Are you thinking of retiring early and want to know how you can withdraw your money penalty and tax free? Don’t listen to the fear-mongering that uncle Sam will penalize you for retiring before 59 1/2. For most, the opposite is true. Early retirement will not only reduce your tax burden; it can even eliminate it all together.
If you are an early retiree, or thinking of becoming one, you can follow several paths to access your hard earned retirement funds. For most, this undoubtedly leads to a lower tax burden than you had in your working years.
Only 3 potential paths however can be tax and penalty free.
- Brokerage Method
- Roth Conversion Method
- SEPP Method (Substantially Equal Period Payment Plan)
Below, I will give a short overview of the process you must follow for each method and provide the pros and cons. I will also lay out the exact amount of tax free money you can withdraw in your early retirement years in each method.
Note: If you want to estimate how long your own specific financial assets can potentially last tax free, click here for the Secret Life of FI Tax Free calculator.
Brokerage Method
A brokerage account as you likely know by now is an investment account similar to your 401K, except you fund it with after tax money. While you are earning an income, your brokerage account will provide quarterly dividend payouts that will be taxed as income.
However, once you are early retired, you can withdraw up to $83,350 (married filing jointly) in capital gains tax free. Yes, you heard that right: tax free. Even better, that income limit is just on the gain of the asset you sold. As an example, it’s possible to withdraw say $200K tax free in a single year, as long as the gain is $83,350 or below.
Obviously, to retire early and live off brokerage only until you are 59 1/2, you will need a sizable brokerage. The number will depend on how many years of early retirement you are planning, the size of your brokerage, and your living expenses.
Let’s illustrate an example. Say you wanted to retire 10 years early, and your annual expenses are $50K a year. At an expected stock return of 8%, you would need at least $350K (~7x your annual expenses) invested in your brokerage to retire early, and have that tax free money last for 10 years.
Here is a graphic that shows the length of time the brokerage will last.
Pros: this method is easiest to execute and the most flexible. You can withdraw without penalty at any time.
Cons: saving up a brokerage of this size will require (1) a higher salary (2) or low annual expenses (3) or time in the market. If you are focused on maxing out 401K in your wealth building years (and you should be), you may not be able to contribute enough or as early to your brokerage to build a nest egg to carry you through a long early retirement.
Roth Conversion Method
The Traditional IRA to a Roth IRA conversion method (sometimes called a Backdoor Roth) will/can provide even more tax free funds in early retirement than any other method, but this may require you to also have a brokerage that you can live off for 5 years. This is because you cannot access your Roth until a 5 year waiting period.
What’s that you say? “F**k yeah, I’ll just convert my entire 401k/IRA to a Roth and have all my funds tax free in 5 years?”
Not so fast, cowboy. Tons of FIers rightly recommend this method but may gloss over some fine print. Two items you absolutely must first understand:
- After 5 years but before 59 ½, you can only withdraw the exact amount you converted to the Roth tax/penalty free. You can’t touch any of the earnings penalty free until 59 ½.
- You will be “taxed” on the amount you convert to the Roth like regular income
Alright Mr. FI, you say, cut to the chase already. Tell me exactly how to manage Roth conversions to be tax free.
It’s actually more simple than most financial gurus make it out to be. You convert up to the standard deduction on your taxes ($25,900 married filing jointly) every year until you are 59 ½, sometimes called a Roth conversion ladder. Depending on how long your brokerage lasts, over 15 years you could create nearly $700K in tax free retirement funds (assuming an 8% ROI), all tax free in this method by converting just $25,900 every year.
The below graphic lays out how this method works with precise dollar amounts you can access tax free per year.
Pretty sweet, isn’t it? Not only do the yearly Roth conversions give you a significant amount of available tax free funds to access at 5 or more years in the future; those funds also produce yearly earnings with compounding interest, giving you significant sums of money you can also withdraw tax free at 59 ½.
Just how much does the Roth conversion ladder extend an early retirees faucet of tax free money? Let’s revisit the earlier example of the retiree with $50K in annual expenses with $350K in brokerage, that allowed her to retire 10 years early on tax free funds.
Let’s make a slight change. Let’s suppose our early retiree wants to retire even earlier at the age of 44 but still only has the $350K in brokerage we examined in the first example, which we estimated to last 10 years.
In the Roth method, instead of living purely off brokerage, now our early retiree also converts $25,900 from her IRA to her Roth every year for 15 years, like we laid out above. In doing do so, her tax free retirement years grow significantly, and she is able to shave years off her working life.
