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.)

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.

Leisurefreak.com

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:

Leisurefreak.com 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.

Retirement plans for the self-employed and the small business owner

Now that I’m self-employed, I had to refresh my memory on the best way to make tax-deductible contributions for my retirement.

Individual Retirement Account (IRA)

The simplest option– which anyone with earned income can use, regardless of whether you’re in business for yourself– is a Traditional or Roth IRA. The downside is that you can only contribute $6,000 per year ($7,000 if you’re 50 or older), and you must have income of less than ~$150,000 in 2021 for the Roth IRA option. There’s no income limit for deducting your contributions to a Traditional IRA.

You can only contribute if you had at least that much in net income for the year. For example, if you only made $3,000, you can only contribute $3,000.

Open your IRA with no fees and a great investment lineup at Vanguard here.

Individual 401k (aka Solo 401k)

If you don’t have any employees besides your spouse or a partner or shareholder in the business, and if you want to contribute more than an IRA lets you, or want to get around the Roth phase-out income limit, then the Individual 401k is probably your best bet. You can contribute as both an employee– $19,500 IRS limit for 2021– as well an employer with up to 25% of your net earnings. The grand total of both your employee + employer contributions can’t be more than $58,000 for 2021.

Set up an Individual 401k for free with Vanguard. Vanguard charges no management fees once your balance reaches $50,000, and it’s only $20 per year per investment fund until then, which is a fantastic bargain.

Just so you know, you will have to file Form 5500 with your taxes each year if you go this route, which will be handled no problems by your tax software or accountant.

SEP IRA or Simple IRA if you have employees

A SEP-IRA lets you, the employer, make discretionary contributions to your employees, but they can’t make any on their own. They can open up their own individual IRAs if they would like to.

A Simple IRA lets employees contribute up to $13,500 ($16,500 for 50+) in 2021, but it’s limited to businesses with 100 or fewer employees. With a Simple IRA, you the employer must make contributions of at least 2% of employee salary through a direct contribution, or you can match some of the employee’s Simple IRA contributions.

You can compare these options in detail here. The SEP and Simple IRAs don’t require any separate IRS filings on behalf of you the employer.

Vanguard also offers a full-blown 401k option if your small business is getting bigger and you want something like what large employers offer. I imagine it costs more and has more hassle than the above options, but check it out if the other options don’t sound right for you and your employees.

Help your employees retire successfully

Educate your employees about their financial options and investment choices. Vanguard has excellent Target date retirement fund defaults, so make sure your employees get automatically shunted into those based on their ages, and make sure they are contributing at least 10% of their income by default as well. They can easily change this contribution, but you want to set them up for success even if they do nothing, which is very common.

Hire a pro to help you make the choice and set things up

If you want an independent financial advisor to guide you through your options as a small business owner or self-employed person, or to give a seminar to you or your employees on investing and personal finance, contact me.

How to retire way earlier in 10 minutes

This is the first post in a series of easy steps I’m writing for the New Year that will dramatically improve your financial security in 15 minutes or less.

Retire way earlier by boosting your retirement contributions in 10 minutes

Log into your employer’s retirement plan (e.g.: 401k/403b) and increase your contribution to 20%. Or, just put in the full IRS-allowed max of $19,500 for 2021. Divide $19,500 into your base salary to get a percentage.

Contributing 20% will only reduce your take-home by 15%-ish, depending on your tax bracket, because of the taxes you’ll save. If you were already contributing 10% to your 401k, an extra 10% will only cost you 7-8%. You can live off 93% of your old spending without even noticing, I promise!

If 20% is more than you can stomach to do right now based on your current spending, just log on and boost your contributions by 2-3% instead, which you definitely not miss since that’s a mere 1.5 – 2.5% of your take-home. After upping your contribution, set a goal of getting to 20% eventually, and use the automatic increase function that most providers offer to boost your savings annually by 2% until you get to 20% (or the max contribution limit.)

No matter how much you decide to contribute, definitely put in enough to get all of any employer matching your company offers. That’s free money you can’t afford to pass up.

Why boost your retirement contributions?

In addition to saving thousands a year in taxes, boosting your 401k contribution from 10% to 15% per year means you will have 50% more money at retirement.

Yes, that’s right, for the price of only a ~3.5% decrease in stuff-you-could-buy-that-you-didn’t-need-anyway, your income in your golden years will go up by 50%! Even a mere 2% boost from 10 to 12% ups your retirement income by 20%, so at least do that much.

I’d take this deal any day; wouldn’t you…? If you’re still not convinced that saving for your future is something you must do now, picture yourself in your 60s or 70s: grey hair– or white, if yours is already grey–, (more) wrinkles, a slower step, and someone wiser, quieter, but a little more lonely and less lively than you are now. Don’t you want that person– you— to be financially comfortable, maybe even relatively wealthy, even if it means a small sacrifice on the younger you?

Do it right now, before you read any further!

Log into your workplace’s retirement account, which for most people is either a 401k or 403b plan. Search your company’s benefits site if you don’t know where to go, or if you know they use Vanguard or Fidelity, head straight there and login (create an online login if you’ve never logged in before.)

Click on your 401k or 403b account if you have multiple accounts, and then look for something that says ‘contributions’ like ‘change my contributions’. Click that, and find your current contribution, usually expressed as a percentage of your base salary. Enter the new number that you decided upon above, and save your work. You should get some kind of confirmation screen.

Great work! Keep reading. You need to do one more thing while you’re logged in.

