Friend accumulated $5M in 401k at age 40. Ways to access

[FrugalSaver]

Here’s the dilemma if you want to call it that. They have profit sharing in their 401k in a company that has exploded higher in recent years. They make about $80k / year. This account now dwarfs anything they have otherwise saved and they are very mistachian.

They are only 40 with almost 20 years to tap 401k.

So 72(t) is an option.

Another thing they are looking at is what if they withdrew money each year and paid taxes and penalty?

This money would completely change their life as far as supporting their kids by working less, etc.

If they tapped $100k per year, I understand they’d pay a 10% penalty taking that down to $90,000 and then pay taxes. Net net this would still be way more money than they bring home from working 50 hours per week.

Am I missing something on the financial impacts for taxes and penalties? 

Any thoughts on this?  Obviously no one wants to pay the penalty of 10% but the money is now so absurd based on their income and mustachian lifestyle, they are exploring options to completely change the next 20 years of their life.

[uniwelder]

You described the negatives of simply withdrawing and paying a penalty, so what about the 72(t)?  I guess they don't want to deal with the permanency of the steady money stream for 20 years whether they need it or not?  Isn't that how the 72(t) works-- once its set up, you can't change the withdrawal amount?

[Paul der Krake]

1) 72(t)
2) Roth conversion pipeline and associated 5 year delay
3) Pay the penalty
4) Wait until 59.5
5) Special "disaster" distributions (terms and conditions apply)
6) Get hit by a bus and become disabled

Those are the choices. The desirability of each is left as an exercise to the reader.

[secondcor521]

7) NUA if any part of the 401(k) is in company stock.  Not really a withdrawal method per se but something to look into.

Also, if this is a concentrated 401(k), they should strongly consider diversifying to protect the $5M.

If I were in their shoes, I'd probably do the 10% penalty for the first five years or so while also starting a Roth conversion ladder.  20 years is too long to do a 72(t) IMHO, especially if there are kids in the picture because kids have a tendency to make budgets doubleplus-unsmooth.

[FINate]

Another recommendation here to diversify a substantial amount out of the company stock if they haven't already.

[FrugalSaver]

Another recommendation here to diversify a substantial amount out of the company stock if they haven't already.

Yes thanks for that. They’ve definitely done that. Now it’s basically substantial amount of money that makes zero sense to deprive themselves of for 20 years when, even for a price, could provide some other security and “comfort”. 

 And while the price of the 10% may seem absurd, it may be the quickest option. The other options should be considered and really well thought out to try to be efficient about it.

[FINate]

Glad they're being smart. I had to mention it as I've seen far too many people make a fortune in company stock, make big life plans, then lose most/all of it.

In their shoes I would just pay the 10% penalty for the first 10 years or so and take joy in having such a great problem. It should be mentioned (though guessing you already know this) that they don't need to take 100K per year in a lump sum or any such thing. Our spending went way down in FIRE, since they are frugal they may find that they pull out much less.

Once they hit 50 or so I would more seriously consider the 72(t). Their FIRE spend will be very well understood by then, along with real world portfolio performance, and would be in effect for a more reasonable length of time of ~10 years to 59.5.

[ROF Expat]

Do they have a mortgage?  If so, how much would it cost to pay it off? 

The "don't pay off your mortage" folks might disagree, but this could be a case where it makes some sense.  If they are paying a monthly mortgage, withdrawing money (and paying the taxes and penalties) from their 401k to pay it off will instantly increase their cash flow by that amount (they will still have taxes and insurance).  If they are relatively mustachian, do they really need want or need to double their income every month at the expense of significant penalties and taxes?  For most people, living on their current salary but not having to pay rent or mortgage would feel like a significant boost.  Also, I presume they have already dialed their 401k contributions to the minimum necessary to get any match or benefits?  They should also look hard at their other saving/investment habits.  There's no sense paying penalties to withdraw money from the 401k if they are still squirreling away money every month. 

[desk_jockey]

8) The IRS Rule of 55 allows an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 1/2 to pull money out of their 401(k) or 403(b) plan without penalty.

I believe both the 59.5 normal age and this rule of 55 age have access triggered on 01Jan of the year that you turn the triggering age, so depending on birthday timing you can actually get access to the money some months younger.

Probably not helpful for friends that are 40, but it is an option.

[zolotiyeruki]

The real key question, at least for me, would be "what other savings do they have", or more specifically "do they have 5 years' worth of expenses saved somewhere else?"  I think the next step would be to build the Roth Pipeline ASAP.

