Protecting Your Financial Wellness From Early Retirement Tax Traps


On our financial coaching line, I spoke with an employee that wanted to retire to spend time with his ailing spouse. She was requiring more and more physical assistance. He also wanted to pursue some travel opportunities while they were both healthy enough to do them. After understanding his reasoning for retiring, I was motivated to help him find the best solution. Specifically, I wanted to make sure he avoided some of the financial landmines when someone retires prior to age 59 ½.

Understand How Much You Really Need

There are few things more painful for a financial planner than to see someone retire only for them to come back to the workforce because they underestimated what they needed. Early retirees can fall into the trap of being very stingy to their future self to meet their goal. If you feel like you can live at 50 or 60% of your current income, give your new spending a test drive now. Go ahead and lower your monthly spending while you are still working for several months to determine if it is a truly livable lifestyle.

Avoid Early Retirement Tax Traps

After totaling up his pension and his wife’s disability benefits, we had to look to their savings to make up the difference in their budget. Many withdrawals prior to age 59 1/2 are subject to a 10% tax penalty. These strategies will help you to avoid that expense:

  • Think twice before you rollover to an IRA. There is an important exception to the 10% penalty for withdrawals made from your 401(k) or 403(b) plan. You can avoid the penalty for withdrawals made in the year you turn age 55 or later, but ONLY IF you retire at that age or later. You lose this exception once you roll over to an IRA. See the chart below for details:

Withdrawal Penalties Based On Age

Retirement Age Penalty
If you retire at age 53 and begin withdrawals from your current employer’s plan Penalty Applies
If you retire at age 55 and begin withdrawals from your current employer’s plan No Penalty
If you retire at age 55 and begin withdrawal from a previous employer’s plan Penalty Applies
If you retire at age 54 and begin withdrawals from your current employer’s plan but will turn 55 by 12/31 of that year No Penalty
  • Non-retirement accounts totally avoid penalties. If you have funds in savings, mutual funds, brokerage accounts or CDs that have already been taxed, take withdrawals from these first. This allows your tax-deferred accounts to keep growing.
  • Roth IRA withdrawals offer early retirement flexibility. IRS rules state that withdrawals from your Roth IRA are made from contributions first. Since your contributions were already taxed, no taxes or penalties are due when you withdraw these amounts. If your contributions totaled $30,000 and your account balance is $50,000, you could withdraw $30,000 or $2,000 a month for 15 months before touching your earnings.
  • Take “substantially equal” installments. The IRS waives the 10% penalty for withdrawals from IRAs and retirement plans under rule 72(t), which allows withdrawals to be made as substantially equal periodic payments. You must continue taking these installments for at least five years or until you attain age 59 1/2, whichever comes later. If you take more or less than your scheduled withdrawal, you will be subject to the 10% penalty for all previous years plus interest! The IRS has approved three methods that can be used to calculate these payments:

    1. Life expectancy – This is the same method used to calculate required minimum distributions when you reach 70 1/2. You simply divide the account balance by your life expectancy. This provides the lowest payment of all three methods.
    2. Amortized over life expectancy – This method calculates the payment based on your (or a joint) life expectancy and an assumed rate of return.
    3. Annuitized over life expectancy – This is the most complex method and requires the use of an annuity factor that calculates the present value of a payment over your life expectancy and an assumed rate of return.

Having the right counsel can help you navigate the road to an early retirement. It’s a good idea to meet with a tax professional before selecting a withdrawal method. Like the employee I mentioned above, you can also see if your employer offers free access to unbiased financial wellness coaching to help you make these decisions.

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