Typically, accessing retirement funds early results in penalties and taxes, but with a few steps, you can learn how to access retirement funds early.

How to Access Retirement Funds Early

Accessing retirement funds early may result in a penalty if you aren’t careful. Fortunately, there are a few simple ways to take money from your retirement accounts without paying penalties.

1. Rule of 55

If you have a 401K or 403b account, you may be able to use the Rule of 55 to escape the 10% early withdrawal penalty. This rule states that if you leave your employer within the year that you turn 55, you can take funds from your 401K or 403b account at your current company penalty-free.

There are Rule of 55 pros and cons because there are many stipulations. For example, for this rule to apply, you must have left your job and be 55 years or older within that year.

This only applies to the current 401K or 403b account. If you know you’ll leave the company and want penalty-free access to other retirement accounts, roll them over to your current 401K, if allowed, before leaving.

To use this rule, your company must allow early withdrawals, and you must follow the company’s rules regarding withdrawal limits. For example, some companies may limit the amount of withdrawals, and others may only allow a lump sum withdrawal.

Keep in mind that you will be responsible for the taxes on your withdrawals. They are only penalty-free distributions, not tax-free.

2. SEPP/72t Withdrawals

The Internal Revenue Code 72t or SEPP allows early withdrawals from your IRA or employer-sponsored retirement account if you take substantially equal periodic payments.

Withdrawals that qualify as SEPP aren’t subject to the 10% early withdrawal penalty. However, there are strict rules they must follow:

• You must take substantially equal periodic payments annually.
• You must take the distributions for at least five years or until you hit age 59 1/2, whichever is longer.
• You must pay applicable taxes for the year you take the distributions.

You can determine your withdrawal amount based on an amortization method that considers your life expectancy.

Use the IRS’s required minimum distribution method, which changes the required distribution amount annually. Or use an annuitization method that uses an annuity factor provided by the IRS based on current interest rates and your age.

3. Roth Conversion Ladder

If you saved most of your retirement funds in a pre-tax retirement account, you can’t access them in most cases until 59 1/2, or you’ll pay the 10% penalty plus taxes. However, funds in a Roth IRA account can be withdrawn penalty-free as long as they’ve been in the account for five years.

If you don’t have adequate (or any) funds in a Roth IRA, you can use the Roth IRA conversion and convert a portion of your traditional IRA to a Roth IRA.

Keep in mind that when you convert funds, you’ll pay taxes at your current tax rate, so it’s best to convert funds periodically versus in one lump sum. The Roth conversion ladder is a method some use.

It means you convert funds based on your expected annual needs in five years. You can withdraw those funds exactly five years from the conversion date without paying the penalty. This should provide a steady stream of retirement income.

4. Pay the 10% Penalty

Of course, you always have the option to withdraw funds and pay the 10% penalty. If you’ve exhausted any of the above options and still need the funds, you can pay the penalty; just try to limit it to as few years as possible.

This method may even make more sense if your taxable income is $0 after deductions and exemptions. This may happen if you’ve already retired and your only income is the money you withdraw.

If you keep the distribution within the standard or itemized deductions you are eligible to receive, you only pay the 10% penalty and no taxes.

Is Withdrawing Retirement Funds Early a Good Idea?

Withdrawing retirement funds early can help supplement your income, especially if you retire early, but it’s not always in your best interest. Talking to your financial advisors is important to ensure you’re not creating financial challenges later in life.

If you create a solid plan to make your retirement savings last throughout your life expectancy, strategically withdrawing funds doesn’t have to hurt your financial future.

However, tapping into your retirement savings just because they’re there and you want something now versus using the funds for living expenses in retirement isn’t the best idea.

Reasons for Accessing Retirement Savings Early

Everyone has different reasons for accessing retirement savings early. Here are a few common reasons:

• Early retirement: If you stop working before age 59 1/2, you may need access to your retirement savings to have adequate funds for living expenses until retirement age.
• Hardship: If you experience financial difficulties or an unexpected hardship, such as extensive medical bills, you may need to access your retirement savings early.
• Education: Higher education expenses increase annually, and sometimes, using IRA funds versus student loans is less expensive. Some expenses may be penalty-free if they meet the IRS requirements.

What Is the Penalty for Early Withdrawal of Retirement Funds?

If you don’t qualify for any of the above methods for early withdrawals, you may be subject to a 10% early withdrawal penalty. This applies to each non-qualified early withdrawal you make. You’ll also be responsible for any income taxes.

