Monday, November 2, 2015

How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA

One of the biggest mistakes I ever made was not maxing out my 401 (k), IRA and HSA accounts between 2007 and 2012. As a result, I ended up paying tens of thousands of dollars in income taxes and taxes on capital gains and dividends. Those are tens of thousands of dollars in taxes that could have built up my networth and passive dividend income. Instead I ended up handing those over to the IRS and my state. The opportunity cost of these money is in the hundreds of thousands if not the millions over the next 30 - 40 - 50 years.

The reason why I never maxed those out is because I didn’t know a lot about them. I also prided myself with my success that I was paying a lot in taxes. When I was doing my 2012 tax return however, I was sick that my total tax liability exceeded the amount I paid on housing and food. In fact, the amount I paid in taxes was equivalent to what I can live on in retirement. I saw that a fellow blogger from the site Budgets Are Sexy had written about maxing out his SEP IRA and Roth IRA’s, thus saving tens of thousands of dollars in taxes just for one year. So I opened a SEP IRA and maxed it out, saving 30 cents in taxes from every dollar I contributed to. Here was I researching companies, competitive advantages, earnings and valuations, yet I had overlooked the simple power of tax-deferral and tax-deferred compounding of capital. As I kept researching, I I found the sites of Mad Fientist and Go Curry Cracker, which opened my eyes on the benefits of tax deferred accounts. These investors had managed to retire early by taking advantage of the tax code, and then were paying zero dollars in taxes during their early retirement. Another one I thoroughly enjoy is Justin from Root of Good, who retired at the tender age of 33 and paid pretty much zero in taxes.

My biggest misconception was the fact that I thought that the money is locked until the age of 59 and a half years, and that I cannot touch the money. This was wrong. I also see this misconception has deep roots in many dividend investors I have talked to. These investors mistakenly believe that you cannot withdraw money from retirement accounts when you are aiming for early retirement in your 30s or 40s or 50s. As a result of this misconception, these dividend investors will end up hundreds of thousands of dollars poorer over their lifetimes. This is the reason why I am writing this article. Ever since I had my awakening moment in 2013, I have tried to educate investors. I have been unsuccessful for some, but I will continue fighting.

I will discuss the rules on withdrawing money from each account, and how someone can circumvent them legally to withdraw money and pay no taxes in the process.

401 (k)

Almost everyone who works at a large company in the US has access to a 401 (k) plan. In 2015 you can contribute up to $18,000/year if under age 50, and $24,000/year if over the age of 50. If you contribute to regular 401 (k) with pre-tax money, you save Federal and State taxes on each dollar you put in those accounts. If you contribute to a Roth 401 (k), you pay taxes upfront, but are not taxed when you withdraw that money. The money compounds tax-free in both vehicles. The only difference is that with the pre-tax 401 (k), you pay ordinary income taxes when you are eligible to withdraw money. In my case, when I put money in a 401 (k), I save 25 - 30 cents on the dollar for each pre-tax dollar I contribute. I could essentially buy stocks at an immediate 25% - 30% discount.

There is also the after-tax 401 (k) contributions, which is an advanced topic I covered earlier. This makes sense only if you can convert those dollars immediately to Roth.

If you simply withdraw money from a 401 (k) when you quit a job, and you are not 55 and are not doing Substantially Equal Period Payment (SEPP), you will pay ordinary income taxes on the withdrawals and also pay a 10% early penalty. So that’s why I don’t advise simply withdrawing money. This is one of the main the reasons why I never maxed out my 401 (k), but merely contributed a little over the employer match (prior to 2013). I believed that the money was "locked in" - when in fact there are ways to get it out.

If you quit your job after the age of 55, and you retire, you can start withdrawing money from this account. The withdrawals from the regular 401 (k) will be taxed as ordinary income.

If you retire before the age of 55, you can withdraw money using Substantially Equal Period Payment (SEPP) formulas. This is a formula that is based on your age and life expectancy and interest rates. For a 40 year old male today, the withdrawal rate is around 2.50% - 3%. If you start SEPP, you have to continue doing it until you are age 59 and a half. Withdrawals are taxed as if they were ordinary income. This calculator from Bankrate could be helpful.

