☕Good morning!

Ever wondered why tapping into your retirement funds feels like defusing a bomb? 

You’re not alone; this is a common sentiment expressed across the various financial independence-oriented subreddits, like FIRE (Financial Independence & Retiring Early) and HENRYfinance (High Earner, Not Rich Yet), two niches home to hundreds of thousands of high earners plotting their course in the fast lane.

A quick dive into HENRYfinance shows nearly every high-earner typically has the same issues:

1. High earning means excelling– you have more options available on shorter timelines.

2. Big paychecks come with big tax bites. 

3. High earners focus on earning rather than financial planning. 

Making Cents of Your Money is about giving high earners the blueprint to get the most out of their financial situation.

Today, we’re talking about early retirement, specifically how to sidestep the pesky penalties that threaten to nibble away at your early nest egg. 

🪢Unraveling the Retirement Knot

Retirement accounts were rolled out throughout the 20th century as a safety net to help employees and self-employed citizens save for retirement as traditional pension programs declined. 

Today, retirement accounts are more than just post-employment protection– they’re a powerful tool for wealth creation. 

The crux of the benefit comes from IRS taxation leniency and contribution opportunities.

Your “taxes later” options like 401(k)s and Traditional IRAs give you a tax break today but then tax you on your contributions and gains upon retirement withdrawal. 

An important point to note here is that your withdrawals will be taxed at the current ordinary rates when they are being withdrawn. If you predict tax rates will increase, as many do, you may pay much higher taxes on your retirement funds. 

Your “taxes now” options include the Roth IRA, funded with post-tax dollars today but grows tax-free.  

However, retirement accounts come with strings attached, notable:

1. Withdrawing funds from these accounts before age 59½ usually results in a 10% penalty. 

2. Once you reach age 72, you must start taking Required Minimum Distributions (RMDs) from your 401(k) and traditional IRA accounts, which can impact your tax situation and force withdrawals even if you don't need the funds.

🧰 Your Early Retirement Toolkit: Taxes Now or Taxes Later

Your “tax later” buckets include 401(k)s and traditional IRAs.

🏢 401(k): Maximize your employer match—it's free money. Contribute enough to get the full match, as it's an instant return on your investment.

💻Traditional IRA: With tax-deferred growth, understand how your contributions reduce your taxable income. 

1. You get tax credits today, as with the Traditional IRA

2. Your contributions, growth, and dividends are taxed upon withdrawal.  

Your “tax now” bucket includes the Roth IRA.

📈 Roth IRA: This is perfect for high earners expecting a higher tax bracket during retirement. Your after-tax contributions grow tax-free, and withdrawals are tax-free in retirement, giving you a robust financial safety net.

🔑 Using What You Got: Early Access Without the Penalties

Unlocking your retirement treasure chest early without penalties is possible, but it requires some planning. 

🪜 Roth Conversion Ladder: Converting your traditional IRA to a Roth IRA for penalty-free withdrawals in five years. 

This technique is about foresight and timing for at least a five-year window.

📊 Plan Your Conversions: Determine how much you'll need annually five years post-conversion. 

You’ll be essentially converting this amount from your Traditional IRA to a Roth IRA, ideally in years when your income is lower to benefit from a lower tax bracket.

This works similarly with 401(k)s, too. Still, the process involves rolling over funds from your traditional 401(k) into a Traditional IRA first, then converting those funds into a Roth IRA. 

🔄 Initiate the Rollover: When you leave your job, transfer your 401(k) or 403(b) funds to a Traditional IRA. This step doesn't incur taxes or penalties. 

Then, you can convert your funds into a Roth IRA. 

Remember that tax is due on the amount you convert in the year the conversion occurs. 

The converted amount is added to your annual taxable income and taxed at your ordinary income tax rate. If the conversion significantly increases your taxable income, it could push you into a higher tax bracket for that year.

Plan for this tax liability and set aside funds to cover it—you wouldn't want to use the funds from the conversion to pay the tax, reducing the amount you have growing tax-free in the Roth IRA.

