How to Fund Early Retirement Without Tax Penalties

Many people aim for early retirement to spend more time with children, spouses, and grandchildren. 

Imagine this: Your ultimate goal is early retirement. It's not because you're lazy; you just want complete freedom over your time. You've doggedly saved for the first 20 years of your working life, and believe you have enough to cut strings (amicably, of course) with your employer.

But then, an ugly reality hits you: Because you're so young, you'll be paying penalties of as much as 10% on all of your withdrawals. Not only does it annoy you to have the government taking such a large cut, but it makes the prospect of early retirement more dubious.

I have good news. There is a relatively easy -- and legal -- way to avoid these penalties, get your money, and enjoy your early retirement! There are four simple step you need to follow.

Step 1: Enough cash to cover five years
You need to have at least five years of living expenses saved up in non-retirement accounts. This will cover the costs of the first five years of your early retirement. You'll see why this is important in step three.

If you're pulling this cash out of accounts that have significant capital gains -- whether from stocks or bonds -- there's good news. You can avoid taxes altogether!

Let me explain.

If you're retiring early, I'm assuming that you've paid off your mortgage, no longer need to pay for life insurance (there's no "future earnings" to protect), and generally live a frugal life. This should mean your living expenses aren't too high.

If you are married and filing jointly, you can realize up to $74,900 after deductions in income (which includes capital gains) without paying a cent on capital gains. In other words, done correctly, you can draw down your accounts every year without paying a dime in taxes.

Here's what the income limits are for each of the different filing statuses if you want to avoid capital gains taxes:

Source: IRS.

Step 2: Converting 401(k) to a Roth
The next step is to slowly take all of the money you've put away in your company 401(k) -- the stuff you want to avoid penalties on -- and convert it to a Roth. It works like this: In year one of retirement, take the amount you'll need for one year of living expenses and convert it to a Roth.

It is best to start this process after you retire, because your income will presumably be lower than when you were earning a salary. This means your conversions will have a lower tax rate than if you started the process while working.

You'll be doing this every year of your retirement until all of your money has been converted to your Roth accounts, or you hit 59.5 years old, whichever comes first. You can do this through most brokerages, but you might want to consult a Certified Financial Planner to get help.

Remember, you will have to pay some taxes on these conversions. That's OK, because you didn't pay any when the money went into your 401(k). Therefore, you might need to convert slightly more than one year of living expenses to account for taxes.

Step 3: Wait five years
Here's why the first step is necessary: After principal has sat in your Roth for five years, you can take it out tax- and penalty-free! That's the major advantage of a Roth.

Starting in year six until you turn 59.5, you can live off of the principal from your Roth.

It should be noted that if your money grows after it is put in your Roth, you'll have to pay a penalty for withdrawing this growth before age 59.5. But because you planned ahead, this shouldn't be a concern.

Step 4: Crank up those other sources of income
One of the beautiful things about this approach is that you really only need to do it until you reach age 59.5. Once you've hit that barrier, there's no need to continue these conversions. You can draw money down from any of your retirement accounts without incurring any tax penalties.

And even if Social Security benefits are cut in the future, they will still provide a substantial source of income for almost every retired person. Make sure you carefully study when to take them -- as benefits increase every year up to age 70.