Monthly Archives: April 2024

One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.

Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone). 

My response: Oh, heck no! 

Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.

The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.

Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options. 

Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon. 

Taxable Accounts

The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning. 

Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!

But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy. 

Spending taxable assets first tends to limit taxable income, which can open the door to (1)  a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement. 

There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion. 

Cons: To my mind, there are few cons to this strategy in retirement. 

The one con in the accumulation phase is that when we choose to invest in taxable accounts instead of in traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.

Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some. 

Inherited Retirement Accounts

Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.

Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate. 

Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth. 

Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.

Rule of 55 Distributions

Rule of 55 distributions are only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. 

This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit. 

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. 

Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).

Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Limited availability as one must separate from service no sooner than the year they turn age 55. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.

Governmental 457(b) Plans

Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉

Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.

Roth Basis

Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement. 

Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½. 

Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions. 

Creates income for purposes of the FAFSA. 

Ideal For: Those with significant previous contributions and conversions to Roth accounts. 

72(t) Payments

I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.

Pros: Avoids the early withdrawal prior to turning age 59 ½. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses. 

Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.

There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges. 

They are somewhat inflexible. That said, if properly done they can be either increased (by creating a second 72(t) payment plan) or decreased (via a one-time switch in method). 

Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans. 

HSA PUQME

Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s. 

Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½. 

Does not create income for purposes of the FAFSA.

Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.

Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.

We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Ideal For: Those with significant HSAs and significant PUQME. 

Net Unrealized Appreciation

Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate. 

This opportunity usually requires professional assistance, in my opinion. 

The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock. 

Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket. 

Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly. 

Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.

It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.  

Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post. 

Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan. 

Pay the Penalty

The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.  

Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops? 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done. 

Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion. 

Combining Methods to Access Funds Prior to Age 59 1/2

For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.

Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year. 

Conclusion

Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.