Thinking About Retiring Early?

Thinking About Retiring Early?

April 09, 2024

When helping my clients build a financial plan our discussion is typically focused on two things: What they want to do in retirement and when they will be able to retire. The answer to the first question is usually a qualitative one, namely things like where my client’s will live, what hobbies they will pursue, and whether they will travel or not. The answer to the second question is quantitative; when will they actually be able to retire and what income will they need when they get there? To solve this question, we need to consider things like social security, pensions, and annuity income. Withdrawals from retirement accounts also play a big role in if/when an individual can retire. This becomes important specifically when a client tells me that they would like to retire early.

What it means to retire “early” means different things to different people but generally speaking it means to retire before you are able to receive social security and take penalty-free retirement account withdrawals. The minimum social security payment can begin at age 62 however, withdrawals from retirement accounts are typically penalized by the IRS if they are taken prior to age 59 ½. This obviously presents some challenges for the individual who would like to retire in their early 50s as all of their income would need to come from retirement accounts which presumably would be assessed IRS penalties in addition to any taxes owed upon withdrawal. Thankfully, there are a couple of rules in place that can help alleviate that problem:

 

Rule of 55

                This rule allows individuals who retire at age 55 to begin taking penalty-free withdrawals from their employer sponsored retirement plan such as a 401(k) or 403(b). This rule only applies to people who retire between the ages of 55 and 59 ½ and stipulates that the withdrawals must be taken from the plan sponsored by the company that the individual was employed at when they retired (i.e., other 401(k)’s and IRAs are not included in this exception).

Because of this, the funds need to stay in the employer sponsored plan in order to remain eligible for the Rule of 55. If the funds are rolled into an IRA, then they are disallowed from this favorable IRS treatment. Lastly, if you begin taking withdrawals utilizing the Rule of 55 and then later take a part-time job, you are still allowed to continue taking penalty-free withdrawals from your prior employer’s plan. It is important to note that this IRS penalty exception does not exclude the withdrawals from any applicable Federal or State income tax.

 

Rule 72t

                What if you are younger than 55? What if you want to retire at, say, age 50? Is there any way to avoid IRS early withdrawal penalties in that scenario? Through Rule 72t this is a possibility! First and foremost, Rule 72t does not require you to have met a certain target age in order to begin taking penalty-free withdrawals. Additionally, under the rule, withdrawals from both employer sponsored plans and IRAs are eligible for exception from the IRS penalty. However, like the Rule of 55, you must be separated from employment if you desire to take distributions from an employer plan.

The key difference between the two rules is that Rule 72t requires what are called substantially equal periodic payments (SEPP). To put it simply, once you begin taking penalty-free withdrawals under Rule 72t, you must continue taking them for at least 5 years or until age 59 ½, whichever is longer. As the SEPP acronym would indicate, these distributions must be of the same dollar amount and taken no less frequently than annually. The amount of the periodic payments is not up to your discretion, however. The IRS provides three different methods (which you can learn about here) for calculating your SEPP payments based on your life expectancy.

Consider an individual who is 52 years old and has decided to retire. If this person decides to take penalty-free withdrawals under Rule 72t, they will need to take substantially equal periodic payments for 8 years or age 59 ½. Consider another scenario where an individual decides to retire from their most recent job at 57 years old. You might think that this person could utilize the Rule of 55 however, for the sake of example, let’s say that the individual worked for one company for the majority of their career and accumulated a large 401k balance but then took a new position with a new company and a different 401k plan at age 54. Under the Rule of 55, they would be able to take penalty-free withdrawals from their most recent employer’s 401k plan but not their prior employer’s plan (assuming they did not rollover that account to the new plan which is quite common). In this scenario, Rule 72t would allow them to take penalty-free distributions from both plans however they would need to take those distributions for at least 5 years or age 62 (which coincidentally is when they could start receiving social security). Whatever the case may be, Rule 72t is not unlike the Rule of 55 in that it does not allow you to avoid paying income takes on your withdrawals. Both of these rules only allow you to avoid the early withdrawal penalty on withdrawals made before age 59 ½.

 

When deciding when to retire, it is important to understand all of your options. The Rules of 55 and 72t put another arrow in your retirement plan quiver, adding flexibility to the timing of your eventual retirement. As always, I would encourage you to seek out the advice of a trusted advisor prior to implementing either strategy or any other financial plan for that matter. Thank you again for taking time to read our blog! As a thank you, here is your song of the week! Enjoy!

Song

This blog was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this blog.