Optimize your investments with a few more button clicks

Switch both your current investments as well as your future contributions to a low-fee Target Retirement fund like those offered by Vanguard or the Fidelity Freedom funds. Choose the year closest to your 75th birthday (e.g.: if you were born in 1980, choose the 2065 fund.) You should see some option like ‘change investments’ and might have to do this once for future contributions and once for the money already invested in your account.

For bonus points, double-check your ‘beneficiaries’, or set them up if you haven’t before. You want to make sure your assets are sent to the people or charities you want to get them if something untimely happened to you.

Don’t have an employer retirement account? Use an IRA instead

If your employer doesn’t have a retirement account, or you freelance and don’t want to set up a self-employed IRA, open a Roth IRA at Vanguard instead, then set up automatic monthly deposits with this link after you’re logged in. The maximum yearly contribution if you’re under 50 is $6,000/year, and $7,000 if you’re 50+. Max out if you can.

I’m assuming a Roth is best for you since I’m predicting you’re at or under the 22% tax bracket (i.e.: you make less than $100,000 single, or your family makes less than $200,000 if married.) If your marginal rate is 24% or more and would rather save on taxes now, use the Traditional IRA instead.

You’re now retiring earlier, or more luxuriously, or both!

Boom! You just secured your age 60+ retirement in the time it takes to make a cup of coffee. Pat your self on the back, take a lap and hit the showers.

Next up, make this simple change to you direct deposit and never worry about spending too much again.

If you want to retire earlier than that, read this too.

Share in the comments how much you bumped up your contribution, and whether you changed your investments or beneficiaries!

The blueprint for retiring early – Part 1

I achieved financial independence at age 38. This is the blueprint I followed to do it.

Step #1 – Fix your spending

First, you have to fix your spending. I don’t mean ‘fix’ like it’s broken, I mean fix it as in only spend a constant, known amount of money. You might adjust this up or down over time, but for any given year you need to set a target spending budget and stick to it.

The key to fixing your spending is NOT by using a traditional ‘budget’, which no one does or sticks to, but with your employer’s direct deposit. Most companies will let you choose at least two or three different accounts to split your direct deposit into.

Let’s say you get paid monthly and have penciled out your budget at $3,000/month for everything: essentials + discretionary. You allocate $3,000 of your direct deposit to go to the checking account that you pay all of your bills and credit cards out of, and then deposit the ‘balance’ (rest of your paycheck) to a savings account which will ONLY be used for transferring money one way to your investment accounts ( = Roth IRA + taxable accounts.)

Having one single tub of money in your checking tempts you to spend everything most months, and then have nothing for unexpected or irregular expenses that only come around a few times a year. To avoid this problem, you should also having at least one other savings account that gets a fixed amount of money too, and use that as your ‘buffer’ fund for discretionary things that you can save up for and only buy once that fund has sufficient money in it.

I actually use multiple sub-savings accounts: one for travel, one for miscellaneous stuff I want like backpacking gear or household items, one for a future new (used) car when mine dies, etc, but do what is easiest to manage for you. If you sent $1,000 to your subsavings account(s) for occasional expenses and $2,000 to your checking for regular monthly bills, your early retirement financial picture would look like this so far:

Screen Shot 2020-05-07 at 10.38.36 PM

I’ve detailed exactly how to set this up, including what bank to use, here. For more on how to figure out what you’re spending in order to estimate your direct deposit needs, read this.

Once you have this banking system of accounts + automated transfers (including your all-important direct deposit) set up, there are only two points of failure:

1) you forget to transfer money from your sub-savings accounts back to your checking to pay for once-in-a-while expenses. Avoid this by using your bank’s app and making transfers as soon as you spend money that comes from a sub-savings account. Say you buy plane tickets for $1,500. As soon as you buy them, transfer that same amount from your Travel savings account to checking so that the money is there when your credit card payment comes due. (I recommend setting all your bills up to auto-pay for simplicity and to avoid late fees.)

2) The second point of failure is outspending the amount you’ve budgeted for. If you’ve correctly computed your recurring expenses that come from checking, you’re ok there. If you haven’t, either adjust your monthly deposits upward, or if it’s just a temporary blip, ‘steal’ money from your subsavings accounts to pay for a higher-than-usual monthly bill. For your discretionary expenses that you’re accounting for in your sub-savings accounts, you must wait to spend that money until you have enough in your sub-savings account to pay for it. For example, if you have a Travel fund, do not book your next vacation until you have enough in that sub-savings account to pay for it. This develops the simple-yet-essential habit of not spending money you don’t have.

Your goal in all of this is to steadily increase your rate of saving as your income increases over time. People with steady employment that fail to build wealth are increasing their spending to match their income increases. Thus they never ‘get ahead’, and with credit cards and debt, they can even spend enough to fall further behind despite worker harder and earning more over time.

For people that are serious about accelerating the date at which they can work for fun versus money, you want to eventually save 50% or more of your annual income. This is hardest when you’re just starting your career and your income is low, or if you’re just starting to get a handle on your expenses. Don’t be discouraged: any increase in savings is a big step in the right direction! I saved barely anything straight out of college (but I did save something), and now, 15 years later, I’m saving well over 50% of my take-home pay as my income has increased by keeping my expenses at the same level they were for the past ~10 years.

The rich get richer

Once you fix your spending, you’re now banking every windfall that comes your way. Bonus at work? You get to keep all that. RSUs vest? Bank it. Annual raise? More and more yearly savings moving you closer and closer to financial independence.

In Part 2 we’ll discuss Steps 2 and 3: maxing out tax-free savings and what investments to choose for maximum growth with minimal long-term risk.