How to Hack your 401k Withdrawal Penalty
Reader question: Can I use my 401k to retire early and avoid the 10% 401k withdrawal penalty? – Jesse, Boston
Yes it is possible to use your 401k to retire early, but it requires a little bit of 401k “hacking”. I actually planning on using the following strategy outlined below when I turn 35 and plan to take break from working for awhile. Most Millennials who are working corporate jobs likely have access to 401k plans and they are definitely the best way to stash away money for retirement. The benefits are widely stated – you can put money in before having to pay taxes on it (you only pay when you withdrawal the money) and most employers offer a matching contribution (so they put additional money in for free).
You should put as much money into your 401k as possible as soon as you can. As of 2015 you are able to contribute up to $18,000 per year (try as hard as you can to hit this number). The more you can put in the more it can grow over time – this is your single biggest retirement savings opportunity. If you can make a sacrifice in your lifestyle now your future self will thank you. Over the past 5 years I have put in the max into my 401k and the money has grown considerably. Also remember that you don’t have to pay taxes on this money so it makes your income looks smaller to the IRS.
But there are a number challenges with 401k’s:
- They typically have much larger fees than other types of retirement investments
- You have limited investment options – you are restricted to investing only in the funds that are available in your employer plan unlike a Roth IRA where you can choose your own investments.
- You are penalized 10% if you take the money out before you are 59.5 years old (that’s a long time from now)
Given all of these challenges how can you use your 401k to retire early?
5 steps to withdraw 401k funds without paying a penalty
There are number of ways to “hack” your 401k so you don’t have pay an early withdrawal penalty but most are geared towards people who are going to stay in their current job and not leave their job. One common method is to take a loan from your 401k, but this article is about how to avoid the penalty if you leave your job, not keep it. So if you are a Millennial and want to retire early using your 401k your options are much more limited – but there is still a solid “hack” around the penalty, but it is not well known.
The most effective way to use your 401k to retire early is to set up what are essentially regular IRA payments to you known as SEPPs (substantial equal periodic payments) – which are essentially continuous withdrawals that can be taken without a penalty. It is important to note that even though you don’t have to pay the 10% penalty using this method you will still be required to pay taxes on the withdrawals based on your current tax bracket at withdrawal (standard for any Traditional IRA distributions). This might seem complicated at first, but it’s actually relatively easy once you understand the fundamentals of how it works.
1. Convert your 401k into an IRA
When you leave your job and are ready to “retire” convert your entire 401k plan into a Traditional IRA (individual retirement account). Unfortunately you need to convert your 401k into a Traditional IRA instead of a Roth IRA because you haven’t paid taxes yet on the money (remember money went into your 401k tax free).
2. Set up an SEPP plan to take penalty free 40k withdrawals
Once it’s in an IRA, you are legally allowed to set-up and take what is noted in the tax law as “substantially equal periodic payments” or SEPPs from the IRA that you just created using your 401k. The only way for this to work is that you have to continue to take these equal withdrawals for 5 years or until you turn 59.5 (whichever is longest). So for most Millennials this will be until you are 59.5 and not the 5 years. This can be a long time, but will eliminate the typically imposed 10% 401k early withdrawal penalty. It is important to note that you are only required to take 1 withdrawal per year.
3. Calculate your payments
After setting up and SEPP you need to figure out how much money you need to take out each year.
Here are 3 IRS approved ways to calculate your periodic payment amount:
- Required minimum distribution (RMD)
- Fixed amortization
- Fixed annuitization
For young investors who want to retire early a good way to calculate what distributions you should take is to take your age (mine is 30) and subtract it from 59.5 (so for me it is 29.5 years). I need to divide the total value of my new IRA by 29.5 to determine how much I should withdrawal. This can get a little complicated and I recommend that when you are planning to set these up just call the company that holds your IRA and most will be able to help you determine what the best payment strategy for you should be. I recently called Vanguard, which is where I hold my own investments and they were able to easily to connect me to someone who could help me calculate what my own withdrawal could be based on my current IRA investment.
4. Split your IRA account to isolate funds for withdrawal
Some tax professionals recommend that to make this easier you actually should split your IRA account so that one portion of it just holds your planned payouts – so then your other IRA investments can continue to grow separately. This is what I personally plan on setting up – putting my planned withdrawals into one investment in my IRA and then the longer term growth money into another investment type (both can live under the same IRA account). So then the equation becomes: convert 401k into an IRA, then split the IRA so one part contains your planned payments/withdrawals and the other your growth investments.
5. Continue to invest in your IRA when you can
It goes without saying that you should try to leave your 401k and IRA money untouched as long as possible – so even if you want to retire early leave your investment accounts alone if you can. Also note that throughout this entire distribution period your investments will continue to grow in your IRA even though you are taking distributions. I personally plan on both taking distributions and adding to the IRA account during this time period so I can actively use money in my 401k as needed in my early-retirement.
To learn more about this 401k “hack” to avoid the early withdrawal penalty check out the IRS page on SEPPs.
Please remember that I am not a tax planner or financial advisor – this is simply part of my own personal plan that I intend on using to retire early. Everyone’s own personal financial situation is unique so I encourage you to consult a registered and licensed tax professional to discuss your own SEPP plan. Let me know if you have any questions in the comments and best of luck using your 401k to retire early.