Saying goodbye to your job through early retirement is the dream. You get a few extra years to pursue your hobbies, travel and relax. However, retiring before age 55 comes with several financial downsides. Significant financial reserves are needed to last the 30-40 years of your retirement life expectancy. You also face several penalties for withdrawing retirement funds before age 55, including taxes and early withdrawal penalties.
Individual Retirement Accounts
IRAs are tax-advantaged accounts for saving for retirement. The two main types of IRAs are traditional and Roth IRAs. IRA distributions are available without penalty starting at age 59 1/2. Take a distribution from a traditional IRA before 59 1/2 and you face income taxes and a 10 percent early withdrawal penalty. You may withdraw your contributions from a Roth IRA at any time, but if you withdraw your earnings, you pay income taxes and the 10 percent early withdrawal penalty on your distribution. The early withdrawal penalty does not apply to qualified distributions, such as those for paying medical bills, in the case of disability and when using the funds to buy your first home.
Your 401(k) plan allows withdrawals beginning at age 55 without an early withdrawal penalty. You do pay income taxes upon withdrawal. If you leave your job before age 55, you end up paying an early distribution tax in addition to income taxes on the distribution. You cannot withdraw from 401(k)s from previous employers either until age 59 1/2.
Substantially Equal Periodic Payments
Substantially equal periodic payments are a strategy to get around the early withdrawal penalty for retirement accounts. You take equal payments on an annual basis from your 401(k) or IRA for a period of at least five years and you avoid the early withdrawal penalty. Qualifying for an SEPP requires you to terminate employment to withdraw on your employer-sponsored retirement plan.
The easiest way to avoid penalties is to refrain from tapping into your retirement accounts. Use other sources of income such as a taxable investment account, rental income or your spouse’s income to finance early retirement prior to age 55 instead of your retirement accounts. The longer your other funds last, the longer your retirement accounts have to grow and sustain you through your retirement.
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