Backdoor Early Retirement: Anyone can tap their 401k or IRA for early retirement without paying a penalty via SEPP / rule 72t

WARNING – Use this advanced technique with extreme caution!

*** This is an advanced, somewhat complicated technique wrought with peril. Consult a tax advisor and use very carefully, if at all. ***

As a financial advisor, I often stress that you cannot save ‘too much’ in a tax-advantaged retirement account. Even though you generally can’t touch your IRA or 401k earnings without paying a 10% penalty until you’re 59.5 years old, there is an option to get at that money and avoid this penalty. Because of this option, it usually makes sense for everyone to max out their tax-advantaged retirement savings before they invest in a taxable account, even if they a) want to retire early (pre-59.5) AND b) they have very little in non-retirement savings.

The IRS has a rule called 72t that allows you to request ‘Substantially Equal Period Payments’ (SEPP) for at least 5 years or until you’re 59.5, whichever time period is longer (so, age 59.5 for most early retirees!)

(There’s another option which I’ll cover later called the ‘Roth IRA conversion ladder‘ which involves moving your 401k/Trad IRA to a Roth a bit at a time each year, waiting 5 years from the first year you do this because the IRS requires it, then taking withdrawals of the contributions you rolled over 5 years earlier.)

closed white wooden cabinet
You too can sneak in through the backdoor.

How SEPP / rule 72t works

The basic idea is that the IRS lets you take ‘substantially equal payments’ from your Traditional IRA each year– or each month– whenever you want to start them. These payments must continue for the greater of 5 years or from when you turn 59.5, and there are severe penalties if you change your mind. You are also very limited on how much of the money you can get your hands on, since the IRS wants it to last until you die. However, the devil is in the details, so read on!

The IRS has a handy FAQ on the SEPP which you should also read. Forbes also sums it up nicely.

Leisurefreak sums up the rules, and the very scary downside if you mess things up:

Once you begin SEPP payments you cannot add to that SEPP IRA or take more money from it for 5 years or age 59 ½, whichever is longest. It is best not to commit all of your IRA funds to a SEPP. That way you have side emergency IRA money outside of the SEPP.

There are 3 different methods to calculate payment and the IRS has restrictive rules for the payment amount. The SEPP IRA amount is based on your age, gender, and the long-term bond rate at the time of establishing the 72(t) SEPP.

Work with a qualified tax professional or financial adviser to correctly set up the SEPP. If at any time you deviate from the substantially equal periodic payments within the IRS guidelines, you may have to pay the 10% early withdrawal penalty going all the way back to day one.

You first need to decide how much money you want to tie up in your SEPP IRA. Once you allocate the money to be paid to you in SEPP form (roughly equal payments for at least 5 years or until you’re 59.5), you generally cannot change this amount. So, you need to think very carefully about how much you want to lock up in the SEPP, and how much income from this SEPP you want to receive (dependent on your market returns during the life of the SEPP.)

First, look up the maximum interest rate you can use by using the last two months prior to the month you’re going to start the payments. Choose whichever of those two prior months had the higher rate if that’s your goal.

Then, plug that rate along with your other info, including the size of the IRA you’re going to use into a 72t calculator like this one from Bankrate to get your fixed dollar payment number as a monthly amount. (Or, start with the dollars you need and then back into the account size of the IRA you need, and move money from your other IRA(s) or rollover your 401k to fund the IRA that you’re going to use solely for your SEPP.)

Here’s a screenshot for a 50-year old person who plans to use $500,000 in IRA funds and chooses the single-life expectancy method, which yields the highest payout possible if you also choose the ‘fixed amortization method’:

Note that ‘beneficiary age’ (e.g.: your spouse) doesn’t affect the calculations for ‘single-life expectancy’. Your marital status and age of your spouse seems to determine which method you must choose. Consult your accountant!

This says our hypothetical 50-year-old could start taking annual payments of nearly $18,000 on a $500 K IRA that they designate for SEPP use, which is about $1,500 per month. Not a lot to live on, but it could make the difference between retiring early vs continuing to have to work full-time if you have other income sources.

How do you set up SEPP payments from your IRA?

You could pay a financial advisor or CPA who is knowledgable about this to set one up for you if you’re daunted by the math. I’m a big DIY guy when it comes to finance, and I’m a financial advisor, so personally I would feel comfortable running the numbers, dividing the annual amount by 12 months, and setting up an automated withdrawal for that amount from my (SEPP-earmarked) IRA at Vanguard.

What investments should you choose?

You can change your investments as you go, just like you can with any IRA, but I would recommend something tailored to your current age and overall risk tolerance. A target retirement fund matching the year you turn 59.5 might be a good choice (e.g. the Vanguard Target Retirement 2030 fund for our 50-year old in 2021), but you should do some hard thinkin’ on this or consult a financial advisor.

What if you run out of money before you turn 59.5?

Well, you run out of money for one thing and therefore don’t get anymore SEPP payments. The good news is that the IRS won’t consider that a violation of the 72t rules and will not assess you a 10% penalty + interest going back to your first payment like they would if you chose to discontinue payments prior to 59.5. (Per this IRS source courtesy of Leisurefreak. But check with your accountant on all of this, including this scenario. I am not a CPA!)

The other good news is that you can do a one-time switch of accounting methods from the fixed-dollar methods (fixed amortization or fixed annuity) to the more flexible RMD method where your withdrawal amount will change annually based on your account balance (and life expectancy.) This might help you reduce your withdrawals if the market tanks, but of course it doesn’t help your income needs.

Should you actually do this?

The SEPP is a way for people who do not have enough income + Roth IRA contributions + taxable investments to retire early (pre-59.5) but would still like to do so. If you’ve been maxing out your 401k all along, but saving little else, this might be you.

My preferred solution to early retirement– and the one I’ve been lucky enough to accomplish by the time I turned 38– is to just max out your retirement accounts and THEN save a lot in your taxable accounts, using these until you turn 59.5 and can tap your Traditional IRA/401k. However, this requires enough income-net-of-expenses-taxes-retirement to be able to do it. For most people reading this will mean making over $100,000 a year at least for many years. Fortunately, most people reading this are exactly in that situation and could do it if they cut their spending and used the Better Tomorrow Financial banking system.

Credit: wrote a few excellent articles on how he used a SEPP IRA to fund his early retirement. I’m using his term ‘backdoor early retirement’ as a great way to describe this technique.

Author: Ward Williams

Ward is an independent financial advisor at Better Tomorrow Financial. He started working as an independent investment advisor in 2009.

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