[lukebuz]

A $500K penalty still leaves $4.5M.   Ummmm....what is the problem here?

[djadziadax]

A $500K penalty still leaves $4.5M.   Ummmm....what is the problem here?

And also fed +state taxes most likely 45%-50% of that 4.5M would take it down to 2M tax free. Then they have to keep it invested, so cap gains tax on the rest...you see that it does not make sense.

Currently they have 80K in earned income, so spending is more like 65-70K after all taxes.

If they take 100K a year directly, without doing any roth or 75t etc, then

100K
-10K penalty
-12K in combined state and fed (12% fed, and assuming 3% state for argument sake)
____
78K left in SPENDING ability which would be more than they make now, and they will NOT exhaust their stash EVER.

Do the same thing with 150K level, and presto, they can retire now and take out from stash forever and have a very FAT FIRE.

[ender]

If they have lived on $80k/year, the entire penalty per year is only $8k/year to withdraw that amount of their income from their 401k. This seems like a non-issue entirely unless they want to dramatically increase their spending.

Without knowing their goals/situation, it's pretty much impossible to know what the right actions here are.

Are they planning on retiring now completely? Do they have any taxable assets? How much of their 80k do they save vs spend currently? What are their actual goals?

72(t) seems like a pretty good thing for them to calculate here. But again, you have to have better context on their goals as to whether it makes sense. At age 40, life expectancy is 45.7 years, so that results in about 110k/year in 72(t) payments ($5M / 45.7).

My guess is that using the 72(t) payment approach is probably what makes the most sense here.

Do they have a mortgage?  If so, how much would it cost to pay it off? 

The "don't pay off your mortage" folks might disagree, but this could be a case where it makes some sense.  If they are paying a monthly mortgage, withdrawing money (and paying the taxes and penalties) from their 401k to pay it off will instantly increase their cash flow by that amount (they will still have taxes and insurance).  If they are relatively mustachian, do they really need want or need to double their income every month at the expense of significant penalties and taxes?  For most people, living on their current salary but not having to pay rent or mortgage would feel like a significant boost.  Also, I presume they have already dialed their 401k contributions to the minimum necessary to get any match or benefits?  They should also look hard at their other saving/investment habits.  There's no sense paying penalties to withdraw money from the 401k if they are still squirreling away money every month. 

In order to get the money to pay the mortgage off they will have to get it somewhere, which in this case seems to be from their 401k via an early withdrawal/penalty, which defeats the benefit here.

7) NUA if any part of the 401(k) is in company stock.  Not really a withdrawal method per se but something to look into.

Also, if this is a concentrated 401(k), they should strongly consider diversifying to protect the $5M.

If I were in their shoes, I'd probably do the 10% penalty for the first five years or so while also starting a Roth conversion ladder.  20 years is too long to do a 72(t) IMHO, especially if there are kids in the picture because kids have a tendency to make budgets doubleplus-unsmooth.

It really depends. A Roth conversion ladder is going to eat up a ton of taxes if you are basically converting 2x your spending each year (assuming they have no already-taxed assets to live on for the first 5 years). They'd probably be better off just paying the 10% penalty every year, because the entire Roth conversion pipeline will be taxed at marginal rates. But this all depends on their yearly spending and what their goals are.

However, for someone earning 80k with a family, I'm guessing the Roth conversion pipeline will be worse financially.

[Just Joe]

I really don't know - could a person relocate to a non-income tax state and skip the state taxes?

[alcon835]

Honestly? Based on their numbers I don't see a reason not to pay the penalty if they want the money.

If they're going to keep working, they may not need the full lifestyle amount each year, but there's also no harm in them doing so.

The only other piece they might consider is home ownership. I think you can still withdraw from your 401k penalty free if you're paying for your house, but there's a lot I don't know about that so it's something you should look into more.

But, to repeat myself, yes. Withdrawing and taking the penalty is 100% a fantastic strategy for them over the next 20 years since it won't meaningfully impact their FIRE plans in any way.

[DireWolf]

I may well be wrong, but it appears to be possible to transfer a 401K or IRA to multiple IRAs. If so, that might be beneficial, as they could tap one for SEPP and then do Roth conversions on the other. The SEPP could provide money to pay the taxes on the conversion (as well as the taxes on the SEPP itself). So, for 5 years keep working and living as normal, but then in year 6 start living on the conversions. You avoid the penalty and you aren’t forced to pull out more than you might want (letting it grow tax free).