Pros and Cons of Early Retirement Fund Withdrawals

Pros

• You may have options for penalty-free withdrawals.
• You can supplement your income if you retire early.
• You may avoid unnecessary interest charges on loans.

Cons

• It can be hard to qualify for one of the early withdrawal exceptions.
• You still owe taxes on any withdrawals except Roth account withdrawals.

Alternatives To Accessing Retirement Funds Early

It’s typically best to withdraw from retirement accounts early as a last resort. Here are some alternatives to consider first:

• 401K loan: You may be eligible to borrow from your 401K. This doesn’t incur penalties or taxes, but you’ll pay interest and must repay the full amount owed within five years.
• Line of credit: If you have equity in your home, you may borrow against it with a HELOC. They typically have low-interest rates and favorable repayment terms.
• Personal loan: Financial emergencies sometimes require funds fast, and a personal loan may offer that option. You can receive a lump sum within a day or two after approval in most cases.
• Part-time job or side hustle: If you can still work (and want to), consider starting a side hustle or finding a part-time job to supplement your income during early retirement, reducing how much you must take from retirement accounts when retiring early.

FAQs

How Much Can I Withdraw From My Retirement Account?

How much you can withdraw from your retirement accounts and how much you should withdraw are two different stories. You can withdraw as much as the account administrator allows.

However, you’ll pay taxes on the amount withdrawn, which can be hefty if you withdraw large amounts.

Ideally, you should take 4% or less of your retirement account balance to ensure your retirement savings lasts throughout your lifetime.

Can I Borrow From My Retirement Plan Instead of Making an Early Withdrawal?

Sometimes, borrowing from your 401K instead of withdrawing funds makes more sense. You avoid the early withdrawal penalty and taxes when you borrow money. Keep in mind, though, that you must repay the amount borrowed with interest.

Can I Avoid the 10% Early Withdrawal Penalty From My IRA for Certain Expenses?

The IRS has certain exceptions for the early withdrawal penalty, including:

• Birth or adoption expenses.
• After the death of an IRA owner.
• Permanent disability.
• Higher education expenses.
• First-time home purchase.
• Terminal illness.
• Unemployed health insurance.

How Long Does It Take To Get Retirement Money?

After cashing out your 401K or other retirement accounts, receiving the funds can take 7 to 10 business days.

Which Retirement Funds Should I Withdraw First?

Ideally, you should withdraw funds from taxable retirement accounts first. This allows tax-deferred accounts to continue growing without the risk of increasing your tax liability. It also helps lower the amount of taxes owed in your later years.

How Do You Calculate Substantial Equal Periodic Payments for a 72t Distribution?

The simplest method to calculate substantial equal periodic payments for a 72t distribution is to take your account balance and divide it by your life expectancy. You can recalculate this number at the end of each year.

Can I Use the Rule of 55 and Still Work?

You can work another job using the Rule of 55. However, you must keep your 401K with your old employer to continue taking distributions without penalty.

What About Roth IRA Early Withdrawal Penalties?

If you withdraw from your Roth IRA before age 59 1/2 and before your funds have been in there for five years, you’ll pay the same 10% penalty plus applicable taxes.

What Qualifies for a Hardship Withdrawal?

The IRS defines a hardship withdrawal as a withdrawal for a heavy and immediate financial need. Common reasons are medical or funeral expenses; however, each 401K administrator can define hardship for their accounts. Other examples include

• Immediate and necessary home expenses.
• Higher education expenses.
• Payments to avoid foreclosure or eviction.

Do I Need To Show Proof for Hardship Withdrawal?

The IRS does not require employers to provide proof of hardship for withdrawal. However, keeping documentation in case you are audited is always a good idea.

Can I Cash Out My 401K While Still Employed?

You can cash out your 401K from previous employers while employed, but you’ll pay early withdrawal penalties if you are not yet 59 1/2. Your current employer may have rules regarding whether you can cash out your current 401K while still employed.

At What Age Is 401K Withdrawal Tax-Free?

The IRS determines the retirement age to be 59 1/2. Withdrawals made after this age are free from the early withdrawal penalty.

The Bottom Line

Knowing how to access retirement funds early without penalties is crucial to your retirement.

The tax code allows several exceptions to the 10% penalty, but it’s best to consult your tax or financial advisor to determine the best course of action.

The post How to Access Retirement Funds Early: 4 Possible Ways appeared first on 7 Saturdays Financial.

