Do Retirement Accounts Make Sense if I Plan to Retire Early?

by Jul 19, 2023All, Retirement

Early Retirement

Putting money into your retirement accounts (401ks, IRAs, HSAs, etc.) is essential as there are tax benefits you take advantage of (pre-tax deductions, no taxation on dividends/capital gain distributions, and tax-free Roth accounts). However, these accounts usually have a 10% penalty if you withdraw from them before you turn 59.5, with an HSA subject to a 20% penalty before 65.

At first glance, retirement accounts may only appear suitable for those wishing to retire after 59.5; there are multiple strategies one can deploy to gain access to retirement funds early without hitting any of these penalties.

Roth IRA

Any direct contributions you make to a Roth IRA can be taken out at any time tax-free and penalty-free. For example, say you contributed $30k to a Roth IRA in the past, which grew to $50k. The first $30k you take out of your Roth IRA is always penalty-free and tax-free, while the earnings are generally subject to taxation and penalties if withdrawn before 59.5.

Roth Conversions & 5-Year Roth Ladders

When you convert traditional IRA money into a Roth IRA, the converted dollars are subject to unique withdrawal rules. Each conversion you complete is tracked separately (aggregated by tax year) and follows FIFO (First In, First Out) rules; you withdraw in the order of the earliest conversion. For example, say you converted $20k in 2021 and $30k in 2022 to a new Roth IRA that has grown to $60k. If you withdraw $30k from your Roth IRA, you will first withdraw $20k from the 2021 conversion and then $10k from the 2022 conversion.

Although you do not have to pay regular income taxes on withdrawing from Roth conversions (since you pay taxes during the conversion), there is a 10% penalty if you withdraw before five years have passed from when the conversion took place. This 10% penalty only applies to the taxable amount of the original conversion. Say you converted $20k of your pre-tax IRA in 2021 to your Roth IRA. The conversion is 100% taxable in 2021 because it is all pre-tax. If you withdraw it in 2023, you haven’t met the 5-year rule and must pay a 10% penalty on the $20k.

However, “backdoor” Roth conversions avoid this penalty issue because this usually occurs with 100% post-tax money. Thus, if you withdraw it before five years, you’ll owe a penalty of 10% on the taxable portion, which is generally $0.

Roth conversions allow a strategy known as a 5-Year Roth Ladder. 5 years before your anticipated retirement, you can convert traditional IRA into Roth IRA money every year. This technique will allow you to withdraw the money in 5 years without penalties. You could keep executing these conversions until you have sufficient penalty-free liquidity before age 59.5.


For early retirees, the IRS allows a method to withdraw from your IRA accounts known as SEPP (substantially equal periodic payment). It will enable you to withdraw a pre-determined percentage of your IRA every year without penalties (pay income taxes as you would typically in retirement).

To elect this, you must choose 1 of 3 distribution methods:

  • Amortization
  • Annuitization
  • Required Minimum Distribution

These methods consider your life expectancy and an interest factor tied to the federal mid-term rate (this interest is taxable income paid to yourself). However, once you elect to take SEPP, you must continue each year until you reach 59.5 or 5 years, whichever is later.

Important: Be careful when choosing to elect SEPP, as if you make a mistake, you may owe penalties for the year with the error and for every year that you have had SEPP. Given these complexities, please consult a tax professional before initiating a SEPP.

5-Year 401k Retirement

The Rule of 55 from the IRS states that if you have a 401k with your current employer and have already turned 55, you can quit for any reason and start taking distributions from that 401k account (but not other 401ks / IRAs) without penalties. You can do this to 59.5, in which case there are no more penalties. You can return to work (age 57, for example) and keep making distributions, but it must be the same 401k you’ve been withdrawing from.

HSA Withdrawals

You can withdraw from your HSA anytime for a qualified medical distribution tax-free and penalty-free, as long as the plan was open before the expense. You can use expenses from a past calendar year or in the current calendar year. You can withdraw from the account for any reason after reaching 65 without penalty, but you’ll have to pay income taxes on withdrawals if you haven’t incurred sufficient qualified medical expenses.

However, with an HSA, you must maintain your medical receipts, as it will allow you to withdraw from your HSA that amount tax-free and penalty-free, potentially many years from when the expense was incurred. Generally, if you can afford to from your cash flow, it’s best not to touch your HSA and let it keep growing. It is important to note that some states, such as New Jersey and California, do not recognize HSAs, which further increases the recordkeeping complexity.

Concluding Thoughts

As listed above, many ways exist to access money for early retirement. Furthermore, you’ll always have access to cash/investments in your taxable accounts. One important thing to be mindful of during retirement is balancing the taxation of your retirement withdrawals, as many variables can drive your overall tax liability (standard deductions, LTCG 0% rates, SS taxability, IRMAA surcharges, etc.).