Family of Four Taking Flight to Financial Independence

You Can Access Your 401k Early (Before It's Too Late!) (Part I)

Shortcut To Penalty-Free Early Withdrawals From Your 401k (Part I)

A common question that is asked when planning for early retirement (ER) is how to access funds from retirement accounts such as a 401k.  Typically, a person is penalized a 10% early withdrawal penalty when trying to access these accounts before they turn 59 ½.  So how can you gain access to pull your 4% safe withdrawal rate from these accounts without incurring the 10% penalty?

I am going to introduce you to one of the work arounds for this which is creating a Roth IRA Conversion Ladder.  Let’s dive in, shall we?

As always, we will use the standard assumption of $1,000,000 at 4% withdrawal rate or $40,000 per year for the below scenario.  Need more information about this?  Read here.

Access Your 401k Before It's Too Late! (MFAH)

What is the purpose of a Roth IRA Conversion Ladder?

A Roth IRA Conversion Ladder will allow for a person to access funds from their retirement accounts without being penalized before they turn 59 ½.  

How do you set up a Roth IRA Conversion Ladder?

1) Work and contribute to 401k (Where we are now!)
2) Retire early and convert 401k to Traditional IRA
3) Convert portion of Traditional IRA to Roth IRA (Roth IRA Conversion Ladder)
4) Wait 5 years
5) Withdraw penalty-free!

When you retire you will roll your 401k into a traditional IRA (this is pretty par for the course).  Most people who retire at traditional retirement age (or over 59 ½) don’t have to do anything further.  They are old enough to withdrawal from the traditional IRA without being penalized the 10%.  

However, for those of us in the ER community, we may want access to these funds before turning 59 ½ without paying a penalty, and this is where the Roth IRA Conversion Ladder comes into play.  

Note, this is one of two ways to avoid the early withdrawal penalty (we will go over the other one in part 2 of this series).

An Example:

Person A plans to achieve FIRE at the age of 40 and currently has $500,000 in a taxable Vanguard Account and $500,000 that has been rolled into a Traditional IRA.  We know that they can easily take $20,000 from the Taxable Vanguard account ($500,000 *.04) but what about the additional $20,000 from the Traditional IRA? This is where the conversion ladder comes in. They can convert $20,000 from their Traditional IRA to their Roth IRA, thus setting up their conversion ladder.  However, the catch is, as shown above, they can’t touch this $20,000 for 5 years.  

How do I make up that money for the first 5 years of ER?

Option 1: You could plan to earn money through part-time work for the first 5 years of your ER to supplement the $20,000.  Once year 6 starts (and assuming you did similar conversions in years, 2, 3, 4, etc.) you can now begin withdrawing from your Roth penalty-free the amount you converted 5 years previous.  

Option 2: Another option would be to have enough cash saved up to sustain you for the first 5 years.  For our example that would equal $100,000 or $20,000 per year for 5 years.   

Option 3: Or what about a combination of the two?  Say $10,000 in part-time work and $50,000 in cash (50,000 / 5 years = $10,000 per year)?  

There are many ways to make it work, and it is definitely a handy little tool to keep in your back pocket.  

Also if you start a conversion and then end up not needing the money in 5 years that’s okay too.  You don’t HAVE to withdraw it. 

If you plan accordingly and if your cost of living is low enough (as it often is in ER) your conversions may not only be penalty-free, but they can potentially be tax-free as well!  So there you have it.  Early access to your retirement account penalty-free.  

What do you think?  Did you know about this?  Would you consider it?


No comments