Access Your Retirement Money Early

An IRA or 401(k) may sound too good to be true, and that's a little bit accurate. The big catch to putting your money into one of these retirement accounts is that it is locked up and somewhat inaccessible to you until age 59.5.

There are a handful of exceptions, such as taking out up to $10,000 toward your first home or paying for education. Keep in mind that you can take your contributions out of a Roth IRA at any time, just not your earnings/growth.

But otherwise, you might have to pay taxes and a 10% penalty if you take your money out early. I'm going to analyze the pros/cons of a couple ways of accessing your stacks of cash.

After each method, I'm also going to calculate how much money I would have in that hypothetical savings scenario. Let's say I have a fixed income of $100,000 and put 20% of my take-home pay into some type of savings, starting at age 22. Assume I plan to stay in the 15% tax bracket in retirement. Let's see how far I've gotten by age 50 using each method.

METHOD 1: Brokerage account

You use a brokerage account all along, instead of putting contributions into retirement accounts. Then, the money is all yours to access from day 1! The downside is that you'll pay taxes on everything you earn, year after year. Plus, you'll have to pay taxes on your contributions that come from your paycheck.

Pros: You can access all your money whenever you want.

Cons: You lose money from all the endless taxes.

Scenario: My take-home pay (after taxes) is $74,000/year, so I contribute 20% or $14,800 every year for 28 years. I will assume a yield of 7%, inflation of 2.9%, federal tax rate of 25%, and state tax rate of 6%. After those 28 years, I have $851,000.

METHOD 2: Pay the penalty

You could add money to your retirement accounts normally, so you'll get the tax benefits as you continue working, and then just take the money out and pay the 10% government penalty for using it early. Take money out as you need it, and account for the 10% you'll lose.

Pros: No muss, no fuss. Your other money can keep growing tax-free.

Cons: You lose the 10%.

Scenario: This time I contribute $15,500 per year (or 20% of what would have been my take-home pay after 401(k) deductions) into my traditional 401(k). I'll assume no employer match to keep things simpler. After 28 years, assuming 7% returns I'll have $1,298,000. Now, assume I take out $50,000/year to live on from ages 51-60 (10 years). I'll owe taxes on that income (in the 25% bracket), as well as a 10% penalty. After the taxes and penalties, my annual income will instead be $33,000. Thus, the money I get to actually use will be $33,000 x 10, plus the leftover 401(k) money: $1,298,000 - ($50,000 x 10). This gives a total of $330,000 (100%) + $798,000 (78%) = $952,440 usable dollars.

METHOD 3: 72(t)

This is the first tricky-moves-McGee thing you can do.

Rule 72(t) refers to tax code 72(t), which says that you can take money out of an IRA or 401(k) without penalty, as long as you take "substantially equal periodic payments". This means you have to regularly take payments until you reach age 59.5, at an amount determined by the IRS. The amount depends on your age and life expectancy.

There are three ways your distribution can be calculated. These are called: amortization method, minimum distribution / life expectancy method, and annuitization method. Yuck! Gross! What!

The amortization method gives you the max income allowed.

The minimum distribution method gives you the min income allowed.

The minimum distribution method gives varied income every year, because it is recalculated annually. The other two methods give fixed income.

Use this Bankrate calculator to estimate your annual distribution options.

Pros: You get a bunch of your money without paying penalties.

Cons: This method is complicated and you'll need the help of a financial advisor. Plus, you don't get to choose your distribution amount. What if it's too small and doesn't cover your expenses? What if it's too much and you need another investment strategy for the rest?

Scenario: Again, I saved 20% of my take-home pay, or $15,500/year for 28 years. I have $1,298,000 at age 50. Using the Bankrate calculator, my distribution would be between $30k and $60k based on the current interest rate and my calculation method. I'll approximate with, again, a distribution of $50,000/year for 10 years. I owe taxes on that amount, but no penalty. That means $39,800 take-home pay. Again, we can calculate our total spendable amount as: ($39,800 x 10) (100%) + ($1,298,000 - ($50,000 x 10)) (78%) = $1,020,440.

METHOD 4: Roth Conversion Ladder

This is one last sneaky (but legal!) way to access your money.

Remember how you can access your contributions to a Roth IRA whenever you want? That is not true of Traditional IRAs, Traditional 401(k)s, or Roth 401(k)s.

The first step is to convert all of your other retirement accounts into Roth IRAs. This is called a backdoor Roth and is also totally legal! You can either move the money into an existing Roth IRA, or convert the account directly. Keep in mind you still have to pay taxes on this money (since you haven't paid taxes on the money in a Traditional IRA). You'll owe income taxes on your contributions and then capital gains taxes on the earnings (up until the point where you convert it to a Roth).

Keep in mind that doing this conversion will add to your income for the year, so you might end up in a higher tax bracket.

The reason you can do a backdoor Roth even if your income is above the income limit, (and that you can convert more than the $6,000 IRA contribution limit) is that a "conversion" is different than a "contribution" in the IRS's eyes. This means that there is a whole new set of rules.

The rule that matters to us is that you cannot access converted funds in a Roth IRA until they have been there for 5 years. So when using this method, you need to plan 5 years ahead and before you'll need the money.

Convert some money every year. That amount of money should be not too small, because it will need to sustain you in 5 years, but also not too big, because you will be paying taxes on it.

Pros: You get to access your money without paying penalties.

Cons: This method is also complicated and you'll probably want a financial advisor to help you avoid mis-steps. Also, you won't be able to access the money for another 5 years.

Scenario: Oof. This one's complicated. You contribute $15,500 to your 401(k) every year for 28 years. But, starting at age 45, you need to start paying taxes on and shifting $50,000 every year over to a Roth IRA, so you have an income from age 50 on. That amount adds onto your income for tax purposes. You do this from age 45 to 55, because you'll use your last withdrawal for age 60. From age 22 to 45, this scenario progresses like normal. You amass $859,000. Then, however, your income jumps up to $150,000 as you start moving $50,000 every year. Because of this, you have to pay more in income tax and you cannot afford to contribute as much to your 401(k) each year -- only $12,000/year. So, for five years you add $12,000 and take out $50,000. This leaves you with $893,700 at age 50, plus $50,000 x 5 = $250,000 in a Roth IRA. The next 5 years, you remove $50,000 from your account and add $39,800 to the Roth. At the end, you'll have a net worth of $643,700 (78%) + $449,000 (100%) = $951,086.

TL;DR: Here's a table that describes our results, in order from most money to least money:

How do you plan to save and access your retirement money? How sick are you of reading about retirement plans?