See the results of this method below, where the red lines (Roth base + earnings) represent the growth of tax free funds via Roth conversions created over 15 years.
Absolute insanity. Instead of running out of brokerage money in 10 years (yellow line), our hypothetical early retiree still has nearly $350K in tax free Roth money (base and earnings are the red lines). That’s the same amount of tax free brokerage money she started with 15 years ago!
At an ROI of 8%, that $350K of tax free Roth money could last our retiree another 10 years before she even has to touch her 401k/IRA.
Pros: It should be obvious. Since Roth base amounts can be accessed after 5 years, this method creates more accessible early retirement money than the brokerage only method. Coupled with a moderate brokerage account, 15 years of Roth conversions at $25,900 a year could potentially create 25 years of tax free funds.
Cons: Same as the brokerage method. You will need a brokerage account large enough to last at least 5 years (unless your employer was one of the few that offered an after tax 401K that you contributed to and converted to Roth while you were still working). Additionally, you cannot touch Roth earnings until 59 ½, so you will need to plan your withdrawals carefully to avoid the tax man.
SEPP Method
FIRE gurus have generally considered the SEPP the least desirable method, as it is less flexible, less predictable (using RMD), requires a tax professional to set up, and/or may provide less or more of the actual funds you want to be able to withdraw.
However, the IRS changed the rules in 2022, making the SEPP much more attractive.
With these changes, we now have the option of choosing an interest rate between 0 – 5% to withdraw from an IRA using the amortization method. With this flexibility, we can setup the SEPP to yield exactly $25,900 yearly in early retirement.
Your specific particulars will depend on at what age you setup the SEPP, the amount you have in your IRA, and which of the 3 SEPP methods you pick to calculate your payment.
Fret not, with the ability to pick your interest % to withdraw yearly, you can precisely nail this down to create a tax free income stream.
Let’s go back to our 44 year old retiree for an example. Instead of converting to Roths yearly when she retires, she could access $25,900 through a SEPP by transferring $460K of her IRA/401K to a new SEPP IRA, and setting up the SEPP with a 5% interest rate.
Doing so will give her the following tax free funds to draw on yearly.
Pros: Setting up an SEPP plan allows early retirees immediate access to their funds. With an SEPP producing yearly income, you can retire early with a smaller brokerage nest egg and stay tax free.
Cons: There are several drawbacks. Those most relevant to a tax free early retirement are below:
- SEPPs can be complicated to setup and will require a tax pro.
- SEPPs can only be adjusted one time over the life of the SEPP if you screw it up.
- Once started, you must take the SEPP payments until you are 59 ½ or for 5 years, which is longer, or you will face steep penalties.
- If you retire with no brokerage or no Roth, your SEPP withdrawal might incur a small IRS bill if your annual expenses exceed your tax write off. Keep in mind, you can only withdraw potentially up to your standard tax deduction ($25,900 married filing jointly) before the tax man wants his cut. If your expenses are going to be significantly higher than this, I would recommend contributing to a Roth and/or brokerage as you build your retirement nest egg to create supplemental tax free income to your planned SEPP.
Final Thoughts
So what tax free early retirement plan is best? It depends on how early you retire, your annual expenses, and your assets, particularly those that are after tax (brokerage and Roths).
Clearly the brokerage only is the most flexible and can produce the most tax free income, but it requires the highest saving rate outside 401k to put in place.
Roth conversions are the most recommended in the FI community, but be careful with the fine print. Many great and well intentioned FI Bloggers put in fine print what Secret Life of FI is printing in bold: you can’t touch Roth earnings until 59 ½.
If the math works out that you can hold off on the earnings, then a Brokerage coupled with Roth conversions is probably the best and most flexible method to retire early.
SEPP is best for those who achieve FI on IRA/401k only. This may come with a tax bill depending on your annual expenses and if you can’t supplement with a Roth/Brokerage.
One final note. Keep in mind that all of the above methods assume a married filing jointly early retirement, which doubles the amount of tax free money you can withdraw. If you have been following Secret Life of FI, then you know marriage (especially with a second income earner) is the top recommended step to achieving FI early in life. Marriage also doubles the amount of tax free money you can pull out of your brokerage or IRA/SEPP.
In the comments: are you planning to be (or perhaps already) early retired? If so, what accounts did you setup to create the bridge funds until you are 59 ½?