Reader Question: “ I lost money on bonds. Should I sell?”

by: Allen |March 4, 2023| Bonds, Investing, Portfolio Design

Thanks for the question, David! Here’s the full text –

“I lost money on bonds, should I liquidate or hold the course? Investments are in an IRA so cannot write off the losses.“

Answer

The first question to ask yourself is – “Why did I decide that bonds belong in my portfolio in the first place?”

Has that reason changed?

If an asset is part of your financial plan, recent performance shouldn’t affect your decisions. There will often be times when part of your portfolio is losing money.

This is normal and doesn’t necessarily mean it was a wrong decision to own those assets. An efficient portfolio is designed to work as a system – certain segments balance out the risks of others. Diversification and rebalancing are key for keeping risk in line, and performance should be evaluated as a whole over multiple years.

Abandoning a long-term investment strategy because of recent losses is like closing the barn door after all the cows have run away!

While bonds aren’t as volatile as stocks, they can have moderate swings in a short period as we saw in 2022. To help you better understand the fixed-income asset class, I’ll cover some fundamentals:

First, you can expect riskier (more volatile) investments to generate higher returns than lower-risk investments. This is why stocks have higher expected returns than bonds, and bonds have higher expected returns than cash.

Next, let’s talk about the two main types of bond risk: duration and credit.

Interest Rate Risk (Duration)

Interest rates and bond values move in opposite directions so when interest rates go up, bonds fall in value and vice versa.

This asset class got slammed last year because the Federal Reserve raised interest rates seven times. There’s a silver lining to interest rate increases, though – new bonds are paying higher income (yield).

In the case of bond funds, new bonds that enter the fund to replace older ones will generate higher yields. This higher income will, over time, offset the value lost from the interest rate increases.

The number of years it takes for the effects of interest rate increases (value decrease + yield increase) to neutralize each other is approximately equal to the fund’s duration. This is a gauge of interest rate sensitivity and is a common measure to use when comparing bonds. High-duration funds hold longer-term bonds and will be more sensitive to rate changes compared to short-duration funds.

Since we know bond prices move the opposite direction of interest rates, it prompts an interesting question:

If I know interest rates will increase, should I avoid bonds or switch to short-term/short-duration?

It’s a logical train of thought.

However, even if we “know” (think) the Federal Reserve is going to increase rates, their adjustments only directly affect the overnight lending rate.

The Fed doesn’t go down the list of different bond maturities and physically adjust the 1-year rate, the 5-year rate, the 10-year rate, etc. These other rates are based on the market prices for the bonds which are set by market forces of supply and demand.

And just like any market, it’s hard to predict exactly what will happen. Expectations about the economy, inflation, and future interest rate increases are already baked in to market prices!

An example of market dynamics: If 10 year bonds are desirable, more people will be buying than selling which drives up the price. This price increase reduces the yield. When the yield gets to a point that the market no longer finds attractive, buyers stop buying and equilibrium is reached.

Overnight Rate: Fed -> Rate

Other Rates: Market -> Price -> Yield (rate)

Overnight rates are directly impacted by Fed rate adjustments. Very short-term bonds like T-bills (maturing in less than 52 weeks) will be somewhat sensitive to rate adjustments. But for longer maturities, it’s anyone’s guess and there are about a gazillion things that affect market dynamics.

Imagine grabbing the end of a 25-foot rope that is stretched out on the ground. If you swing your arm up, the rope closest to your hand will experience the greatest movement but the other end of the rope will move little, if at all.

This is a good metaphor for interest rate dynamics – the overnight rate is directly affected, very short-term bonds are somewhat affected, and longer-term bonds move much less predictably.

Credit Risk

The other risk factor for bonds is credit risk – the possibility you may not receive the interest or principal you’re promised.

Treasuries (government bonds) are considered to be zero credit risk because the government can simply tax its way out of budget challenges. Corporations don’t have that same ability – they can go bankrupt and default on their debt.

The less stable a company is, the higher the risk of default, and the lower its bond values. Remember, lower value means higher yields! Low quality corporates are also called “junk bonds” or “high yield.”

Now, back to why you chose to hold bonds in your portfolio…

It’s important to understand that fixed-income assets can provide varying degrees of stability, diversification, and/or income depending on the type that are selected.

Stability

• Short-term bonds are more stable and less sensitive to interest rates than long-term bonds.

