In July we brought you ... You Can Access Your 401k Early (Part I), and now it is time for another option to access your 401k early (Part II). So now we bring you ...
Shortcut To Penalty-Free Early Withdrawals From Your 401K (Part II) (The version that might give you a headache (but will be worth it)).
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| Tara and our youngest got more travel shoes (Vivobarefoot). What the shoes say fits in well with our plans. Read on for the steps to access your 401k early. |
In Part I of this post we talked about accessing your 401k early (before you turn 59.5) by using the Roth IRA Conversion Ladder.
In Part II we are going to discuss what is known as the SEPP 72t. This strategy is slightly more involved (in my opinion) than simply setting up a conversion ladder and waiting 5 years to pull it penalty free; however, it does have some perks.
What is a SEPP 72t?
SEPP stands for Substantially Equal Periodic Payments. This option is a little trickier to set up than a Roth IRA Conversion Ladder, but it could prove to be worth the extra effort if your goal is to get the most bang for your buck from your retirement funds (and honestly, who doesn't have that goal?).
If you choose to use SEPP 72t as your early withdrawal strategy, you will have 3 methods of withdrawal to choose from:
1) The Required Minimum Distribution Method or
2) The Amortization Method or
3) The Annuitization Method
On top of choosing which method is right for you, you will also have to choose a life expectancy table (aka – how much longer do you plan to live?), and you may have to choose an acceptable interest rate as well (if you choose method 2 or 3 from above list).
Sound confusing? That’s because it is! But don’t write off this strategy just yet. If you are interested in learning more about this from the experts, check out this link from our good friends at the IRS. It will go into detail about each method.
Can you give me a quick overview?
Honestly, this method is still confusing to me at times, but here goes.
Step 2: Determine the withdrawal rate you want to take from your retirement accounts. This could be anything, but typically this is where the 4% withdrawal rate would come in to play.
Step 3: Get in touch with a tax professional at the firm that holds your IRA (for us this would be Vanguard) and have them walk you through each of the 3 methods mentioned above. You can then choose the method that comes as close as possible to the withdrawal that you determined in Step 2.
As an aside, I have spoken with an accountant who has worked with many early retirees and has experience with the SEPP 72t. He highly recommends Vanguard and their tax professionals when dealing with a SEPP 72t. His exact quote when he found out I would be working with Vanguard when the time came to potentially set up an SEPP 72t was, “Oh! You didn’t say it was Vanguard. You are going to love those people. They have an awesome staff dealing with this stuff.” I tend to agree.
Each method above also has different rules, so depending on which one you choose you may need to adjust your withdrawal amount every year. Your tax professional (aka Vanguard) will be able to explain this to you.
You will also have the option to change the method you choose one time, so be sure you are happy with what you pick.
Step 4: Withdraw your desired amount every year. This will also be included as taxable income in the year that you withdrawal it (whereas with the conversion ladder, you get taxed 5 years early).
Step 5: Continue with your withdrawals for 5 years or until you reach 59.5, whichever is longer (for us, assuming we retire around the age of 40 and start a SEPP 72t, we would need to continue with our withdrawals until the age of 59.5).
You are subject to major penalties if you stop withdrawals or withdrawal the incorrect amount (please don’t do this).
Pros
You can access your retirement funds now, so you don’t have to wait for five years like in Part I of this series.
You are taxed on the withdrawal the same year that you withdrawal it, thus allowing your money to grow tax free for as long as possible.
Cons
You must continue the withdrawals until you reach 59.5 whether you need the money or not. (Note, this doesn’t say you have to spend the money).
If you mess up on your withdrawals you could face some penalties (again, please don’t do this).
You have to have a tax professional help you set everything up! I know, I have this one listed twice, but that’s only because a lot of people loathe the idea of asking for help (especially when dealing with money) so this may seem unappealing to some (not to me though).
What do we plan to do?
We have another year or so before we have to decide this, but as of now I am strongly leaning in favor of using the SEPP 72t and having it set up to withdrawal around 3.5% per year. This would mean that we choose the Amortization Method (option 2 above). This will largely be determined on how easy it is to have everything set up with Vanguard. We won't know for sure until the time comes.
The main reason we are leaning towards the SEPP 72t over the Roth IRA Conversion Ladder is because I like the idea of having access to the funds right away (whereas with the conversion ladder we would need to tap into our cash account (or have side income) for the first 5 years of retirement). Personally, I have other plans for our cash account. I also like the long-term tax implications of being taxed in the same year that you withdrawal the money.
So what do you think? Do you have a headache yet? Is this strategy something you would consider?
-Erik
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