I’ve been trying to convince my friend Lorenzo to pursue financial independence, and I think he’s starting to see the benefits. Recently married, he’s started saving aggressively, paying down debt, and tracking their net worth which he shared with me. “Holy crap!” I exclaimed, “You guys almost have enough to retire in Costa Rica!” He didn’t share my enthusiasm. “Yeah, but most of our money is locked up in 401ks.” I remember thinking the same thing – 401k investments are like funny money, useless until retirement age. Then I learned there are strategies for making early withdrawals without any penalties.

Picture of hiking.I’d love for more friends to join us in early retirement.

Why the 401k is so important for early retirees

A huge advantage of the traditional 401k is the tax arbitrage opportunity. When we were working, our marginal tax rate was 28%. By maxing out our 401k contributions, we avoided paying that marginal rate on a large portion of our savings.

Last year, I quit my job and our income dropped drastically. Our effective tax rate ended up being 5% – only because I still had some income. It’s actually possible to pay zero taxes in early retirement, and my friend Jeremy at GoCurryCracker shares exactly how he does that. When we need to use the money in our 401k accounts, we’ll have even less income. Instead of paying a 28% marginal tax rate on that money upfront, we’ll be paying a 0-5% effective tax rate when we cash out.

Majority of our investments are in tax-advantaged accounts, including over $500,000 in traditional 401k accounts. If we had paid taxes, then invested the money into brokerage accounts, we would have $140,000 less.

Basically, if it wasn’t for pre-tax investments like our 401ks, I would still be sitting in a cubicle. I certainly wouldn’t have spent this last year practicing hobbies and pursuing passions like traveling to Colorado, Nova Scotia, Costa Rica, Jamaica, and Spain.

Picture of hiking.Enjoying freedom, thanks to my 401k.

Do I have too much in my 401k?

Half way into our journey to financial independence, I started to think we had too much money in our 401k accounts. We would need money to bridge the gap between our early retirement and traditional retirement years. I did some back of the napkin calculations and decided we needed to divert our savings to after tax brokerage accounts.

That same year, while reviewing our taxes, I told our accountant about my plan. He immediately stopped scanning forms and looked up at me over his glasses. “Are you sure you want to do that?” I explained to him my reasoning – I didn’t want the money “locked up.” He saw I was serious and reached into his desk. “Well if you really want to do it, here are the payment vouchers for the additional $10,000 in taxes you’re going to owe next year.” He had my attention.

Picture of retiring early.

Instead, he told us to do a little more research on a 401k loophole called the SEPP. In doing my research, I came across more than one way to make early withdrawals from a 401k without any penalty.

Make penalty-free early 401k withdrawals with SEPP

The SEPP (Substantially Equal Periodic Payments) exception allows you to setup penalty-free distributions from your 401k. These distributions are fixed, and there are several formulas the IRS has for calculating how much can be distributed each year. Once setup, these distributions must continue for a minimum of 5 years, or until you reach retirement age. Of course you still have to pay taxes, but the 10% early withdrawal penalty is waived.

Disadvantages of the SEPP include limited flexibility in adjusting the size of the distributions, and you can’t just turn them off. This could be a problem if you have some unexpected income one year and didn’t want to withdraw money from your 401k.

Make penalty-free early 401k withdrawals using a Roth IRA conversion ladder

Another option is a Roth IRA conversion ladder. In this case, you roll your 401k into a traditional IRA when you leave your job. Then, each year, you convert some portion of the IRA into a Roth IRA. This means paying taxes on the amount you convert. After a 5 year waiting period, you can withdraw the principal from the Roth without penalty. Do this every year, and you’ll have steady stream of penalty-free withdrawals waiting for you.

This is my favorite method. It gives a lot more flexibility in controlling the amount of income you pay taxes on each year. Of course, you need to plan ahead. It will be 5 years before any converted money becomes available.

Just pay the penalty

In many cases, it would be better to pay the 10% early withdrawal penalty than to pay higher taxes while working. If you don’t have a job, your effective tax rate will likely be less than 5%. Even with the 10% penalty, you would end up with a 10-15% total tax burden. That’s still much less than paying a 28% marginal tax rate.

Obviously, you would be better served not paying the 10% penalty at all. Taking some time to setup a Roth conversion ladder or a SEPP would be a much better idea. Unless you want to work 11% more.

Picture of Catalonia.Make better decisions, work less.

The 401k can propel you into early retirement

Unless you are already in a very low tax bracket, there is no excuse for skimping on your pre-tax contributions. If you’d like to see more charts and math on the subject, you can read why I say to Screw the Roth, and Max Your Pre-Tax.

Keep in mind, if you’re paying 25% more in taxes, you need to save 33% more to end up with the same amount (1 ÷ 0.75 = 1.33.) For someone who plans on quitting a high income job to enjoy early retirement, taking advantage of 401k accounts means keeping 20-30% more money and working 25-42% less. That’s like having to work a day less each week – just by using your 401k.