[secondcor521]

I believe both the 59.5 normal age and this rule of 55 age have access triggered on 01Jan of the year that you turn the triggering age, so depending on birthday timing you can actually get access to the money some months younger.

This is true for the age of 55 rule but is not true for the 59.5 normal age rule.  For the 59.5 normal age rule, you actually have to make the distribution after you turn 59.5, not January 1 of that year.

[secondcor521]

I may well be wrong, but it appears to be possible to transfer a 401K or IRA to multiple IRAs. If so, that might be beneficial, as they could tap one for SEPP and then do Roth conversions on the other. The SEPP could provide money to pay the taxes on the conversion (as well as the taxes on the SEPP itself). So, for 5 years keep working and living as normal, but then in year 6 start living on the conversions. You avoid the penalty and you aren’t forced to pull out more than you might want (letting it grow tax free).

SEPPs have to continue for 5 years or until age 59.5 *whichever is longer* so in this scenario if they start a SEPP it'd be for about 20 years.  If they stop after 5 years (as you imply), they'd have a busted SEPP and would have to pay whatever penalties would be associated with that.

[secondcor521]

It really depends. A Roth conversion ladder is going to eat up a ton of taxes if you are basically converting 2x your spending each year (assuming they have no already-taxed assets to live on for the first 5 years). They'd probably be better off just paying the 10% penalty every year, because the entire Roth conversion pipeline will be taxed at marginal rates. But this all depends on their yearly spending and what their goals are.

Maybe, maybe not.

The 10% penalty would be every year for the next twenty years.  Starting a Roth conversion ladder, depending on how much other accessible money they have, and how much they want to spend during those five years, would only result in a higher marginal rate for the first five years.  After that, no 10% penalty.  I think one would have to pencil it out.

They could also divide IRAs and do a small SEPP as someone else suggested.  That would probably help mathematically but might be hard to do the tax planning on from a practical point of view.

OP, note that there are three SEPP methods, each with different rules and resulting withdrawal amounts.  They can also do a one time switch to the RMD method without penalty, but the switch is permanent.

[Catbert]

I would do some combination of Roth pipeline and just paying the 10% penalty.  I would also try to live as much as possible on whatever money they have outside the 401k the first 5 years for the pipeline.  Really need to spend some time with a spreadsheet to figure out the mix.

I would not do 72t 20 years out.  The rules are very strict and specific.  If you screw it up you'll owe back taxes/penalties for the previous years.  A lot can happen in 20 years.  Also it's possible to completely blow up an IRA if, for example, you hold a lot of dot.com stock and the stock implodes (e.g., Enron).  You're required to take out a certain amount each year even if the IRA is now empty.

Also explore the 401k rules.  Can money be left there?  Can your borrow against it after retirement?  Or borrow before and not be required to pay it all back when you leave.  Most plans require loan be paid back quickly after you leave, but I believe this is a plan requirement and not a law.  If allowed, there might be a play to be made so that your borrow a few years of expenses and pay the interest but no 10% IRS penalty.

[markbike528CBX]

....snip.....
I would not do 72t 20 years out.  The rules are very strict and specific.  If you screw it up you'll owe back taxes/penalties for the previous years.  A lot can happen in 20 years.  Also it's possible to completely blow up an IRA if, for example, you hold a lot of dot.com stock and the stock implodes (e.g., Enron).  You're required to take out a certain amount each year even if the IRA is now empty.
..snip....

No so. 
Only for the annuitzation or amortization methods.  Even if you start with those two methods, you can switch to the RMD method for the rest of the SEPP withdrawals.

The RMD method is recalculated each year, and accounts for the balance at that time.

That said, 20 years is a long 72(t)  / SEPP.   At 5M, the likelihood is for the IRA to EXPAND to a humungous value.

On diversification, I'd leave no more than 20% (1M) as company stock (or similar), if that, probably just enough for " old times sake."

[markbike528CBX]

Company or provider 401k rules may prohibit anything other than a lump sum withdrawal prior to 59.5 (despite the "rule of 55" in IRS law).  <---- my MPP.
So, it would get rolled over to  one or more tIRA's then distributed.

At 5M an 40 years of age a SEPP max is closer to 140k/year for the amortization method, 130K annuitization, and the previous mentioned 100K/year for the RMD method.

