Yes, classically a Roth IRA is supposed to be used to provide savers with the opportunity to enjoy tax-free retirement income later on in life.
Who doesn’t want to NOT have to pay taxes during retirement?
But if you understand the in’s and out’s of the rules, they can also be used to provide retirement income in thus difficult years between an early retirement and age 59-1/2.
It’s a very simple and easy-to-execute strategy.
But you still have to be careful! There are some important rules to keep in mind.
Otherwise, you might still get stuck paying that pesky 10% penalty you’re trying to avoid on a portion of your savings that is supposed to be tax-free
In this post, we’re going to talk about how you can work this little-known loophole into your early retirement hacking plan.
The Roth IRA Early Withdrawal Rules
Before we get into this strategy, let’s first talk about the different parts of just what makes up a Roth IRA.
As you probably already know, a Roth IRA is a retirement account where you save your money using after-tax dollars. That means at the end of the year when you file your Federal income tax return, you do NOT get credited for contributing to the Roth (and hence taxes are paid on that money).
The upside, however, is that your savings grows tax-free for the life of the account. Once you’re ready to retire (after age 59-1/2), you get to take out the money tax-free to use for your living expenses. A lot of people see this as being a great feature because when you’re older and retired, who wants to have to pay taxes?
Early Access to Your Contributions
While having tax-free income later on in life is a really cool thing to have, a Roth IRA also has another really useful built-in benefit: You can pull out your contributions whenever you want to.
That’s right! Because your Roth IRA contributions were funded with after-tax dollars, the government doesn’t care when you access this money. Since you already paid your dues on this income, its yours to do with as you please – tax free.
Now remember that when we say “contributions”, that’s different than your earnings. Here’s the difference:
- Your contributions – the money you saved. This is the part you CAN take out whenever you want.
- Your earnings – the money that grew on top of your contributions. This is the part you can NOT take out until you turn age 59-1/2 without penalty.
If you contributed $20,000 over the course of 5 years, and your balance was $25,000, then you’d be able to withdraw $20,000. The other $5,000 would be the earnings and ineligible for early withdrawal.
Sounds good so far right? Before you can go withdrawing your contributions, there’s just one small thing you need to be aware of:
Make sure your Roth IRA passes the five year rule first.
The Roth IRA Five Year Rule
What’s up with waiting for five years?
Officially according to the IRS rules, you’ll want your Roth IRA to have aged at least five tax years before pulling out any of your contributions from it. Otherwise your earnings won’t be what they call “qualified” or tax-exempt when you go to pull them out after age 59-1/2.
In other words: Even though you could pull your Roth contributions out any time you want, there is a danger there of inadvertently making the earnings taxable if you make your withdrawal too quickly.
You’re under age 59-1/2 and you start a Roth IRA. 3 years later, you withdraw your contributions. You can do that, but the earnings on those contributions are no longer tax-free or penalty-free.
If you keep the Roth open, allow it to age five years or more, and you become at least 59-1/2 years old, then the earnings would become tax-free. This would go for both any earnings you had accumulated before you withdrew your contribution and after.
The good news: The clock starts when you make your first Roth contribution. Once you’ve opened your Roth IRA and it has aged for at least 5 years, the requirement is satisfied. You don’t have to wait another five years for each set of contributions. In year 6 if you contributed $5,000 and suddenly had an emergency, you could turn right back around and pull your contribution out without affecting the earnings.
Note that when we say “tax years”, we mean the year your contribution counts; not necessarily when you made the deposit. Example: You contributed to your Roth IRA in 2015 but it counts towards your 2014 tax year. Since tax year 2014 starts January 1st, 2014, this means that January 1st, 2019 your Roth will have aged 5 tax years and satisfied the five year requirement. Now you can withdraw your contributions and the earnings will all count as tax-free later on.
If you want a ton of more detail, financial writer Michael Kitces has a really helpful article that explains this scenario far more thoroughly.
How a Roth IRA Can Help with Early Retirement
Let’s say you plan to retire early at age 50. If you can’t touch your retirement savings until age 59-1/2, then what do you do about the next 9-1/2 years?
That’s been one of the big struggles for anyone trying to lay out a strategy for how they can fund those early years before they can access their savings.
But as you can see, the perk of being able to access your Roth IRA contributions is one of the tools you can use to help bridge these early years.
Though it probably won’t fund the entire thing, it’s very likely that you could produce $500 to $1,500 of monthly tax-free income to help cover expenses during these first few years (depending, of course, on how long you’ve been contributing and how much money you’ve got saved up). I know I’m planning to use it as part of my master early retirement strategy!
Combine this with any one of our other early retirement funding strategies (72T, backdoor Roth IRA ladder, dividend income, etc.), and you’ve got yet another way to accomplish your overall financial freedom strategy.
Of course the big elephant in the room when it comes to using this strategy is the danger of running out of money too soon. This is why you have to really put some thought into how you want to structure not just your early retirement, but your whole financial future. Don’t risk having no money to live on by the time you’re 80, 90 or even 100 years old. Plan your withdraws sparingly!
Readers – How many of you plan to use the Roth IRA early withdrawal rules to help bridge the gap between when you retire early and when you can officially touch your retirement savings?
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