrictions as to when you can access that money, or you’ll face a hefty penalty for cashing in early. Thus the quandary.
“What if I retire at 50 and can’t withdraw any money from my IRA nest egg until I’m 59 ½? Better to put my savings in a regular account just to be safe.”
That’s the argument I hear a lot.
Here’s what I think of the issue: Assuming you already have an emergency fund, it is almost always worth maxing out your 401k or IRA before you contribute to regular accounts.
I understand the concern.
Life is long and full of surprises, and you don’t want your money locked away until you turn 59 ½, when you can withdraw your IRA money without penalties. Take money out before then, and the IRS slaps you with a 10% penalty. Ouch.
Fortunately for you, the rules around IRAs may give you all the flexibility you need. And since every 401k can be rolled into an IRA tax-free when you leave your employer, this applies to basically all your tax-advantaged accounts.
According to the IRS, you are allowed to withdraw money from your IRA before the age of 59 ½ without paying that hefty 10% penalty for the following reasons:
- Pay for qualified higher education expenses
- Take withdrawals due to disability
- Take withdrawals due to death (for your beneficiary)
- For a qualified first-time home purchase up to $10,000
- To pay medical expenses in excess of 7.5% of adjusted gross income
- As an unemployed person, to pay for your health insurance premiums
- Take early withdrawals according to three early payment plans
This is great news.
If you retire early and find you have unexpected expenses, almost all of them are covered by the penalty exceptions above.
Want to buy your first house? You can take some cash out penalty-free.
Have apocalyptic medical needs, such as an unexpected surgery? In retirement you will likely be generating very little income, so if it is a large or unexpected expense, you will likely be able to take most of it out of your IRA since the bill will vastly exceed 7.5% of your AGI.
Want to re-tool and go get a new degree? You can withdraw penalty free.
Find yourself needing to come up with cash to pay your health insurance premiums? Yep, you’re covered here, too.
Housing and health care are two of the biggest line items in any budget, and the IRS is giving you a pretty liberal pass on these two categories when it comes to early withdrawals.
And we should spend some more time talking about that last bullet.
Penalty-Free Early Withdrawal Plan
Let’s say your concern is not about an unexpectedly high expense and it’s not about health insurance. You’ve got an annual target to meet and you’re just worried that you’ll end up with too much in the retirement accounts and not enough outside of them.
Not to worry.
The IRS allows you to begin withdrawing your money before the age of 59 ½ penalty free if you follow one of three early withdrawal plans. These are known as the following:
- Required Minimum Distribution Method
- Amortization Method
- Annuitization Method
The IRS has written an explanation of each, along with example cases to walk you through how they work over here. There is another nice summary with links to a few early payment calculators over here.
The logic underpinning all of them is that you take a mortality table that shows how long an average person is expected to live, and you divide the balance of your retirement accounts across how many years you are expected to live according to that mortality table. What pops out is a number – in a couple of methods this number is static, in the Required Minimum Distribution Method it is calculated each year and so your distribution may look different year to year. That number is how much you must take out of your IRA each year. And if you do this, you will be able to withdraw the money early and completely penalty-free.
You must do this for for at least five years or until you reach the age of 59 ½, whichever is longer. After this period, you have the same flexibility to withdraw as much or as little as you want each as any retiree.
What happens if you get a couple years down the road with this method and decide it’s not for you?
You will have to back-pay a 10% penalty on all your past withdrawals from the account, but you can stop the forced distributions from your account.
All in all, not a bad setup since you still have optionality.
Worst Case: Tax-Free Growth vs. A 10% Penalty
The case is a fairly strong one already, but we should examine what would happen in the absolute worst case scenario, which is that you totally bungled it up and do in fact have too much money in your IRA accounts. For some reason the expenses you need immediate cash for are not medical in nature or for a first home or higher education. You also want the cash one time or a limited time and don’t want to go with a penalty-free withdrawal plan.
The trade-off you have essentially made is having allowed that money to grow tax-free vs a penalty of 10%. And I would argue that for most people, even if you ignored the loopholes to withdraw above and were guaranteed to have to pay a 10% penalty on all dollars in an IRA that it would still make sense to do so to allow your money to grow tax-free.
In practice, whether or not it would make sense depends on three things: 1) your marginal tax rate 2) the performance of your assets and how long you leave the money there and 3) whether you need to realize your gains by selling whatever is in your portfolio throughout the years
If you sell a bunch of stocks that have done well and use the proceeds to buy something else, you have created a taxable event. The more you do this, the more the tax-advantaged nature of the IRA helps you over the years. But even for a low-key investor who plans to leave his dollars in an index fund and not touch them for years, putting the dollars in an IRA may still put him ahead while giving him the option to switch his strategy and trigger taxable events without a hit. Why? Simply because of dividends. The average dividend payout of the S&P is a little over 2% a year, and those dollars are taxable every year even if you keep up a strategy of investing only in index funds, and reinvesting those dividends into more index fund shares.
Here’s an example below for a $1000 contribution for an investor who has a 30% marginal tax rate:
In almost any investing scenario, the tax advantaged nature is worth more than the 10% penalty.
There are certainly corner cases and specific scenarios in which it might make sense not to max out your IRA and 401k and park your dollars in taxable regular accounts instead. But for most people, the combination of exceptions the IRS has granted to withdraw your funds early, plus the advantage of not paying taxes on those dollars at work will outweigh any downside.
For one thing, you are likely to avoid paying any penalty by either making use of the exceptions for medical, housing or higher education expenses. If not, you can avoid the penalty by option for an approved early withdrawal plan. And if none of those come to pass, you probably still come out ahead paying the 10% penalty but allowing your dollars to work tax-free for years.
Max out those retirement accounts. They will serve you well.
Want To Analyze Your 401K?
If you’re wondering whether your 401K is working at its most efficient potential for you, there’s a neat product offered by Blooom. It’s a free 401K analyzer which will show you how your allocation stacks up as well as any hidden fees you are paying. It takes about two minutes to run a health check on the site. You can get the health check-up on your 401K over here at Blooom.
How do you allocate your dollars between retirement accounts and regular, taxable accounts? Do you invest with different strategies in those accounts?
Other Related Reading:
- Two Metrics You Need To Track To Achieve Extreme Wealth
- Everything You Wanted To Know About 401Ks: Choosing A Fund, Reading a Fund, and More
- 50 And Nothing Saved For Retirement: What To Do, Where To Start