There are certain ways that you can withdraw money without incurring the 10% penalty, such as buying a house, education etc. But withdrawals will be still taxed at ordinary income tax rates.

There are required minimum distributions at age 70 ½ for money in a pre-tax 401 (k) or Roth 401 (k). If you do not withdraw a certain amount at least, there are steep penalties. If you are still working however in a company in which you do not own more than 5%, and you have your 401 (k) money in that company plan, you are not subject to required minimum distributions. I had a co-worker who recently retired at the age of 73. They were able to delay required minimum distributions for 3 years, allowing their money to compound tax-free for longer and grow their passive income stream even further in the process.

With a 401 (k), you are limited to investing in the menu of mutual funds that your employer workplan offers. Most large employers have a large pool of employees, which enables them to offer cheap index funds to plan participants. A few offer brokerage windows that allow employees to select their own individual investments such as dividend stocks, bonds, ETFs etc.

A few small employees offer expensive mutual funds that cost 1%/year. It might still make sense to max out a 401 (k) plan there, even if you are paying 1%/year, as long as you plan to stay at the place for less than 5 - 6 years. If you leave the employer, you could roll the money over to an IRA or to your next employer's 401 (k) plan. Unless your financial situation is desperate however, I would advise against cashing in a 401 (k) plan early when changing employers.

The thing I have not discussed is that most employers tend to add matching funds to the 401 (k) plans of employees who make contributions that exceed certain amounts. For the purposes of discussing taxes, this fact is not relevant. For the purposes of accumulating assets for retirement however, this employer match is an important part of your total compensation package. I for once have always taken advantage of the employer match, no matter how I disagree with the investment options in the plan.

You may also want to read up on the "Roth Conversion Ladder" below, in the section for Roth IRA's.

Regular IRA

With a regular IRA, you can contribute up to $5,500 or $6,500/year, depending on whether you are younger than 50 or older than 50. Dollars coming in are deductible, and withdrawals are taxed as ordinary income. However, deductions phase out at moderate incomes, which makes it tough for people to max out 401 (k) and IRA. For high earners who are not eligible for a Roth IRA however, they can still put money in an IRA but they won’t get a tax deduction today. They can however immediately convert that amount into a Roth IRA, which we will discuss below.

There are required minimum distributions at age 70 1/2. If you do not withdraw a certain amount at least, there are steep penalties. This is similar to what we see for 401 (k) plans.

You can invest in pretty much anything with Regular IRA's - including individual dividend paying stocks, bonds, mutual funds, ETFs etc.


Health Savings Account is available to individuals in the US who have enrolled into a high-deductible health plan (HDHP). For 2015, individuals cannot contribute more than $3,350/year, while families cannot put more than $6,650. There is a catch-up contribution of $1,000/year for individuals who are older than 55.

An HSA allows people to save on Federal, State and Social Security and Medicare taxes. For every marginal dollar I put in an HSA, I save 25% Federal taxes, 5% on state taxes, and 7.65% on Social Security and Medicare Taxes. I can withdraw the funds at any time to pay for medical expenses without being taxed on them. I can also invest the money and let it compound for the long-term. If I pay non-medical expenses, there is a 20% penalty in addition to ordinary income tax being paid on the withdrawal.

After the age of 65, I can spend the money on anything I want, without paying a penalty. There are no required minimum distributions. While withdrawals after the age of 65 are taxed as ordinary income, withdrawals for medical expenses are never taxed. I would imagine that when I get to be 65, I will have some medical expenses. So maxing out this account today, getting all the tax benefits, letting the money compound for decades, and withdrawing the money for medical purposes down the road without paying any taxes is a no-brainer for me.