Diversification

• Treasuries are a better diversifier for a stock-heavy portfolio than corporate bonds because treasuries are free of credit risk.
• There is usually a flight to safety during economic downturns, and this often causes treasury prices to rise while stocks are falling. This effect stabilizes the overall portfolio and reduces volatility.
• Corporate bond values get dragged down during recessions (due to credit risk) and fail to provide diversification when it is needed the most!
• Long-term treasuries are considered to be better diversifiers than short-term treasuries.

Income

• Short-term bonds are less risky (duration) than long-term bonds so they pay lower yields.
• Treasuries are less risky (credit) than corporate bonds so they pay lower yields.
• High-yield corporates (junk bonds) are riskier than other corporates and generate higher income.

As you can see, there is no free lunch.

If you want more stability, you’re giving up some diversification and income.

If you want more income, you’re giving up some stability and diversification.

Putting it all together:

It can be alarming when you lose money on a “safe” asset like bonds, but it’s always important to keep a long term view.

• Is your plan still on track?
• Have you rebalanced to manage risk?
• Is your portfolio designed to work as a system or is it a hodgepodge collection of assets you threw together?

Don’t look at the bond portion of your portfolio in isolation – think about your asset mix (stocks/bonds/alternatives/cash) as a whole and the role(s) you want bonds to play. Choose the appropriate type for this objective.

A suitable portfolio balances risk with return and aligns with your goals, timeline, and risk tolerance.

Book a free consultation if you’d like help creating a financial plan and designing an investment portfolio that is right for you!

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Should You Pay Off Debt Or Invest?

by: Allen |January 17, 2023| Debt, Investing

You’ve got extra cash! Maybe it’s from a raise, a bonus, or cutting expenses. Now, you want to improve your financial fitness but aren’t sure whether you should aggressively pay down debt or invest it.

Like most topics in personal finance, the correct answer is “it depends.”

There is good news -neither option is wrong. Both are much better for your wealth than an Amazon shopping spree or rushing out to buy a new car.

You should not make your choice based on “one-size-fits-all” advice that a guy on the radio prescribes, but rather your family’s situation, values, and goals.

Here are a few factors to consider when making your decision:

First – what’s the interest rate on your debt?

Credit cards typically have rates of 15 – 25%, whereas a 30-year mortgage rate could be sub-3%. Compare that to an investment portfolio expected to generate 7-10% annually over the long term.

Borrowing money at credit card rates and investing to earn a lower return doesn’t make sense. In this case, you’re better off directing every dollar you can toward extinguishing that debt. An exception would be investing up to your employer match in a retirement plan like a 401(k) or 403(b) since that match is “free money.”

On the other hand, a low-interest mortgage is a reasonable debt to pay the minimum on and carry as long as possible. The interest on this debt is tax deductible (only relevant if you itemize on your tax return). Sensible investments earn more than 3% over the long term, so you’re essentially borrowing at a low rate to invest at a higher rate.

If you have a cash reserve beyond an adequate emergency fund, consider using the surplus to pay down your highest interest debt. Checking and savings accounts historically pay low rates and you can often “earn” a higher rate by reducing debt instead of letting cash sit idle.

Remember that investment returns are volatile

Investment returns are not guaranteed.

That’s why they generate higher returns than cash over the long-term – because you’re willing to accept uncertainty. There can be long stretches with negative returns, and history has produced a few periods when you’d have been better off paying off your mortgage than investing.

Paying off debt – even low-interest debt – provides a guaranteed return and can offer peace of mind.

I’ve never heard anyone say they regret paying off their mortgage early.

Carrying zero debt can also make it easier to swing life transitions like a career change, sabbatical, or early retirement.

Think beyond debt interest rate vs. investment ROI

Comparing the interest rate on your debt with investment returns is a simple method. Those approaching retirement have additional variables to consider – how much will they need to withdraw from investments every year to cover debt payments? And what does that mean for the bottom line?

A retiree with $1,500/month mortgage payments will need to raise $18,000 more from *somewhere* than if their house were paid off.

That $18K would typically be withdrawn from their portfolio.

Depending on the account type(s) that are pulled from, this could require a $22K+ withdrawal (and increase to taxable income) to cover the taxes and $18K proceeds.

Larger withdrawals in retirement can mean:

• A higher effective tax rate
• More portfolio depletion during down years
• Higher tax rates on Social Security income or dividends/capital gains
• Less room in the current bracket for strategic Roth conversions, tax gain harvesting, etc.
• Higher AGI/MAGI which affects shadow taxes like IRMAA (Medicare surcharge), ACA premium tax credits, and deduction/credit phase-outs

Retirees should work with a competent financial planner that understands long-range tax planning. They can look at the overall situation and advise on impacts of carrying debt versus paying it off early.

