How To Get Your Money Out Of Your 401(k) Before 59 1/2

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Photo courtesy of TaxCredits.net

For some reason, I’ve been doing a string of tax articles lately that have been surprisingly well received, so I figured I’d keep going. Why ruin a good thing, right?

401(k)’s. They’re great aren’t they? They let you defer taxes on your income, giving you a tax refund, and anything you earn in them is tax-free!

Only problem is, there’s a catch. Money inside your 401(k) is kinda like a raw pot roast. You can’t eat it right away.

First you have to withdraw the money, just like you have to cook the pot roast before eating it. And like a pot roast, if you cook it too fast, then the whole fucking thing gets burnt to a crisp and you have to hack off half of it just to find something edible.

I’m…I’m not a great chef.

Uh…let’s put some hot sauce on that. I’m sure nobody will notice.

ANYHOO, the point is, because 401(k) withdrawals are taxed at your marginal rate, if you withdraw it too fast, you’ll end up getting a big chunk of it taxed away. That’s bad.

So the trick is to withdraw it slowly. When you leave your job, your earned income effectively drops to $0. And remember, we all get $11k-$12k of income tax-free. In Canada, it’s called the Personal Deduction, and in the USA it’s called the Standard Deduction. Historically, the standard deduction in the US was much smaller than the Canadian one, but with the most recent Trump tax cuts, as of 2018 they’re now about the same. If you’re married (like us), you can get $24k out of your 401(k)’s every year tax-free after retirement.

One big problem though. If you’ve reached Financial Independence and you retire in your 30’s or 40’s, you can’t actually withdraw from your 401(k) because you get hit with an additional 10% penalty for any withdrawal you take before the strangely-precise age of 59 1/2.

Canadians, count yourself lucky on this one. RRSP’s have no age requirements for withdrawal, so the only thing Canadians need to worry about is withdrawing their accounts slowly enough.

But for Americans, there IS a way to get your money out tax-free too! It just requires you to jump through a bunch more hoops.

It’s all based on the IRS rule that Roth IRA conversions, rather than contributions, can be withdrawn penalty-free 5 years after the conversion has taken place.

What The Hell is a Roth IRA Conversion?

OK, I’ll tell you! Stop yelling at me!

Anyway, a Roth IRA Conversion is money taken from your Traditional IRA and then transferred over, or converted, into your Roth IRA. Now remember that Traditional IRA contributions are tax-deductible, so when you do a conversion, the amount gets added to your taxable income. So it’s kinda sorta like a withdrawal, in that you want to do it slowly enough so that you don’t get hit with a tax bill, only instead of withdrawing into your checking account, it goes into your Roth IRA.

Which is great, since you can withdraw from your Roth IRA tax-free and penalty-free, but only after 5 years. Note that each withdrawal has its own 5-year countdown. So a withdrawal done in 2000 would only be available for withdrawal in 2005, a withdrawal done in 2001 would only be available in 2006, and so on.

Now you might be thinking that’s great, but this is for Traditional IRAs. What does this have to do with 401(k)’s?

Well, it’s true that you can’t do a conversion from a 401(k). BUT, you CAN perform what’s called a 401(k) rollover, and transfer your balance from a 401(k) into a Traditional IRA. The IRS allows you to do this because if you leave your employer, they want to give you a way regain control over your retirement savings in case you left on bad terms, or the employer goes bankrupt. AND because this is going from a tax-deferred account to another tax-deferred account, a 401(k) rollover is completely tax-free.

Important: Everything I wrote here applies equally to 401(k)’s, 403(b)’s, and TSP’s. But 457’s (which are for state employees) actually don’t have an age restriction for withdrawals. You can just directly withdraw from those whenever you want penalty-free. And, as long as you do it slowly enough, it would be tax-free as well!

Putting It All Together

So here’s how we put this all together.

When you’re working, you contribute to your 401(k) to take advantage of any employer-matched contributions, those sweet, sweet tax deductions, and of course tax-free growth. AND if you happen to work for certain types of companies, you may be able to double your tax-deferred contributions in a process I like to call Double Fisting Your Retirement Accounts.

Over the course of your career, you may end up starting and contributing to multiple 401(k)’s.

Then, when you do quit, you roll-over all of them into a Traditional IRA. This is done tax-free.

Now you have a big-ass Traditional IRA. It’s full of tax-deferred money you saved over the years, and like a big ol’ raw pot roast, you want to eat it but you can’t. Yet.

So now you start to convert it. Being careful to keep your conversions to within your Standard Deduction of $12k per individual or $24k per married couple, each year on January 1st, you fill out the paperwork with your IRA provider to convert $24k into your Roth IRA.

The next year, you convert another $24k.

You do this for 5 years. On the 5th year, you are now eligible to withdraw that first IRA conversion tax-free and penalty-free!

And so on, and so on.