⏳ The Five-Year Waiting Game: Wait five years after each conversion before you can access the funds without penalties. 

This is a crucial period for the funds to be eligible for penalty-free withdrawal.

🔄 Plan Successive Conversions: During the five-year waiting period, continue converting funds annually to ensure a consistent flow of accessible money in the future, always considering your current tax bracket.

Each rollover period looks the same; however, if you’re in a lower ordinary tax bracket because you left your job, your taxes will generally be lower.

💰 Withdraw After Five Years: Once the five-year period is over, you can withdraw the initially converted amount from your Roth IRA, tax and penalty-free, since taxes were paid at the time of conversion.

Essentially, what you convert is now your "contribution" to the Roth IRA.

Importantly, while you can withdraw the converted amounts without penalty after five years, the earnings on those conversions during that five-year period would be subject to taxes and penalties if withdrawn before age 59½ unless an exception applies—that’s why it’s critical to dial this in with a financial planner and CPA to ensure you withdraw the correct amounts. 

🔄 72(t) SEPP: Keep the penalty at bay with equal periodic payments

The 72(t) SEPP method is a great way to avoid the early withdrawal penalties, but it is a commitment– deviating from the plan can result in penalties, defeating the whole purpose. 

🤔 Step 0: Determine Withdrawal Amount

Before starting, decide how much money you need to withdraw annually from your IRA until you reach age 59.5. 

This amount should align with your living expenses but also consider the longevity of your funds beyond age 59.5.

Remember, early retirement is just a small part of retirement—make sure you’re still setting yourself up well for a long life! 

📏 Step 1: Calculate Withdrawal Amounts

The IRS has formulas to calculate three potential withdrawal amounts based on your life expectancy and retirement account balance. 

Consult with a financial planner to choose the calculation that best fits your financial needs. 

🔄 Step 2: Transition to an IRA

If your funds are in a 401(k) or 403(b), you'll need to roll them over into a Traditional IRA. This rollover should be tax-neutral and penalty-free, setting you up for the SEPP plan.

💸 Step 3: Start Withdrawals

You can begin taking the calculated annual distributions from your Traditional IRA. 

While these withdrawals are subject to regular income tax, they avoid the 10% early withdrawal penalty. 

If your financial situation changes, the IRS allows a one-time modification of the withdrawal method.

⏳ Step 4: Maintain the Schedule

Continue the withdrawals for at least five years, or until you reach age 59.5, whichever comes later. It's crucial not to deviate from the scheduled amounts or timing, as this could incur penalties.

Are Roth Conversion Ladders & SEPPs Right For You? Ask Away! 

Join me, the mind behind Making Cents of Your Money, Dan Pascone, for LinkedIn Office Hours in an open platform for questions, discussions, and sharing expert financial advice.

Date & Time: Friday, Apr 19, 2024, 1:00 PM - 2:00 PM

Where: LinkedIn (invite here!)

Take advantage of this chance to get your financial planning questions answered for free! 

Hit “Attend” on LinkedIn to secure your participation and set that Calendar alert. 

I look forward to seeing you there!

Making Cents of Your Money:  Roth Conversion Ladders & SEPPs

Simply eating the 10% early withdrawal penalty from retirement accounts is easier, especially if the accounts have experienced significant growth, but rarely (in some cases, it makes sense!) is your most financially sensible option. 

Learning the vehicles to early retirement penalty-free is an empowering moment because it removes the mental chains of thinking, “Well, I might as well keep working until I’m 59.5 so I can actually access my retirement money…”

By all means, work as long as your heart desires, but do it because you want to and not because you feel locked into extra years or decades of employment because of IRS rules. 

If retiring early is on your radar, or if you're just curious, knowing your options is a game-changer. 

We’ve gone over just two early financial freedom strategies that still consider late-life leisure, but many more unique, nuanced approaches can help you get the most out of your nest. 

A financial planner with specific experience with high earners eyeing early financial independence or even complete early retirement is an excellent way to determine your best options. 

Until next week,

Dan from Tailored Cents