Takeaway

You may have trouble deciding on if you should prioritize paying off debt or investing. Remember – it doesn’t have to be a binary decision. There’s always the option to split your cash and tackle both goals.

Personal finance is always personal, so choose the option that aligns with your family’s values and objectives!

If you have questions about debt management, reach out and book a complimentary intro meeting.

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Are I Bonds A Good Investment?

by: Allen |October 5, 2022| Bonds, Investing

Unless you’ve been living under a rock for the last year, you’ve probably heard of I bonds.

What are they? Are I Bonds a good investment? Should you invest in I Bonds now, or are you late to the party?

Read on to learn more about them and to understand if they may be a good fit for your situation.

What are I Bonds?

“I Bonds” is the common name for Series I Savings Bonds that the US Treasury issues at www.treasurydirect.gov. The interest rate on these bonds adjusts for inflation, and it resets every six months. I Bonds have been gaining popularity since 2021 as inflation (measured by CPI) began spiking above historical norms.

The current rate for I Bonds is 9.62% which applies to the first six months you own them (if you buy before October 31st, 2022). This interest rate is insane for a risk-free investment – principal value plus interest is guaranteed! You cannot lose money on I bonds, and the return is close to the stock market’s historical average of 10% (which is NOT guaranteed).

For comparison, 1-year and 2-year Treasury Bonds currently yield about 4.15% and carry a risk of principal loss if you don’t hold to maturity. I Bonds continue to earn interest until you cash them in or until the bonds turn 30 years old.

So what’s the hair in the soup?

A couple of things. First, you can only buy $10,000 of I Bonds per social security number per year. Trusts, businesses, and children can all purchase them, so a family of 4 with an LLC and a trust could buy a maximum of $60,000 in a calendar year. Additionally, you can use your tax refund to purchase up to another $5,000 worth.

The second caveat is that you cannot redeem I Bonds in the first 12 months. So if you use your entire emergency fund to invest in them and your car’s transmission goes out a week later – tough break. That money is locked up for a year, and you might have to resort to a credit card. There’s also a three-month interest penalty if you redeem them within the first five years, although the interest rate is so high that this is not exactly a dealbreaker.

Finally, the interest rate adjusts every six months. The current rate for October 2022 – April 2023 is 9.62%, which means a 4.81% yield for the first six months you own them. The next six-month rate is 6.46% for the remainder of the first year (or the first six months if you buy November 2022 – May 2023).

Beyond that, the rate is uncertain but will be based on inflation metrics and has a floor of 0% (will not lose value).

How is the I Bond rate determined?

Consumer Price Index (CPI) is used to measure the level of a basket of consumer goods and is reported by the US Bureau of Labor Statistics monthly. The change (typically increase) in CPI over time is inflation. During the period of September 2021 to March 2022, CPI increased by 4.81% and this is what set the current I Bond annualized rate of 9.62% (4.81% semiannually x 2).

The next six-month rate is based on inflation from March 2022 to September 2022, and the CPI chart below shows how the rates are derived. CPI has been climbing quickly for the last two years but has virtually leveled off.

Consumer Price Index (CPI) 2021-2022

A $10,000 investment in October at 9.62% (for half a year) would generate $481 of interest, and your new principal value in March would be $10,481. At the next six-month rate of 6.46% (for half a year), the end-of-year value would be $10,820. A full year’s return of 8.2% – not bad!

At this point you have two choices:
1) Redeem the bond and forfeit 3 months’ interest, dropping your ending value to $10,650 – still a great risk-free return of 6.5%
2) Continue to hold the bond until rates are no longer attractive

I Bonds can be a great risk-free investment if you have idle cash laying around that you won’t need for at least a year. It’s important to note that they only keep up with inflation, and aren’t a replacement for a long-term investment strategy. The interest you earn on I Bonds is exempt from state and local taxes but is taxable federally.

If you decide to buy I Bonds, purchase in October to guarantee the 9.62% rate for the first six months and 6.46% for the second. I recommend not waiting until the last few days in case there’s an issue with the transaction or settlement.

For more information or to purchase, head over to https://treasurydirect.gov/savings-bonds/i-bonds/

Are you an I Bond investor? Not sure when to buy or sell? Reach out for your free consultation to talk about your situation and goals!

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The post Are I Bonds A Good Investment? (October 2022) appeared first on 7 Saturdays Financial.