Retiring Early? Watch Out for This Pitfall

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IRAs and 401(k)s are tax advantaged, so it’s smart to invest for your golden years using one. Learn why retiring early could throw a wrench into this plan. 

One of the best money moves you can make for your future self is saving and investing for retirement. Depending on your salary and financial situation, this can be a difficult prospect, but if you can manage to carve out money to save, using a tax-advantaged retirement account will also help you in the here and now.

Traditional IRAs and 401(k)s lower your taxable income because they’re funded with pre-tax dollars. So if you earn $60,000 per year and contribute $5,000 to a 401(k) plan through your employer, that’s $5,000 worth of income the IRS won’t tax you on now — instead, you’ll pay taxes on it when you withdraw money in retirement. These plans are great, but they come with one pitfall if you’ve got your eye on retiring before age 59 1/2.

Early withdrawal penalties

In exchange for saving you on taxes during your working years, the money you put in a traditional IRA or 401(k) generally can’t be accessed without a 10% penalty if you’re under age 59 1/2. The exceptions to this include suffering a total and permanent disability, covering health insurance premiums while you’re unemployed, or taking out up to $10,000 to use toward the purchase of your first home.

But if you’re hoping to retire before you reach the age where you can take distributions without penalty, you’re out of luck.

How can you pay for early retirement?

It would be quite disappointing to be financially ready to retire and find yourself unable to access the money you’ve saved and invested. If you think early retirement might be in the cards for you, check out these other types of accounts that will give you access to your money at any age.

Taxable brokerage accounts: A regular brokerage account doesn’t restrict your access to your money (although, if you’re hoping to avoid costlier capital gains taxes, it’s prudent to hold investments for at least a year and a day before cashing them out). Speak with your tax professional to minimize your tax obligation during your retirement years. The best brokerage accounts come with low or no fees, robust mobile apps, and access to educational resources.Roth IRAs: These accounts are funded with after-tax dollars, and you’re allowed to withdraw your contributions without taxes or penalties. If you want to withdraw gains from your Roth IRA without penalties and taxes, however, you’ll need to wait until age 59 1/2 unless you qualify for an exception (many of which are the same as for a traditional IRA). And note that Roth IRAs have income limits, so if you earn too much, these accounts aren’t an option for you.CDs: Certificates of deposit, or CDs, offer you the chance to earn interest on your savings in exchange for locking it up for a period of time (a few months to several years). When your CD term is up, you can withdraw the money from it with no penalties no matter what age you are. CDs are a far safer investment than stocks, but consequently, they don’t pay as well over the long term — so you’re likely to be disappointed in your gains if you keep all your retirement savings in them.

Early retirement is a dream for a lot of people, and if you’re one of the lucky ones who can pull it off, be sure you’ll have access to some of your funds before you reach traditional “retirement age.”

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