The Best Accounts for Early Retirement
The concept of early retirement has grown tremendously in the last decade.
More and more Americans are not only stumbling into, but also planning on it from early on in their careers.
And even if you don’t plan to retire early, I doubt you’d be disappointed if things fell into place in a way that allowed you to do so.
If either of these points of view describe you, then you need to keep in mind that many of the popular tax-advantaged retirement saving methods aren’t very well structured to support retirement before age 60.
For one thing, full retirement age for Social Security is now 67 years old and you can’t even file for early benefits until age 62 (which is closer to when most people actually retire).
Additionally, most tax-advantaged retirement accounts don’t allow for penalty-free withdrawals until you reach age 59.5.
So, what are you to do if you want to retire in your 50s or even earlier?
Well, let me walk you through several options to fill in these “gap” years between your early retirement date and the time you reach age 59.5 and can begin tapping your retirement assets.
As we go through the list, I will hit each approach in the order that provides the most flexibility and monetary benefit to support an early retirement to those that provide the least.
457 Plans
Only 7 million Americans participate in 457 plans, but this relatively small group of workers has access to one of the best avenues for saving for early retirement that there is.
457s work similarly to other common retirement plans like 401(k)s, TSPs, and 403(b)s, but enjoy one very distinct feature: you can begin making withdrawals from a 457 plan upon your retirement, no matter your age.
This is the only tax-advantaged account that offers this level of flexibility as a boilerplate feature of the plan.
Another perk of 457 plans is that you can make maximum contributions to both a 457 and any of the other retirement plans I mentioned before (401(k), 403(b), TSP).
So, 457s effectively provide savers with double the tax-advantaged investment space with the added flexibility of earlier access to your retirement funds.
You should keep in mind that you have to retire from the employer that sponsors the 457 before you can make penalty-free withdrawals, unless you are 59.5 or older.
However, if you have access to a 457 and think you may want to retire before 60, you should prioritize contributions to these accounts to bake that flexibility into your retirement plan.
Employer-Sponsored Plans
You may be surprised to see standard employer-sponsored retirement plans next on my list.
After all, I just pointed out that these plans do not enjoy the same withdrawal flexibility before age 60 that 457s do.
And that’s almost, nearly, entirely true.
Before I explain, let me begin by pointing out the tax benefits these accounts provide cannot be ignored.
Whether you use a Roth or Traditional 401(k), 403(b), or Thrift Savings Plan, having the option to either defer or permanently limit the taxes associated with these accounts can be worth a huge sum of money over your investing lifetime.
So much so that you can’t ignore them for the sake of early retirement flexibility.
But back to the point I teased a minute ago, there are a couple of ways to get into these accounts before age 59.5, without paying early withdrawal penalties.
The first, and easier method is the rule of 55.
The rule of 55 allows one to begin withdrawing funds from an employer-sponsored retirement plan (including the three I mentioned above) once you retire from the employer that sponsors that plan, assuming you retire at age 55 or later.
That was a bunch of words, so let me paraphrase.
The rule of 55 allows you to make penalty-free withdrawals from your employer-sponsored plan if you retire from that employer at age 55 or later.
Another method is to use 72T Distributions which allow you to begin making withdrawals at any age, assuming you continue doing so until 5 years have passed or you turn age 59.5, whichever occurs later.
72T Distributions can be calculated one of three different ways and once you pick a method, you have to stick with it until you meet the term requirements of the withdrawals.
With the general ground rules covered, let me say that I don’t love 72T Distributions because they can be challenging to calculate and if you mess it up you could owe some hefty penalties to Uncle Sam.
Yes, it exists, so I feel obligated to point that out, but I would try nearly any other method I’m discussing in this post first.
IRAs
Again, you may not have expected me to touch on an account type that has early withdrawal penalties in a discussion about early retirement.
But, once again, there are some workarounds.
First, you can also make 72T distributions from IRAs.
Since we’ve already discussed 72T distributions and I don’t love that method, I’ll share a different one…
You may be aware that Roth IRA contributions can always be withdrawn tax and penalty free.
What you may not know is that funds that are converted from a Traditional IRA to a Roth IRA are treated like contributions after five years have passed.
Thus, by converting any Traditional IRA funds to a Roth IRA you effectively start a five-year clock for that conversion. Once it runs out, those dollars are eligible for removal, penalty-free.
And that’s true no matter what your age is when you make the conversion.
You do need to keep in mind that each conversion you make gets its own five-year clock, so be sure you have a way to keep up with those conversions when you start.
Also, you must have opened a Roth IRA at least five years before you withdraw any earnings from any Roth you have. This is true even if you are 59.5 or older.
If you don’t have a Roth IRA already, I recommend opening one and tossing a dollar into it. That will start the five-year clock for every Roth IRA you ever have, even if you close the first one.
I know there’s a lot of five-year clocks running in this scenario now, so let me try to summarize.
- You must have opened your first Roth IRA five years before you make any withdrawals of earnings from any Roth, even if you’re older than 59.5.
- Each conversion you make to a Roth IRA must sit for five years before it is treated like a contribution and available for a penalty-free withdrawal.
- There are also five-year clocks for Inherited Roth IRAs and for Roth 401(k)s, but I’m not going to explain those here. If you want to read more, check out our post about the Five-Year Rule or the video version.
Taxable Brokerage Accounts
The last account I’ll write about is the taxable brokerage account.
In case you’re wondering, there are no highly specialized tax benefits for funds saved in a taxable brokerage account, though long term capital gains and qualified dividends are taxed at lower rates than income.
And that’s no small matter.
You could potentially save as much as 17% or more in taxes by gleaning income from these lower-taxed sources than income.
Beyond that, the primary benefit of using taxable brokerage accounts for early retirement is the flexibility they provide.
For one thing, withdrawals from a taxable brokerage account can be made at any time without penalty.
That means if you retire before age 59.5, you could potentially use your taxable brokerage to fund the first years of your retirement until you’re old enough to tap the IRA or 401(k).
That isn’t necessarily the case with the accounts we listed above.
The other important opportunity afforded by taxable brokerage accounts is the ability to finance the Roth Conversions we discussed early.
As I mentioned, each conversion is a taxable event. If you don’t have cash available outside of your retirement accounts, you may have to cannibalize your Roth dollars to pay for conversions.
That is not a very efficient way to use those dollars.
Finally, having a significant amount of money in a taxable brokerage account can give you access to cash while also providing you with a high degree of control over your tax situation.
For example, your brokerage should allow you to select which lots of assets to sell from within the account. This gives you an option you to sell off those groups of assets with large capital gains when you have room to absorb those from a tax standpoint, or to sell assets for below their purchase price when you want to harvest losses, and everything in between.
To maximize this control, you should hold assets in a taxable brokerage account that aren’t producing taxable income in the form of bond yields or dividends.
Focus on capital appreciation in the taxable space to maximize your tax control.
Wrap Up
In addition to the accounts I’ve listed above, you should also have a basic savings and/or checking account, but there’s not a lot to say about that so I’m not going to.
If I were to identify the most important characteristic of early retirement planning, it would be flexibility.
You don’t know what the future holds so you need to give yourself options to handle whatever life throws at you. After all, over half the time people retire due to circumstances that are beyond their control (as in loss of job, health issues, serving as a caretaker for family, etc.).
