Best Retirement Account Types (Especially if You Want to Retire Early)

early withdrawal penalty exceptions

Want to retire early? See which retirement account types can give you the most flexibility.

There are many retirement account types, and each type has its own tax implications.

There are seemingly dozens of hidden workarounds — for example, even if you are over the income limit for a Roth IRA, you can actually still contribute to one through what’s called a  “backdoor” Roth contribution. It can be confusing.

On top of it all, if you’re planning to semi-retire so you can ditch the cubicle before your 60s, you’ll likely want to access your retirement accounts early, which adds another wrinkle: bridging the gap while using the right early withdrawal penalty exception. 

The “Bridge the Gap” Myth

There’s a popular line of thinking that, if you retire early, you will need to “bridge the gap” between now and when you turn 59-1/2. That age, 59-1/2, is when you can access most U.S. retirement account types without any early withdrawal penalty.

Often, people will suggest continuing to work full-time until you’re 60, saving cash, or investing into a taxable brokerage account so that you will have money during this “gap” period. However, I’m excited to tell you that the gap is a bit of a myth. There are actually several reliable early withdrawal penalty exceptions — so you can access your retirement accounts before you are 59-1/2.

Do you get taxed twice on 401k withdrawal?

No. For 401k accounts and other retirement account types, you won’t be “taxed” twice. But if you withdraw funds early without some strategic planning, you will pay taxes plus a 10% early withdrawal penalty. So it may feel like getting taxed twice!

What is the 10% early withdrawal penalty?

For most retirement account types, you will normally incur a 10% penalty plus taxes if you access the funds early. Tax planning and forethought can help you take advantage of these early withdrawal penalty exceptions, retire years earlier, and help your nest egg last longer.

What is a hardship withdrawal?

Another option in addition to the ones I describe below is taking a hardship withdrawal. According to the IRS, some retirement account types may allow you to make a withdrawal without the early withdrawal penalty — but only if you have an “immediate and heavy” financial need. You will still pay taxes.

The hardship withdrawal is limited to the amount of money necessary for that hardship. So the hardship withdrawal is not a helpful early withdrawal penalty exception for a planned early retirement.

Here’s a quick overview of different investment account types. There are some exceptions for each and rules for hardships, disabilities, and contribution limit rules. So check with a tax professional before making any major moves.

Investment and Retirement Account Types and Tax Implications

Account type details are accurate as of 2019. Speak with a tax professional before changing account types or making any transactions .

Viewing on mobile? Click here to view the full table.

Investment or retirement account type Tax advantage Age when you can access without early withdrawal penalty Other special properties
Non-tax advantaged brokerage account None. Capital gains (when realized) and dividends are taxable. Any time! No required distributions.
401(k) and other tax-deferred employee retirement plans, including 457(b) and 403(b) Contributions are usually tax deductible.

Employer may match a portion of contribution.

Avoids incurring taxes on the growth until a withdrawal is made.

59½ Required distributions at 70½. Can be rolled over into an IRA or a new employer’s non-Roth employee plan.

Note: once you retire, 457(b) plans can be accessed without the early withdrawal penalty (taxes may apply)

Roth 401(k) Growth is tax-free. 59½ Required distributions at 70½. Can be rolled over into a Roth IRA or new employer’s Roth 401(k).
IRA Contributions are usually tax deductible.

Avoids incurring taxes on the growth until a withdrawal is made.

59½ Required distributions at 70½. Can be converted into a Roth IRA (taxes may apply).
Roth IRA Growth is tax-free 59½ No required distributions! Also, you can withdraw your principal contribution before 59½ without incurring an early withdrawal penalty.
HSA Contributions are usually tax deductible, possibly tax free (see below).

Avoids incurring taxes on the growth until a withdrawal is made.

Employer may contribute.

Money spent on qualifying medical expenses is not taxed at all.

65 You don’t have to withdraw a qualifying expense in the year the expense occurs.

I’m about to list six ways to access these funds early once you semi-retire early or FIRE. In addition to material from the table above, I’m also going to be sharing some new information.

Please note though, the below methods are helpful for once you’re already FIRE or semi-retired. I strongly do not recommend doing any of these for short-term needs if you’re still working full time and saving. You will lose out on future compound growth and reduce your options later in life. Until you’re retired, I recommend not making any withdrawals from your retirement accounts unless it’s to avoid bankruptcy or foreclosure.

If you’re already 59½ or older, the below strategies will probably not be as helpful for you. You can already access all retirement account funds (other than non-qualified HSA funds) without needing an early withdrawal penalty exception!

