The bridge: What you need when you retire early

One of my life’s goals is to become financially independent. This means that I won’t need to rely on work to earn an income.

(Yeah, it would be nice if we as a society could move to something approximating universal basic income, but in the meantime, we’ve got to put on our own oxygen masks, since no one is there to put them on for us.)

I believe (as does Chris Hogan) that your workplace retirement plan—your 401(k)—is the most lucrative tool you have in saving for retirement. Beyond that, I’d put the Roth IRA up there (if you’re eligible).

These tax-advantaged accounts have a stipulation though, that you can’t withdraw your funds before you reach a certain age. If you do, you’ll incur steep penalties.

This makes some sense. They are designed to incentivize long-term spending for a specific purpose (retirement), and so that you can’t game the system.

But not everyone is going to retire at age 65. You don’t need to be a foaming-at-the-mouth FI/RE person to be able to get to the point where you’re ready to retire and live off your assets before your government-approved age.

You don’t want to incur penalties. They are steep.

What you need is a bridge.

The age gap

As a rule, you need to be over age 59 1/2 to be able to take withdrawals from retirement accounts.

If you do any withdrawals prior to this age, you will usually be assessed a 10% penalty, plus have to pay income tax on some or all of the withdrawal.

That’s could be up to a 40% penalty! Imagine taking out $100,000 and having to pay $40,000? Ouch.

There are exceptions to this rule, but it’s the rule we want to go with for now.

So what do you do if you are ready to retire before age 59 1/2?

Bridge over troubled retirement

If you are planning, or even thinking of, retiring earlier than age 59 1/2, you will need to have access to funds that will not incur penalties for accessing them.

For many of us, that means a taxable investment account.

This can be a standard brokerage account where you can invest in mutual funds with already-taxed dollars. There are no tax-advantages to this account, except that when you withdraw your earnings, you will be taxed at capital gains rates, not income tax rates.

This means a tax rate of 15% for most people. Which is way better than 40%.

This account can be tapped at any time at all, with no penalties (though accessing earnings that have been held for less than a year will trigger short-term capital gains rates, which is the same as income tax rates, so you don’t want to do that).

This type of account isn’t nearly as good of a deal as the 401(k) or Roth IRA, but it’s still a better deal for those who are considering early retirement.

How big a bridge do you need?

The tricky thing is that you generally don’t want to put in any more than you have to, lest you lose out of the better deal of the retirement account.

So you need to do a little bit of math.

If you were wanting to retire at age 54 1/2, say, you would need to have five years of income saved in this account. Unlike your larger retirement plan, you don’t need to worry about replacement, since once 59 1/2 rolls around, the rest of your accounts should come into play.

So if you wanted to live on $50,000 a year (after tax, which is like an $80,000 salary), you would want to have somewhere in the vicinity of $250,000.

That’s a lot, of course, but if you’re going for early retirement, you’ve presumably got much more than this in your retirement accounts.

I call this a bridge account because it provides an income bridge between your working years and your retirement-eligible account years.

A backup plan: Roth IRA.

There is an interesting loophole here involving the Roth IRA.

The Roth IRA will penalize you for withdrawing your earnings. But not your regular contributions. As long as you have held your contributions in your accounts for at least 5 years, you can withdraw them. At any time.

I don’t recommend taking advantage of this unless you’re in retirement. Taking out your contributions too early can rob you of the power of compounding interest, and so possibly hundreds of thousands of dollars.

But if you’re in early retirement and you don’t have a big enough bridge account, I would take money out of your Roth IRA before tapping your 401(k) or other account. It’s the least worst option.

And remember, you’ve already paid taxes on this money, so you won’t incur any penalties at all.

What is your age target?

It’s an interesting thing, this early retirement.

Some of us are worried that we won’t be able to be retired at all. But others of us, those who are on a solid plan and working it year after year, may realize that eventually your financial net worth grows to such a point that working (either full-time or otherwise) just isn’t as necessary.

And if you’re at that stage, you don’t want to have to keep working just to avoid penalties.

A bridge account can help you here. The only question you want to ask is: when are you planning to get to the point when you’ll have the option of retiring?

If you don’t know that, that’s a question worth asking yourself, and working to figure out.

We’ll tackle that too here. Stay tuned.

Have you read my disclosure policy? Remember that nothing on this site should be considered investment advice. But I can still help you. Contact me and let’s talk about your specific situation.

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