You may have noticed a certain ladder-like shape to this diagram, which is why this technique is referred to as a Roth IRA Conversion Ladder.

And of course, once you turn the magical age of 59 1/2 (why does the IRS pick such weird numbers?), you can stop with this ladder business and just do regular withdrawals.

And that’s how you access your 401(k) money before the age of 59 1/2.

Comments? Questions? Has anyone done this themselves already? If so, let’s hear it in the comments!

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45 thoughts on “How To Get Your Money Out Of Your 401(k) Before 59 1/2”

  1. Great review. I love the idea of the Roth conversion ladder. For now though, income too high. Maybe I’ll be able to take advantage of in the future but as WCI said…you dont want the tail to wag the dog.

  2. Hi!

    Quick question as a Canadian who may work in the USA in the future.

    Can a Canadian transfer a RRSP account to a Traditional IRA, do a Roth conversion while in the USA and then go back to Canada and take the money out tax-free? At what point is it not worth it?

    Roth IRA withdrawals are not taxable in Canada due to Canada-USA tax treaty, but I am wondering if the age restrictions apply.

    Thanks!

    1. I wouldn’t advise transferring between American/Canadian retirement accounts. That shit gets super complicated, and the rules are different depending if on your citizenship/residency status.

      Keep the IRA/RRSP money on their own sides of the border. Once it’s been withdrawn into a normal checking account, then you can transfer it to your heart’s content. You can’t screw yourself up too badly with that approach.

      1. Can you please do a full article for Canadians with US retirement accounts? I know it’s super niche, but it would be really useful!

  3. Question about Canadian withdrawal: I have a buddy who suggests pulling out RRSP money and putting it in a TFSA account (up to yearly max amounts of course) rather than waiting to RIF at 71. A portion of tax on RRSP withdrawals comes off upon withdrawal and then T4RSPs are issued to report the income to be taxed as part of your earning in the year of withdrawal. Suggestions for Canadian withdrawals?

    1. I’ve had long talks about this with Justin from RootOfGood.com and his take on that is the 72(t) SEPP withdrawal is too inflexible. Basically, doing a 72(t) SEPP requires you to calculate a certain amount you will withdraw each year using a series of complicated formulas, and then once you start you can’t stop. If you make a mistake at the beginning, or if at any point you forget or make a mistake on one of the withdrawals, the whole scheme blows up and you get hit with taxes and penalties.

      Not worth the heartache. This method is far more flexible and, more importantly, tolerant to mistakes.

  4. All great but what about us Non-Resident Aliens which is probably the case for you guys too FC and Wanderer. Can we withdrawal money from a Roth-IRA without paying any taxes? Aren’t we going to be taxed by our country of residency (Canada in your case and Brazil in mine?)

    1. Roth IRA withdrawals are treated the same whether you’re a resident or a non-resident. And no, Canada won’t tax you on that since it’s a tax-free withdrawal. What would you report?

  5. In the diagram you show the year 1 contribution being pulled out in year 5. Does that meet the requirement or would you have to wait until year 6 which would be a full 5 years after the contribution?

    1. It goes Jan 1st 2000 to Jan 1st 2005, which is 5 full years.

      Actually, the way the rules are written, the IRS actually counts it from Jan 1st of the year the contribution was made, so if you made the contribution Dec 31, 2000, the IRS considers that Jan 1st, 2000, and therefore you’d be able to withdraw in Jan 1st, 2005, or 4 years plus a day.

      I wouldn’t risk that though. Just do the full five years so it’s completely unambiguous.

  6. Your example assumes 100% of the 401k funds are from pre-tax contributions. If any of the 401k funds being converted are after-tax contributions, your example must comply with the pro rata rule for the Roth IRA conversions and has negative tax implications. It also assumes that the individual doesn’t have any other traditional IRAs with after-tax contributions.

    Also, there are a number of Section 72(t) eligible distributions which will provide access to your 401k funds immediately instead of having to wait five years.

    1. Correct. This is the most common scenario. If you’re doing anything complicated like making post-tax 401(k) contributions or with Roth 401(k)’s or something, you’re on your own.

      And like I mentioned above, I’m aware of the 72(t) SEPP method, but that method is much more inflexible. You screw up one withdrawal and the entire thing comes crashing down with big fees and penalties. I like this method better myself.

  7. Nice writeup. One thing that always confuses me: Can I do this now while I have a job and good income or do I have to wait for when I have no income coming in?

      1. Hi, Just to clarify, you recommend transferring each year an amount from traditional IRA to roth IRA – $12K per individual. You recommend to do this only once I’m retired and not working. And when transfer this amount I will not incur any taxes on the transfer since it is within the $12K standard deduction amount. Are these all the important facts? Right now I put everything into Roth accounts (Roth 401K and Roth IRA). Your system is to save paying the taxes, it appears, is this correct? As a general rule, do you recommend not paying the taxes upfront via the Roth?
        Thank you for sharing!