Critical takeaways for evaluating retirement account types

1. 457(b) plans allow you to take a distribution before the age of 59½, without the 10% early withdrawal penalty. (Once you retire/separate from your employer.)

This is huge if you’re interested in FIRE or an early semi-retirement. Keep in mind though, you’ll still owe taxes on the growth.

2. Roth IRA plans allow you to take distributions of the principal before the age of 59½,  without the 10% early withdrawal penalty.

This basically means you can withdraw however much you’ve deposited into the Roth IRA over its life (not the growth portion).

3. HSA plans are very versatile, and can be particularly relevant for early retirees. Also, you can access these funds without the early withdrawal penalty once you’re 65!

Pre-tax investments are always nice, but your money can be withdrawn tax-free if you have a documented qualifying medical expense. Many people will only use the HSA as a way to pay short-term medical expenses with tax-free money, which is totally good. But, if you want to retire or semi-retire early, you may want to consider saving your receipts and withdrawing the tax-free money later, in your retirement!

The Mad Fientest has an article on this topic that digs into this strategy in detail (as well as the three next items I will discuss).

As one more bonus, HSA funds can be used for non-medical purposes, without an early withdrawal penalty, once you’re 65. To me, this is what makes the HSA the ultimate retirement account type.

Early retirement and semi-retirement both include traditional retirement years, when you’re 65+. So penalty-free access is a major benefit if things end up going well and you don’t use all of your HSA funds before your late 60s.

4. If you’re planning to FIRE or semi-retire with low expenses, the Roth conversion ladder strategy may be able to save you a ton on taxes.

Here’s the concept. When you convert funds from a pre-tax IRA into a Roth IRA, you incur taxes. If your income that year is low enough, you will pay low or possibly no taxes. Then, since it’s in a Roth account now, that money will be tax-free for future growth and withdrawals.

You will have to wait 5 years after the conversion to withdraw the money, in order to use this 10% early withdrawal penalty exception and avoid additional taxes. In this period, you’ll want to live off of savings, non-retirement investments, or existing Roth IRA principal distributions.

So, if you convert 1 year’s worth of expenses from pre-tax IRA to Roth IRA every year, then by year 6 you can start distributions and live off of your converted Roth IRA funds. This is why it’s called the conversion ladder — you would need to do the conversions each year for a year in the future.

Plan this carefully, factoring in tax brackets and your other income for the year. This approach can work really well for FIRE followers once they retire, since they may have very low income for the year if they’re just living off of investments.

Semi-retirees will want to be mindful of their part-time work income, as this may bump up your tax bracket for the IRA conversion. If your tax bracket is too high in the years you are converting, this method may incur such high taxes that it is no longer your best option. Unless you’re very comfortable with the math behind taxes, I recommend speaking with a tax professional before starting this approach.

5. By using a method called Substantially Equal Periodic Payments (SEPP), you can access IRA funds before you’re 59½, while avoiding the 10% early withdrawal penalty…

…And since tax-deferred 401(k) or 403(b) plans can be rolled into an IRA plan, you can end up accessing those funds through this method too (after rolling into an IRA).

This is also called the 72(t) rule.

With this approach, you take withdrawals from your IRA account on a schedule for either 5 years, or until you are 59½ — whichever is longer.

This early distribution option is a great tool. There are rules for determining your distribution schedule, and severe penalties for doing so incorrectly though. So, I recommend further reading and consulting a tax professional if you’re interested in this option (check out the links at the end of this article).

6. Taking the 10% early withdrawal penalty plus taxes and withdrawing early from a retirement account may put you in better position than investing in a standard brokerage account.

If you are saving for the long-term and your income allows you to contribute to a tax deferred account (like an IRA or 401(k)), you may want to consider actually paying the 10% penalty and taxes — if the previous options aren’t available or feasible for you. In many cases, you may still come out ahead compared to skipping the initial tax deferral and investing in a taxable investment account. This will depend on your tax rates, so make sure to run your projected numbers.

The big conclusion here though is that waiting until age 59½ is not the only viable option for retirees with savings.

IRA, 401(k), 457(b), and 403(b) plans are more flexible than many people realize. If you’re saving for the purpose of retirement or semi-retirement, you may want to exhaust all other tax advantaged options before investing with a taxable account.

However, taxable accounts can still be a valuable option if your income level makes you ineligible for tax-advantaged accounts, or if you are investing for a shorter-term goal.

With these conclusions in mind, you can feel confident and prepared to evaluate retirement account types and “bridge the gap” when you reach early retirement age.

Further reading and references:

Broad insight on this topic:

HSAs:

Roth IRAs:

Required minimum distributions:

401(k):

Roth 401(k):

457(b):

403(b)

SEPP:

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