Q. I am tired of practicing. I want to retire early. I have done a good job saving and investing and am stepping that up so I can have enough by age 55 to support my needed retirement income. How can I get to my money without paying the 10 percent penalty for withdrawing before age 59½?
Explore This IssueACEP Now: Vol 40 – No 02 – February 2021
A. Many doctors dream of retiring from the workforce before the traditional retirement age of 60 to 70. Most of them cannot do it because they spend too much, did not save enough, and did not invest wisely. They simply do not have the resources to retire at their desired standard of living without additional savings, a few more years of compound interest on their investments, and perhaps even the additional income from Social Security.
The select few who do have the resources to retire earlier than that worry about the age 59½ rule. This is a rule that applies to retirement accounts like traditional individual retirement arrangements (IRAs) and Roth IRAs. At its most basic level, the rule says that if you withdraw money from an IRA prior to age 59½, you will not only owe any taxes due but also face a 10 percent penalty. However, this rule should never prevent someone who is otherwise able to retire prior to age 59½ from actually doing so for a number of reasons.
First, anyone who saved enough money to be able to retire before age 59½ probably was not able to fit all of their savings into their available retirement accounts. They likely also have a sizable taxable account from which money can be withdrawn without any penalty simply by paying any long-term capital gains taxes that are due. Those taxes, of course, only apply to the gains; the principal comes out tax-free. Generally, the earlier you retire, the larger the ratio of your taxable accounts to your retirement accounts will be. So you can simply live off the taxable assets until you turn 59½ and then tap into the retirement accounts. Spending taxable assets first is generally the best move anyway as it allows your retirement accounts to continue to benefit from the tax and asset protection offered by retirement accounts for a longer period of time. Taxable assets also create their own income, whether that be qualified dividends from mutual funds, interest from certificates of deposit or bank accounts, or rents from income property. These sources of income can be used to cover your retirement expenses instead of being reinvested.
Second, many types of retirement accounts are not subject to the age 59½ rule. For example, many doctors are eligible for a 457(b) account, a type of deferred compensation. While the distribution rules in every 457(b) are different, you can often access this money penalty-free as soon as you stop working. 401(k)s and 403(b)s have an age 55 rule where you can withdraw from them penalty-free once you are 55 and have stopped working. If you plan to do this, be sure not to roll your 401(k) into an IRA as soon as you separate from the employer!
Withdrawals from health savings accounts (HSAs) to pay for health care are also not subject to the age 59½ rule. Those withdrawals come out tax- and penalty-free at any age. While an HSA generally cannot be used to pay for health insurance premiums, it can be used to pay premiums for COBRA (the federal program that allows workers to continue benefits provided by their group health plan for a limited time following job loss or certain other life events). After age 65, all withdrawals from an HSA are penalty-free, although only tax-free when used for health care.
Third, Roth IRA contributions can always be withdrawn tax- and penalty-free. Only the earnings are subject to the 10 percent penalty. Note that if you have funded your Roth IRA via Roth conversions (such as through the backdoor Roth IRA process), that principal is subject to a five-year waiting period before it can be withdrawn tax- and penalty-free. (See www.acepnow.com/article/backdoor-roth-iras-funding-one/ for more on backdoor Roth IRAs.) If Roth IRA principal withdrawals are your plan to cover living expenses between ages 55 and 60, then you need to make sure you’ve started doing any necessary Roth conversions by age 50.
Fourth, consider the substantially equal periodic payment (SEPP) rule. This allows you to start withdrawing from retirement accounts at any age penalty-free. Once you start SEPP withdrawals, you must continue them for at least five years or until age 59½, whichever time is shorter. The amount you can withdraw is limited but is approximately equal to the amount you should be withdrawing anyway if you want your money to last for a long period of retirement. There are three different methods you can use to calculate these withdrawals, but all of them would allow a 50-year-old to withdraw 3 to 4 percent of the portfolio per year penalty-free and a 55-year-old to withdraw 3 to 4.5 percent.
Fifth, there are many exceptions to the age 59½ IRA withdrawal rule. These include paying for medical insurance, disability, qualified higher education expenses for you or your children, a first home for you or your children ($10,000 limit), a new child or adoption ($5,000 limit), an IRS levy, and a military reservist distribution if on active duty.
Finally, IRA money is never locked up. It is your money, and you can access and spend it any time you like. The age 59½ rule only applies a 10 percent penalty to otherwise unqualified withdrawals. Few early retirees ever have to pay that penalty, but it is always an option to just pay it.
Congratulations on saving up enough money to retire early. Knowledge of IRS rules and careful management of withdrawals should allow you to cover your expenses without ever paying the 10 percent early withdrawal penalty on IRAs.