Sources:
https://www.bankrate.com/retirement/calculators/72-t-distribution-calculator/   --- I've verified this for myself
and for the mid-Term rate https://apps.irs.gov/app/picklist/list/federalRates.html and https://www.irs.gov/pub/irs-drop/rr-21-07.pdf
120% of Mid-Term rate is 1.07%

MPP related:  Even though the 401k is "frozen" for me at the moment, I still keep the 401k as:
1)it provides a "Financial Engines" calculator -- I find it comfortingly optimistic compared to my spreadsheet.
2)it is a separate provider/ mutual fund diversification from my other accounts.
3)I'm just damn lazy in FIRE
4)Don't need the money

[TomTX]

I really don't know - could a person relocate to a non-income tax state and skip the state taxes?

If by "relocate" you mean "establish residency" - yes.

[seattlecyclone]

The SEPP provides a rather generous amount of penalty-free income in this case. The 20-year lock-in is kind of a drag but when the inflexible method provides so much money already I'd hesitate to pay an extra 10% just for some more flexibility. The optimal thing might be to split off something like $1 million into a separate IRA that you can withdraw from as needed, while doing a SEPP with the other $4 million.

[DireWolf]

I may well be wrong, but it appears to be possible to transfer a 401K or IRA to multiple IRAs. If so, that might be beneficial, as they could tap one for SEPP and then do Roth conversions on the other. The SEPP could provide money to pay the taxes on the conversion (as well as the taxes on the SEPP itself). So, for 5 years keep working and living as normal, but then in year 6 start living on the conversions. You avoid the penalty and you aren’t forced to pull out more than you might want (letting it grow tax free).

SEPPs have to continue for 5 years or until age 59.5 *whichever is longer* so in this scenario if they start a SEPP it'd be for about 20 years.  If they stop after 5 years (as you imply), they'd have a busted SEPP and would have to pay whatever penalties would be associated with that.

I’m fully aware of that and was not trying to imply stopping the SEPP. It can keep going and keep paying the taxes on the conversions.

[ericrugiero]

Generally, the best way to do this (in my opinion) is a Roth conversion pipeline.  You convert money each year from traditional IRA to Roth IRA (roll the 401K to IRA first).  (You have to pay taxes when you convert it but not when you withdraw and spend it.)  After the money "seasons" for 5 years in the Roth IRA you can withdraw and spend it tax and penalty free. 

The down side is that you can't withdraw any money penalty free within the first 5 years.  It has to be converted and then sit for 5 years.  Do your friends have any money they could live on for 5 years?  If they have cash, taxable investments, Roth contributions, home equity, etc that will pay for most of the first 5 years expenses the Roth conversion pipeline is almost certainly the best option. 

If they don't have 5 years expenses outside of their traditional 401K, then doing a Roth conversion pipeline requires them to withdraw a lot of money the first 5 years.  They would withdraw enough to live on (with a 10% penalty) and ALSO convert money for 5 years later.  This would be 210% of their living expenses and would put them in a higher tax bracket.  The SEPP conversion would be more tax efficient in this case but is less flexible.  As others mentioned, they can split their money into separate IRA's and do the 72T sepp conversion on one of them. 

Also, they could just pay the 10% penalty. 

It's worth your friend hiring a tax planning professional who is familiar with FIRE.  The good news is that they have more money than they need (at their current spend) so they should be OK with any of the options.  That's no reason not to hire a professional who knows this field and really try to optimize.  There is a lot of money on the table here and doing it wrong could be very expensive. 

edit:  Show your friend this:  https://www.madfientist.com/how-to-access-retirement-funds-early/

[yachi]

If they don't have 5 years expenses outside of their traditional 401K, then doing a Roth conversion pipeline requires them to withdraw a lot of money the first 5 years.  They would withdraw enough to live on (with a 10% penalty) and ALSO convert money for 5 years later.  This would be 210% of their living expenses and would put them in a higher tax bracket.

I wish this were mentioned more often.  I think it could help people who are a year or two away from the 5 years of expenses.  I modeled a 20-year scenario that showed OP would pay 14% less taxes starting this Roth conversion pipeline and paying a 10% penalty the first 5 years vs paying a 10% penalty for the entire period.