        1. You got it.

          I actually haven’t come across a reason to use a Roth 401(k) yet. I mean, mathematically it only makes sense if your tax rate is higher in retirement than when you’re working, so unless you have a gold-plated pension that INCREASES your earnings after you retire or something, then it might make sense. But who the Hell has that?

  8. Sorry if this is a stupid question but I’m confused. If you pull 24K out (tax free!) of your Traditional IRA, don’t you get taxed on any money you withdraw from investments to pay for living expenses for the year (seeing as that money would be in addition to the 24K you converted to the ROTH)?

    1. Do you get taxed on investment income in your regular investment account? Yes, but if you structured your investments to return income in qualified dividends, you’ll be able to make up to $70k per married couple tax free.

  9. Do you have any plans to do blog posts for Canadians and their tax?
    And since I see I haven’t done it yet, thank you for your site. We’re on our way to FI (better late then never, eh? Notice that little Canadianism…?)

  10. Pretty cool. This is definitely timely as tax season is approaching, and I am starting to think an awful lot about what buckets I’ll put my excess money into: IRA, Roth IRA, or a Taxable VTSAX account once my wife and I’s $5,500 retirement limits are maxed out. Being an experienced real-estate-investor guy now, I am starting to think more about how to fund future real-estate deals. The Roth Ira has caught my attention as a good funding source. I can max it out every year, and then if I find the right property, I can withdraw my Roth IRA contributions for the down payments, and just let my earnings ride, ride, ride. This has been an attractive scenario in my mind recently as I’ll get the best of both worlds: tax-free growth without the 10% penalty for taking out the contributions for down payments on real-estate.

      1. Yes, I read this site all the time, and I often share your anti-real-estate perspectives with enthusiasm on my personal facebook page. I think your views are valuable to a-lot of my millennial friends who are just starting out financially and mistakenly think that “buying a house” is always a smart financial decision to make, even when sometimes it can be a TERRIBLE financial choice. I just thought this would be a safe place to discuss some ideas I have been thinking about recently. I own stocks and real-estate currently, and I’ve had positive experiences owning both of them. I am learning what works best for me, and thinking critically and creatively about every decision I make. I may never raid any roth money, but I like knowing it’s available if I ever do find a better investment for it. Peace out, and keep on keeping on.

  11. Nice post! Where would you personally (and others please chime in) pull the extra $16k or so needed to live on $40k a year using the 4% rule on $1M? Would you pull from a large taxable account that you’ve already been using in the 5 years leading up to being able to use your first $24k Roth Conversion? It seems if one goes the large taxable account route, it would need to be large indeed…. 5 years of expenses plus enough to get you through to 59 1/2… yikes.

    Or, convert $40k from your IRA to Roth and pay tax on the extra $16k… just curious what the best strategies are to get to roughly $40k per year annual spend with $24k in tax-free money.

    Thanks for what you guys do here! It’s by far my favorite early retirement blog.

    1. Your entire portfolio should be yielding around 3-3.5% cash (the Yield Shield) and you can pull it out of all your accounts by doing buy/sell swaps as I wrote about here:

      https://www.millennial-revolution.com/freedom/withdraw-portfolio-retirement/

      Any other shortfall can be made up by realizing capital gains.

      This $24k “withdrawal” is just moving money from one account to another. The withdrawals from your portfolio to fund your living expenses is another thing entirely.

  12. I wish we had a option to get money out of our “superannuation fund”. I am not sure if a way to get it out before preservation age(67). We have tax free amount of 18,000 per person- 36,000 a couple. Australian here

    1. If you’re an Australian citizen, no. There’s actually a danger amongst early retirees in Australia not to put too much money into a super otherwise it’ll get trapped and you can’t get it out.

  13. Nice article! The only thing this was missing was the obligatory scream of disgust at the screwed-up US tax laws that force people into doing this 5-year-rolling-Roth-IRA-conversion nonsense in order to get access to your own money. What a pain in the butt….! Ugh…

  14. Thank you for making this easy to understand. I’ve heard about this concept before but when you get into specifics my eyes glaze over and I stop listening. I think this is the first time the concept was made clear to me. Thanks!

  15. What if you are still working but want to start converting your $$$ over? I’m already in a high tax bracket. It may not make sense to start converting over…. any ideas? American gal here….

  16. Here’s a question regarding TSP. Does the entire TSP have to roll over? I’ve contributed both Traditional and Roth dollars to my TSP. My statements account for the growth of Traditional and Roth dollars separately, so there are distinct balances.

    Would it be possible to just roll the Traditional TSP dollars into a Traditional IRA?

  17. Great article, great comments & questions and superb answers + insights. The sense of humor + expletives are icing on the cake!! Thanks Millennial Revolution

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