Logistically speaking, how would one retire early without getting hit with withdrawal penalties?

As far as I know, most tax-incentivised retirement accounts slap you with penalties for making withdrawals before retirement age.


Let's assume that I am 40 years old and have enough money in my 401k and Roth IRA to retire. I want to retire and live off of the growth of these funds. How would I make withdrawals from these accounts without incurring penalties?

I've seen plenty of guides on early retirement (FIRE), but I can't find material on actually retiring early.

  • Might be worthwhile having a sit down with a financial planner to work out a detailed plan factoring in tax load. – Myles Oct 10 at 20:28
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    One reason why you don't see a lot about this is because it is really difficult to get that much into tax-incentivized accounts at/before 40, since they generally have contribution limits. Usually the people who manage to do so also have other resources outside of those accounts (for a comfortable early retirement at 40 on just IRA+401k, you would roughly have to contribute the maximum every year from 15 years old onward--which is hard to do if you're not already wealthy anyway!). – user3067860 Oct 10 at 21:28
up vote 12 down vote accepted

The most common method for early retirement from IRA/401k is to use a Roth conversion ladder optionally combined with taxable accounts. With a Roth conversion ladder you would start 5 years before your planned retirement and convert a years worth of expenses to a Roth IRA each year. Then on year 6 you can withdraw what you converted 5 years ago because it is 'seasoned'. Basically you avoid the early withdrawal penalty by paying taxes on and waiting 5 years and by doing it every year you can put together a ladder of converted money that can be used penalty free once you retire.

Some notes:

  • Many people plan to simply use taxable accounts for the first few years before starting the ladder because the converted 401k/IRA money adds to your taxable income and can push that money into a higher tax bracket.
  • Tax brackets are the same reason you wouldn't want to convert all of your money in a given year.
  • There are other methods like 72(t), but it is much more complex and as I recall they lacked flexibility
  • For folks in lower tax brackets (0% cap gains bracket) taxable accounts with tax efficient re-balancing are also a valid option.
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    This should be the accepted answer, this is the approach most early retirees take right now. The Roth conversion ladder is far more flexible and beneficial than 72(t) withdrawals. – enderland Oct 11 at 8:42
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    I have heard this option mentioned, but cannot find it in any official documentation. Can someone cite an official source like the IRS website? – Benjamin Cuningham Oct 12 at 14:36
  • @ElysianFields - I am always happy to see multiple options to solve a problem. The Sec 72(t) might be less flexible, especially for a very young retiree. On the other hand, the Roth ladder requires 5 years of stacking a conversion on top of one's current income. e.g. A couple with $100K taxable converting $40K would pay an extra $8800 in tax for the 5 years of this plan. Sec 72(t) withdrawal of a taxable $40K would be $4419, just half that amount. That said, I'd still agree that a mix of the two plans is probably better than either just one. – JoeTaxpayer Oct 12 at 20:32
  • @JoeTaxpayer anyone who is planning on retiring early enough that either the 72(t) or Roth conversion ladder is relevant has a lot more options, though. Roth principle, simply paying a penalty on 401k early withdrawals, taxable, etc. Most people who retire early enough for either of these to matter also don't have $140k in income, either. The reality is that there are a lot of pieces to this puzzle but the conversion ladder is one that most people use, because it literally can make your entire retirement tax free. If your early retirement is going to be very spendy, things change a bit. – enderland Oct 13 at 7:07
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    I really ought to just write an answer here... :) – enderland Oct 13 at 7:16

There is a provision for this. It’s called Sec 72(t) and it permits you to take annual withdrawals according to your age, for 5 years or until age 59-1/2 whichever is later. Tax is due, but this avoids the 10% penalty.

Note - while not really part of the question, you should be aware that the 401(k) withdrawal has a fixed 20% withholding for taxes. Depending on your situation, this may set you up for a large refund. Better to use the IRA for withdrawals where you can adjust the tax withheld.

Edit - in response to the comment. By breaking the funds into a number of accounts, one can choose to tune this process to a sum to give a minimum amount that makes sense, e.g. $24K/yr which for a couple is the standard deduction, no tax due. Of course, a mix of pre and post tax money would probably be best.

You are assuming that the funds saved for your retirement must all be in specific tax accounts at the outset.

First of all, you should be wary of the difference between your investment portfolio (ie: which stocks/bonds/etc. you invest in), and the investment 'vehicles' that you use to make those investments (ie: 401k vs IRA etc.).

This distinction is especially important when reading information online, which may not be based on your jurisdiction, and therefore won't incorporate the tax concerns you may be having.

Whether any of this matters to you will depend on how much you have already invested through 'tax deferred' vehicles (not all of which penalize you for early withdrawal).

If you have a specific question about your specific financial situation + goals + tax jurisdiction, you should ask that separately.

The Section 72(t) and the Roth IRA conversion ladder are the two methods I've heard of for USA residents

I follow several early retirement blogs, most of which ignore this issue. The one that deals specifically with advice regarding tax advantaged accounts is the MadFientist

His article on this subject provides more detail for further reading, as well as example scenarios of each https://www.madfientist.com/how-to-access-retirement-funds-early/

He also does the math comparing the above against paying the 10% early withdrawal penalty.

In his example, the math demonstrates the 10% early withdrawal penalty is an affordable expense in certain situations only loses out slightly against a conversion ladder or a Section 72(t)

Example graph: https://www.madfientist.com/wp-content/uploads/2016/07/early-withdrawal-strategies-graph.jpg

Definitely review the examples and run the numbers for your situation

  • The linked articles reference the 10% and imply it's not awful, but never really run the math. When one has a 12% (for example) marginal rate, bumping to 22% to include a penalty seems pretty awful to me. – JoeTaxpayer Oct 10 at 20:38

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