Roth IRA

This is the holy grail of retirement accounts. While money contributed to a Roth IRA do not provide any tax deduction today, money compounds tax free and can be withdrawn tax-free after 59 ½ years of age. Contributions, but not earnings from a Roth IRA, can be withdrawn at any age. The catch is that individuals who earn too much money cannot contribute to a Roth IRA They can do the backdoor Roth IRA described above, where they put money in a non-deductible IRA and immediately convert into a Roth IRA. The nice thing with a Roth IRA is that there are no required minimum distributions on money in that account. Translation – the account compounds tax free for years, and does not have requirements on withdrawals..

You can invest in pretty much anything with Roth IRA's - including individual dividend paying stocks, bonds, mutual funds, ETFs etc.

When you quit your job, you can convert the regular 401 (k) into a Roth IRA. After five years, you can withdraw that converted amount penalty free, even if you are younger than 55 years. The thing to consider of course is that this conversion will be taxed as ordinary income. So if you have $300,000 in your 401 (k) plan, you will pay a marginal tax of over 39%, which is prohibitively expensive.

The smart way to do this is to convert just enough from a 401 (k) to a Roth IRA, so that you pay the least amount in taxes today. For example, my plan is to convert approximately $20,000/year from a 401 (k) and Regular IRA into a Roth each year in retirement. The $20,000 assumes a married couple, filing jointly. It is comprised of two standard deductions and two personal exemptions. As long as my qualified dividends are below $75,000/year, I will not have to pay any Federal Income taxes.

So the plan is to convert $20,000 from an IRA/ 401 (k) into a Roth IRA when taxable income is low in order to be the least amount of taxes ( if any). The $20,000 will then be available for withdrawal in five years. The next year, I will convert another $20,000 from a IRA/ 401 (k) into a Roth IRA. That money will be available for withdrawal in 5 years penalty free. This can go on and on. When you have assets in a tax-deferred account, you have more flexibility, and can essentially "manage" your income tax bracket. This exercise is called the Roth Conversion Ladder, and has been extensively researched.  You do an IRA to Roth IRA conversion, and after five years, the money will be available for withdrawal, tax-free and penalty free. Who said you can't have your cake and eat it too?


All of this requires planning, and long-term thinking. This planning is well worth it however. As a buy and hold dividend growth investor, who plans to hold on to stocks for decades, I believe that I fit the requirements for long-term planning.

Let's assume that I earn $20/hour at a day job.  Let's also assume that I max out my 401 (k) and save $5,400 in taxes per year because of that. This means that the amount I saved in taxes in equivalent to me working at a day job for 7 long weeks. Yes, you heard that correctly - by maxing out my 401 (k), I do not have to waste 7 weeks of my life every single year by slaving away to pay the IRS. I am amazed how so many frugal people are willing to avoid paying for health insurance, inconvenience themselves by taking the bus to work, and eat cheap and unhealthy food to save a couple of dollars, when they are ignoring the big expense items like taxes.

If you are able to cut tax expenses to the bone, you will be able to accumulate more income producing assets in less time. This is a mathematical fact.

Not having to pay taxes on dividend income and realized capital gains will speed up the asset accumulation phase. Even if taxes on qualified dividend income increase over time, the dividend income in my 401 (k), IRA, Roth IRA and HSA will be shielded from taxation for three to four decades.

But yes, you read that correctly. For any dollar I put in a 401 (k) or IRA today, I reduce my tax liability by 25% at Federal level and about 5% at state level. So if I put $18,000 in a 401 (k), I also save $5,400 that I can put in a Roth IRA. If I convert my 401 (k) slowly into a Roth IRA, I will never have to pay taxes again on that money and the money that is generated from it. In addition, if a physical person inherits my money ( relatives, spouses, girlfriends etc), they will not have to pay taxes on that income. They will have to withdraw a certain percentage each year, but that is not a problem to have when you earn tax free income for life.

Do you take long-term tax planning into consideration with your investment plan?

Thank you for reading.

Full Disclosure: None

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investors
Health Savings Account (HSA) for Dividend Investors
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Should taxes guide your investment decisions?

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