For the Roth ladder option, I used a withdrawal rate of $172,750 (the top of the 22% tax bracket for 2021) for years 1-5, and half of this ($86,375) for years 6 thru 20.  In years 16 thru 20 OP is no longer funding the Roth IRA, as he'll be 60 in year 20.  OP ends up paying $348,190 in taxes for the 20-year period.  OP had a total of $1,379,310 of spending power.

For the take the penalty scenario, I used a withdrawal of $88,915.44.  This is actually a goal-seek based on maintaining the 20-year spending power at $1,379,310.  This one results in a total tax of $398,999 over the 20 years.

Because OP stopped rolling over into the Roth IRA in year 16, both options end up with the balance of the retirement money in pre-tax accounts.

[myrrh]

An extra $50k in savings is not exactly chump change, even if it's over the course of 20 years. Thanks for doing that math, yacchi! OP should also do the math for this and for other scenarios, but it sounds like taking the penalty for five years while you build the Roth ladder is a great option.

[zolotiyeruki]

If they don't have 5 years expenses outside of their traditional 401K, then doing a Roth conversion pipeline requires them to withdraw a lot of money the first 5 years.  They would withdraw enough to live on (with a 10% penalty) and ALSO convert money for 5 years later.  This would be 210% of their living expenses and would put them in a higher tax bracket.

I wish this were mentioned more often.  I think it could help people who are a year or two away from the 5 years of expenses.  I modeled a 20-year scenario that showed OP would pay 14% less taxes starting this Roth conversion pipeline and paying a 10% penalty the first 5 years vs paying a 10% penalty for the entire period.

For the Roth ladder option, I used a withdrawal rate of $172,750 (the top of the 22% tax bracket for 2021) for years 1-5, and half of this ($86,375) for years 6 thru 20.  In years 16 thru 20 OP is no longer funding the Roth IRA, as he'll be 60 in year 20.  OP ends up paying $348,190 in taxes for the 20-year period.  OP had a total of $1,379,310 of spending power.

Don't forget the standard (or itemized) deductions, which would enable OP's friend to convert even more each year while staying in the same tax bracket.

[yachi]

If they don't have 5 years expenses outside of their traditional 401K, then doing a Roth conversion pipeline requires them to withdraw a lot of money the first 5 years.  They would withdraw enough to live on (with a 10% penalty) and ALSO convert money for 5 years later.  This would be 210% of their living expenses and would put them in a higher tax bracket.

I wish this were mentioned more often.  I think it could help people who are a year or two away from the 5 years of expenses.  I modeled a 20-year scenario that showed OP would pay 14% less taxes starting this Roth conversion pipeline and paying a 10% penalty the first 5 years vs paying a 10% penalty for the entire period.

For the Roth ladder option, I used a withdrawal rate of $172,750 (the top of the 22% tax bracket for 2021) for years 1-5, and half of this ($86,375) for years 6 thru 20.  In years 16 thru 20 OP is no longer funding the Roth IRA, as he'll be 60 in year 20.  OP ends up paying $348,190 in taxes for the 20-year period.  OP had a total of $1,379,310 of spending power.

Don't forget the standard (or itemized) deductions, which would enable OP's friend to convert even more each year while staying in the same tax bracket.

A more in depth analysis should include:
1) standard or itemized deductions
2) matching the spending year-by year instead of the total.  The assumption that the first 5 years is 2X withdrawal and then it's 1X withdrawal doesn't leave you with the right spending power because taxes per dollar are higher during the first 5 years.

[TomTX]

72(t) seems a no brainer. You're drawing between $115k and $170k/year* depending on method and the funds should last indefinitely with that low of a withdrawal rate. Simple, basically foolproof.

*Or less if you use a lower sensible interest rate. Set the parameters yourself: https://www.bankrate.com/retirement/calculators/72-t-distribution-calculator/

[robartsd]

First, I'd figure out how much money I expect to spend each year, commit to withdrawing that amount for the next 20 years and set up a 72(t) SEPP for that amount by transferring an appropriate amount to a separate IRA and starting the SEPP. It would be OK to be somewhat low in the estimate used to start the SEPP; there would always be the option of rolling over some of the remainder in another IRA and starting another SEPP should it be discovered that the initial SEPP was too small. The only way the SEPP could be reduced is if the value drops and the SEPP is switched to the RMD method.

The remainder would sit in another traditional IRA where in a worst case scenario it could be withdrawn to provide extra funds (paying the 10% penalty only on this withdraw). I'd gradually convert some of this to Roth as funds and tax situation allow, increasing the amount of funds available penalty free.