How to Access Your 401(k) Money Penalty-Free

How to Access Your 401(k) Money Penalty-FreeThe majority of my net worth is tied up in my 401(k).  The reason, if you remember, is that my employer gives me an unlimited 35% match on my plan. This makes it hard to pass up the free money. However, it makes it a lot harder to get to that money when retiring early.

When I was younger, I really just planned on having millions… being rich would just carry me into retirement.  However, after digging more into things and looking at guys like Mr. Money Mustache, I realized I don’t need millions to achieve financial independence.  I just need enough to have more money coming in than going out.  And that money needs to last pretty much until I’m gone.

I’m definitely not as frugal as Mr. Money Mustache, but I’m not a big spender either.

That said, I plan on having some rental income coming in once I stop working.  However, if I’m going to make my early retirement plan work, I’m still going to need some of that 401(k) money.

But the government is pretty strict on encouraging you to keep your money in your retirement account until you’re old.  As expected, you have to pay federal and state taxes on the money coming out, but if you’re younger than 59½, you also have to pay an early withdrawal penalty of 10%.  Ouch!!  You might think that 10% is just the cost of doing business, but that’s really a large amount of your plan.

My 401(k) should be well over $1 million if I keep going at the rate I am for the next ten years (this doesn’t include my wife’s plan).  $1 million sounds like a pretty solid number, but like I’ve mentioned before, you tend to forget about the taxes part so you’re already losing a very good chunk of that amount already.  But a 10% penalty would be $100,000!!! Gone and for nothing.

And, in a lot of cases, that hurdle can be a good thing.  If it was easy to get your hands on that money, a lot of people might pull it out for what they consider important, but could cause them to lose everything they have saved and possibly be penniless in retirement.

However, we’re not your regular retirement folk and have a real and legitimate plan.  Losing an additional $100,000 would be really detrimental to the route to retire early.  So what can be done to get that money out?

I’ve looked at a few options and there really aren’t a lot of choices…

1) Cash Out and Pay the Penalty

Like we’ve just discussed, that’s the easiest option but will cost you a large part of your near egg.  Not a good option for us.

2) Rule of 72(t)

This is a pretty interesting option and can work for you if you need to start withdrawing money in a short order of time but don’t need the whole thing all at once.

The way it works is that you can start withdrawing a specific amount each month (here’s a calculator to show you how much you can take out).

However, once you start the withdrawals using this method, you’re now committed… you must continue to pull out that same amount every month for a minimum of five years until you’re either 59½ or until your 401(k) funds are depleted.

This can pose a problem if you pick an amount that’s either too large or too small.  If the monthly amount is too large, you run out of money too quickly.  If the amount is too small, time will crush you with inflation and now the amount you chose might make it hard to cover all your expenses.

I considered this option, but I really hate to be locked in with no control to change things as needed.

3) Roth IRA Conversion Ladder

I’ve saved the best for last.

After a lot of digging, I came across a method called the Roth IRA Conversion Ladder.  In a nutshell, the government lets you take money from your 401(k) and move it to a Roth IRA.  After a five-year waiting period, the money that you converted is now considered a contribution.  If you remember from my Roth IRA post, contributions to a Roth IRA can be withdrawn at any time with no penalty… thus skipping the 10% penalty of the 401(k) plan.

Now, obviously you need to pay taxes when you do the conversion, so if you converted it all at once, you would get hit with a pretty big tax bill.

This is where the “ladder” part of the plan kicks in.  To make this more realistic for the tax man, you convert an amount that you’ll need for year one (five years from the time you make the conversion).  You then pay taxes on it and wait.  The next year, you convert an amount probably slightly larger for year two (to account for inflation) and pay taxes again.  You do the same for every year until your 401(k) is emptied.

After the first five years pass, you can now withdraw the first year conversion amount from your Roth with no more taxes to pay on it (you already did that) and no penalty.  You do the same every year thereafter.

On the plus side, you’re not required to withdraw from the Roth, so if you don’t need the money, it can continue to grow in your Roth until you do need it.

You’ll also be paying taxes based on your current tax bracket, so hopefully you’ll be in a good position to not have to pay a high percentage.

The downside is that you’re paying taxes for five years on money you can’t touch, so make sure you’ve got things in order so you can cover that.

The Roth IRA Conversion Ladder is something that will help me to retire early without getting dinged.  I hope it might be good information for you as well.

Although 100% legal, all of the methods above need to be very carefully planned and executed.  Get a tax professional involved to make sure it’s done right.

Let me know what you think and thanks for reading!!

— Jim

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2 thoughts on “How to Access Your 401(k) Money Penalty-Free”

  1. After initially selecting either the annuitization or amorization methods (these give the highest payouts) when doing 72(t) withdrawals, you can make one change during the withdrawal period to the RMD method, which is the lowest payout method.

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