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How to Use a 401(k) Plan for Early Retirement

Joe Udo

I started contributing to my 401(k) when I started my first full-time job. It wasn't a hardship because the contribution was deducted out of my paycheck before I even saw it. The reduced paycheck was still much more than I earned as a college student.

The two biggest benefits of a 401(k) plan are employer matching and tax deferral. Many employers match a portion of your contributions to the 401(k) plan. That's often a 50 percent return on your investment, depending on the amount of the match. There is no other investment that will give you such a significant return that quickly. Plus, you get to defer paying taxes on the money you put in a 401(k). The longer you can put off paying tax, the faster your money will grow. Most people earn less in retirement than they do while working, so you may pay a lower tax rate on the money when you withdraw it in retirement if you drop into a lower income tax bracket. Tax deferral is likely to improve your retirement finances unless tax rates increase immensely in the future.

401(k) plans are a good introduction to investing because the money is withheld from your paycheck and there is a small selection of investments you can pick from. When you change employers, you can move the money over to a new 401(k) or an IRA. You can borrow from your 401(k) or make hardship withdrawals if absolutely necessary.

Of course, there are some downsides to 401(k)s. Some 401(k) plans have high fees and operating expenses and the quality of investment options could be poor. You also have to pay a 10 percent early distribution tax penalty if you withdraw the money before you're 59 1/2. The early withdrawal penalty can be a big problem for people who retire in their 50s or earlier and need to use the money in their 401(k) for living expenses.

Some people who plan to retire early invest at least part of their retirement money in a taxable account so that it will be accessible at any time and they won't have to worry about the early withdrawal penalty. But there are also several ways to withdraw money from your 401(k) without having to pay the early withdrawal penalty:

Retire when you're 55 or older. If you retire during or after the year you turn 55, then you can withdraw from your 401(k) plan without having to pay the penalty. This exception only applies to the 401(k) associated with the job that you retire from. So, if you have another 401(k) from a previous employer, then this exception won't apply to that 401(k). However, if your employer allows it, you can move the old 401(k) over to your current employer before you retire to access that fund.

Substantially equal periodic payments. Another way to access your 401(k) early is using IRS rule 72(t). First, you'll need to roll over part or all of your savings to an individual retirement account. Then you'll need to set up annuity payments from the IRA using an IRS-approved distribution method. The rule is pretty complicated, and you might need to work with a financial advisor to make sure it's done correctly. Your financial advisor should help you figure out how much money you need per year and then set up a rollover IRA to supply that amount. Once you start the substantially equal periodic payments process, then you will need to continue withdrawing for at least five years or until 59 1/2, whichever is longer. If you stop the payments before that time, then you will have to pay the 10 percent penalty on the entire previously withdrawn amount. The penalty can be quite substantial, so you really need a good financial advisor to help you though this process.

Convert to a Roth IRA. You can often withdraw your contributions to a Roth account without having to pay a penalty if the account is at least five years old. However, if you convert your traditional 401(k) balance to a Roth IRA, then you have to wait until five years after the conversion before you can withdraw that contribution without incurring a penalty. You also have to pay income tax on the amount you convert from a traditional to a Roth account.

401(k) plans are useful, even if you plan to retire early. Employer matching and tax breaks can help you to save more and retire sooner, especially if the investment options are good and the fees are low. There are also various ways to access your money in the 401(k) plan before age 59 1/2 without penalty. So, don't let the early withdrawal penalty stop you from contributing, even if you're planning to retire early.

Joe Udo blogs at Retire By 40 where he writes about passive income, frugal living, retirement investing and the challenges of early retirement. He recently left his corporate job to be a stay at home dad and blogger and is having the time of his life.

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