Imagine you have diligently saved over the years for your retirement. You have a substantial amount, and the math works that you would be able to work part-time or even retire early if you could access your funds. Unfortunately, you are younger than 59 ½ and your money is tied up in pre-tax or qualified plans. Certainly a “first-world problem.”
Retirement plans, such as IRAs, 401(k)s, SEP-IRAs or SIMPLE IRAs, allow you to save money pre-tax, thus lowering your taxable income during your working years. Some plans allow you to contribute after-tax money as well. The funds in these plans grows tax-deferred until retirement age. After 59 ½, you can begin taking distributions, paying only ordinary income tax on the taxable portion of your withdrawals. If you choose to access your money early, the IRS imposes an early distribution penalty of 10% on the withdrawal. Depending on your current tax bracket, an early distribution can cost you 40% to 50% of your withdrawal.
While you cannot avoid paying taxes on that money, you can avoid the early withdrawal penalty that is levied on the gross amount of your withdrawal prior to age 59 ½. Roth IRAs are funded with after-tax money, so they are a bit more flexible than other pre-tax retirement plans. You contribute money after-tax, and the earnings grow tax free for your retirement years. Direct contributions are always accessible, penalty and tax free. Earnings can be accessed penalty and tax free after age 59 ½. However, to contribute to a Roth IRA, your adjusted gross income (AGI) must be less than $131,000 for single or $193,000 for joint filers.
How do you access your retirement money early if you don’t have a Roth IRA? It takes a little planning, but it is possible. The Tax Increase Prevention and Reconciliation Act of 2005 repealed the income limits on Roth conversions starting in 2010. Therefore, many investors who were above the income limits for contributions were able to convert money from pre-tax retirement savings plans.
You can convert money from your pre-tax plans to a Roth IRA, paying the tax on the money at the time of the conversion. Roth IRAs allow you to withdraw converted money after it has been in your Roth for five years. Roth conversions are not an all-or-nothing deal. You can do it slowly over the years, converting only amounts which you can afford to pay the taxes on. Furthermore, each conversion amount has its own five-year time period, so with multiple conversions, there may be multiple five-year periods underway at once.
If you know you will want to pull money out early, you can begin converting a set dollar amount each year to a Roth. It is advisable to pay the taxes from funds outside of the pre-tax account. After funds have been in the Roth account for five years, you can withdraw the converted funds tax and penalty free. Earnings on the converted funds should remain in the account until age 59 ½. Otherwise, withdrawals of earnings will incur the 10% early withdrawal penalty.
Your retirement savings are meant for your retirement years, but if you are able to retire early, there are ways to access your funds. If you have questions regarding how a Roth IRA conversion can work within your overall financial plan, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.