More and more these days, I sit across from clients who have worked 25+ years at a big oil/gas company where they have saved aggressively to their company sponsored plans and invested wisely. They have reached a point where they are a decade ahead of schedule in terms of retiring. The desire to retire is there, but being so far ahead of schedule often leads to the question of, “How do I access my retirement savings without getting crushed by penalties?”
It’s a legitimate concern to have. For many early retirees, we find that the bulk of their wealth is tied up in 401(k) plans and IRAs, which are designed to not be touched until age 59 ½. With the exception of specific circumstances, accessing those funds early will trigger a 10% early withdrawal penalty on top of the ordinary income taxes you’d pay for the withdrawal. For example, if you’re someone in the 22% bracket, any additional dollars you pull out could mean a 32% to 34% hit on your taxes. So, if you withdraw $100,000 dollars that would be the equivalent of a $66,000 – $68,000 net withdrawal.
Withdrawing Funds (Early) Without Penalty
Now here is what many people miss or overlook: the IRS has carved out multiple penalty-free pathways for accessing retirement funds early. This is where we step in, helping you identify the option that best fits your situation. This could be the difference in a clean exit from the workforce or a costly, avoidable mistake.
The Rule of 55
If you leave your employer in the year you turn 55 or older, whether through retirement, layoff, or a resignation, then you can take distributions from your employer’s 401(k) without incurring the 10% penalty. This is called the Rule of 55, and it applies only to the plan of the job you just left from. It does not apply to old 401(k)’s from a previous employer nor does it apply to IRAs.
The rule is particularly powerful for clients in their mid-to-late 50’s who are ready to walk away from their job. The key is not to roll that 401(k) into an IRA the moment you leave, as doing that would eliminate access to this exception entirely. In real life practice, I had a client retire from a major oil/gas firm at age 56. In this scenario, all their retirement assets were pre-tax assets which included their 401(k) and lump sum pension from the company. They did receive a year’s worth of severance as well. So, we had to answer the question of how do we bridge their income from 57 to 59 ½ without incurring the 10% penalty. After many conversations and mapping out a worst-case scenario, we ended up leaving five years’ worth of expenses in the 401(k) and consolidating the other assets into an IRA so they could still have access without penalty. By doing that, we bridged the gap they needed while leaving a substantial buffer in place for any emergencies that could arise.
SEPP or 72(t)
For clients who are retiring a bit earlier and have a majority of their wealth in 401(k) or IRA, you can use a strategy called Substantial Equal Periodic Payments, known as SEPP or the 72(t) rule. This provision allows you to take a series of calculated, equal payments from your retirement account for the greater of five years or until you turn 59 ½. For example, if you start at 45, you’re committed to making these series of payments until you’re 59 ½ . Now on the flip side, if you are 56 then you are committed to making payments for 5 years until 61. You may be asking yourself, well then why would I not just use The Rule of 55? It’s because everyone’s situation is different and the SEPP rule allows you to pull from either an IRA or 401(k). For example, if you’re 56 and left an employer and have a large IRA balance and a smaller 401(k) balance, then the SEPP strategy might be a better strategy for you.
The other question is, how much money can I access utilizing SEPP? The IRS allows three calculation methods: the Required Distribution Method, The Fixed Amortization Method, and the Fixed Annuitization Method, with each of them producing a different annual payment. While you are getting access to your funds early, the tradeoff is rigidity. If you modify the payment schedule before your term ends, the IRS will impose the 10% penalty retroactively on everything you’ve already taken out, plus interest. This is not a strategy to enter casually.
Planning for Early Retirement
If early retirement is on your horizon, the time to plan is not the year before you leave. I start working with clients five to ten years out because these strategies require careful thought. The SEPP requires a commitment that lasts years and the Rule of 55 hinges on a specific sequence of events tied to your departure date.
At the end of the day, the 401(k) was designed with age 59 ½ in mind, but there are exceptions. If you are looking to retire early, I’d encourage you to speak with an advisor to help you plan carefully. It may be that those exceptions can work favorably for your specific situation, and fund a life well-lived, years ahead of schedule.
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