We have $1.6 million but most is locked in our 401(k) plans — how can we retire early without paying so much in taxes?

I am trying to come up with a path to retire within the next two to three years and need some help. I will be 54 this summer and my wife is 48. Between us we make about $210,000 a year. We currently have about $1.6 million saved with $680,000 in my former employer’s 401(k), $300,000 in my wife’s former employer’s 401(k), $600,000 in my current employer’s 401(k) and $75,000 in various stocks we hold. I currently contribute about $25,000 to my 401(k) every year, which includes my employer’s match.

We have a vacation home worth $225,000 that is paid for and have about $250,000 equity in our current home. We have two children in college right now but that will be done after next year. I feel we can live pretty cheaply, for around $70,000-$80,000 every year, but we do want to travel in an RV a lot once we retire and we want to do this while we can still enjoy the outdoor lifestyle. We’ll cut it down to one house, probably the vacation home, or we’ll sell both and move/build somewhere else. But we’d be sure to live in the vacation home for two years to avoid paying gains on the sale of it.

I feel we have enough savings and it’ll continue to grow the next two to three years before we decide to call it quits but the challenge is how to get to the money since it’s all in 401(k) plans right now. We could fund a year of retirement with just the sale of the stocks we hold but would still need to fund at least another year before we could tap into my 401(k) at age 59 1/2.

Is it worth just paying the 10% penalty on early withdrawals versus paying tax and converting a large amount of the former 401(k) plans to a Roth? My company does allow withdrawals through the rule of 55 but you have to withdraw it all and I know I don’t want that tax liability. Any help or advice would be appreciated.

Thanks!

Dear reader,

Congratulations on amassing such a lofty nest egg. You bring up an interesting dilemma some retirement savers may not think of, which is having your retirement assets locked away in investment portfolios intended to be used at an older age.

Employer-sponsored retirement accounts, such as 401(k) plans, are a great tool for investing for retirement because they are tax-deferred, which means more money is growing until it’s time to withdraw. They also have a higher annual contribution limit than some other tax-advantaged portfolios, such as individual retirement accounts. But, as you’re experiencing, the money can be hard to withdraw for those looking to retire before age 59 ½, as they will face a 10% penalty on top of the taxes they’ll owe at distribution.

Fear not — there are ways around this problem, financial advisers said.

The first task is to double check on your company’s policy for the age 55 rule (for readers unfamiliar with this rule, it allows people age 55 or older who were separated from their jobs — either because they were fired or voluntarily left — to tap into the 401(k) from their current employer before the required age 59 ½). Companies may have their own stipulations on this rule, but an “all or nothing” policy seems rare, said Henry Hoang, founder of Bright Wealth Advisors.

Read: This is how you can withdraw from your 401(k) at 55 — without paying a penalty

If it’s really not possible, there is the 72(t) option, also known as the substantially equal periodic payments, or SEPP. With this rule, investors have to take equal distributions for the longer of at least five years or until age 59 ½ (the Internal Revenue Service uses formulas to determine the amount of these payments). SEPPs can get pretty complicated, and investors should exercise extreme caution. If investors break the rules of the 72(t) option — mistakes include taking too much money or rolling other money into the account — the 10% penalty could apply to all distributions, said Matt Stephens, financial adviser and founder of AdvicePoint. “If it is set up right and executed right, it can work fine,” he said.

One way to make the 72(t) work is to roll over the 401(k) assets into IRAs, said Daniel Graff, principal and client adviser at SBSB Financial Advisors. “You can actually slice and dice your IRA into as many pieces as possible,” he said. With this strategy, you could then break up the IRAs and apply the 72(t) to a portion of your assets. But again, this can be a complicated process, so you may want to refer to a financial planner to assist with this strategy so that you don’t make an expensive mistake. Here’s more information on 72(t) distributions from the Internal Revenue Service.

You said you plan to work for another two or three years, so you may also want to think about investing your future 401(k) contributions into a taxable brokerage account instead, Graff said. For the typical retirement saver, this might not be the right path, but considering you plan to retire within a few years and the distribution restrictions that come with a 401(k) plan, this could be a reasonable strategy. You’re likely right on the cusp of the 22% and 24% federal tax brackets (and those 401(k) contributions may help push you into the lower bracket) but you might find forgoing that deduction now in lieu of saving in an account you can tap into at any time to be worth it. With a taxable brokerage account, you do contribute with after-tax dollars and would pay the taxes on the gains in that account, but you also aren’t forced to wait until 59 ½ years old or get hit with a penalty for the distributions.

For all of your accounts — the current and former 401(k) plans and the stocks — do a thorough analysis of your investment holdings, Stephens said. “Anything can happen in the stock market,” he said. “I would look at how diversified the portfolio is. It sounds like an obvious thing but 2008 was a long time ago, and people don’t remember what it’s like to lose half of their investments.”

For investors with long time horizons until retirement, this is not an issue, but if you plan to rely on these funds in the very near future, you need to ensure they’re protected.

“The worst thing that could happen to them, which is actually a pretty high likelihood, is a near-term stock market correction,” Hoang said. Consider keeping some of your assets in cash so that you don’t have to draw down your portfolios if the stock market is having a bad year, he said.

Also, Roth conversions may work when you’re officially retired, because you’ll be in a lower tax bracket without your salaries.

As for your home, it’s great that you’re thinking of the capital-gains tax implications. Selling the primary residence first definitely comes with tax benefits (as you know, married individuals get a $500,000 exclusion if they’ve lived in the home for two out of the last five years).

I write this caveat in nearly every column piece, but I always think it’s worth reiterating — make sure you’ve double and triple checked your living expense estimates. You said you expect to live on $70,000 to $80,000 a year, which may be totally doable for your lifestyle choices, but imagine all of the expected and unexpected costs you may run into, such as healthcare (especially if you’ll be out of work for a few years between retiring and Medicare eligibility), extensive travel, desires to help future grandchildren pay for college and so on.

“Putting all of those things into a financial plan will help you figure out if you’re ready to retire,” said Stephanie Trexler, chief executive officer and financial adviser at Golden Goose Wealth Planning.

Think of this analysis as buckets, Trexler said. One bucket is for the absolute necessities, such as the costs to keep the lights on, pay property taxes and feed your family. The next could be entertainment, including a golf membership or frequent dinners out. Also have a bucket for emergency situations, which no one could ever predict (like the current pandemic we’re living in).

Another consideration that might seem obvious but is worth noting: think carefully about your days in retirement before you actually do it. You mentioned traveling around in an RV, which sounds like fun, but think about all of the ins and outs of this plan, and what you’d do as a backup if you ever grow tired of that lifestyle. You may also find it easier if you transition into retirement, Trexler said. “Are you really ready to retire and hang up your hat or can you work part-time and ease into retirement to provide more flexibility?” she said.

With nearly all retirement plans, there needs to be social engagement, physical activity and a sense of purpose for your days, especially considering your retirement could potentially last three, even four decades.

“A lot of times when we’re in the middle of a career, we imagine a glorious retirement,” Graff said. “Then when it happens, you go ‘Oh my gosh, why should I wake up tomorrow?’”

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