The thought of early retirement can seem daunting. What with every tax-deductible government-sponsored retirement account not allowing you to remove your funds without penalty at 59 and a half and all... Right?....
Stop right there! What if I told you there was a way to withdraw your funds from your 401k and IRA earlier than at the age of 59 and a half WITHOUT having any penalties? By the end of this post, you'll know everything you need to utilize tax-deductible retirement accounts without the fear of punishment when it comes time to withdraw your contributions!
What People Know
Most people who invest in retirement accounts seem to know that the funds they put in won't be coming out for a while. As a government incentive to invest in one's future, any funds withdrawn before the age of 59 and a half (with the exception of certain emergencies and first-time home buyers) are taxed at your standard income tax rate PLUS an additional 10% penalty tax! If you're working and make an early withdrawal, this is HUGE! For example, if you're in a 25% federal tax bracket with 7% state tax, you're already losing 32% of the money you withdraw, but with the additional penalty tax you now lose 42% - almost HALF of your money! This is like taking a job, thinking you'll be paid $50,000/yr and actually only to be stiffed with a $29,000 check at the end of the year!
And even if you're retired and withdrawing such small amounts that you don't have to pay taxes (or you don't have to pay much), everything is still 10% more expensive! If you're banking on the 4% withdrawal rule with an average portfolio growth of 7% (leaving your retirement funds to appreciate at 3%) NOW you have to withdraw 4.4% for an equal amount of money while reducing your appreciation to 2.6%. That's inhibiting your wealth growth by 13.3%! At this point, if you're like me, you have to question if investing in a tax-deductible account is even worth it if you plan on retiring with your youth.
But if you're planning on retiring early, don't let this 10% penalty tax defer you from making tax-deductible investments! There is a way to withdraw your money PENALTY-FREE before the age of 59 and a half!
What People Don't Know - Clause 72t
Clause 72t is an IRA or 401k retirement account's saving grace for the individual who doesn't want to wait to retire! It states that you can withdraw your money without penalty at rates of up to 120% the federal midterm rate, using either the federal midterm rate from either of the last 3 months! This changes everything!
The federal midterm rate fluctuates and correlates to the current federal interest rate - right now the 120% may only be around a 1.63%withdrawal rate, but interest rates are low - I would anticipate interest rates rising again in the future! For those of us anticipating the rise (either now or when approaching retirement), we can capitalize on the opportunity and secure a great withdrawal rate!
This game-changing retirement account clause is incredible, but does have one catch to be aware of - you must make the commitment to withdraw at this rate for 5 YEARS! For those who plan on living on the 4% rule, this isn't an issue, but for people who are determining their withdrawal rate to match a certain dollar amount needed per month, market fluctuation could disrupt the retiree's entire financial game plan! There are several ways to combat this, but they all derive from the same concept - make sure you are withdrawing enough so that if the market does go down, you still have enough to survive! You can do this by either creating a reasonable buffer zone in your savings so that if there is a drop, your percentage withdrawal is still enough to support you OR by withdrawing at a higher percentage rate. Remember, you can always reinvest the funds you withdraw if you don't need them!
Here we can see past 13 years worth of federal 120% midterm rates. While interest rates have risen and stabilized in the past 3 years, there has been lots of talk of raising it more actively now that the economy is believed to be stable. China's economy issues have slowed this raise, but it will happen! This will drive the midterm rate up, back towards the 4% mark - which is what I use to calculate my retirement plans!
Tax deductible retirement accounts are certainly appealing when you can hide away up to $23,500 of income away from the IRS! If you plan on retiring early, make sure you consider the impact clause 72t has when choosing which account to invest in - utilizing it should add some value to investments in tax-deductible retirement accounts! Also, if you didn't make an IRA contribution for 2015, it isn't too late to catch up! This year, 2015 IRA catch-up contributions will be accepted until April 18th!
Readers, do you feel confident enough in the government to let them determine the maximum rate you can withdraw without penalty? Do you sacrifice the benefits of tax-deductible investing for the freedom to access your funds anytime you like?