Retiring early? Plan ahead to avoid early withdrawal penalties

Imagine you have diligently saved over the years, accumulating a substantial amount of money for your retirement. If you could access your funds, you would be able to work part-time or even retire early. Unfortunately, you are younger than 59 ½ and your money is tied up in pre-tax or qualified plans. 

Retirement plans, such as IRAs, 401(k)s, SEP-IRAs or SIMPLE IRAs, allow you to save money pre-tax, thus lowering your taxable income during your working years. Some plans allow you to contribute after-tax money as well. The funds in these plans grow tax-deferred until retirement age. After 59 ½ , you can begin taking distributions, paying only ordinary income tax on the taxable portion of your withdrawals. If you choose to access your money early, the IRS imposes an early distribution penalty of 10 percent on the withdrawal in addition to the ordinary income tax due. Depending on your current tax bracket, an early distribution can cost you 40 to 50 percent of your withdrawal.

While you cannot avoid paying taxes on your distribution, there are ways you can avoid the early withdrawal penalty that is levied on the gross amount of your withdrawal prior to age 59 ½ . 

Roth IRAs are funded with after-tax money, so they are more flexible than other pre-tax retirement plans. You contribute money after-tax, and the earnings grow tax free for your retirement years. Direct contributions are always accessible, penalty- and tax-free, while earnings can be accessed penalty- and tax-free after age 59 ½ . However, to contribute to a Roth IRA, your adjusted gross income must be less than $131,000 for single or $193,000 for joint filers.

How do you access your retirement money early if either you don’t have or are ineligible for a Roth IRA? It takes a little planning and five years, but it is possible. The Tax Increase Prevention and Reconciliation Act of 2005 repealed the income limits on Roth conversions starting in 2010. Therefore, many investors who were above the income limits for contributions were able to convert money from pre-tax retirement savings plans into Roth IRAs. A conversion is a taxable event, but the true benefit to a conversion is the tax-free growth potential and tax-free withdrawals in retirement. However, Roth IRAs also allow you to withdraw converted money penalty- and tax-free after it has been in your Roth for five years. 

If you know you will want to pull money out early, you could begin converting a set dollar amount each year to a Roth, paying the tax due, with funds from outside of the pre-tax account, at the time of the conversion. Roth conversions are not an all-or-nothing deal. You can do it slowly over the years, only converting amounts which you can afford to pay the taxes on. Furthermore, each conversion amount has its own five-year time period. So with multiple conversions, there may be multiple five-year periods underway at once. Earnings on the converted funds should remain in the account until age 59 ½ . Otherwise, withdrawals of earnings will incur the 10 percent early withdrawal penalty.

While early withdrawal penalties will vanish at 59 ½ , you don’t always have to wait that long to access your retirement funds. Typically, the longer funds grow tax free in a Roth, the greater the benefit should become.