For all of its shortcomings, the traditional retire-at-65 system does have a few cushy benefits in the US. You get low-cost health insurance coverage through Medicare, a reasonable pension through Social Security, and you also get to start taking penalty-free withdrawals from your 401(k) plan.

This system was originally designed to accommodate people who would work through their entire adult life, and retire only when they had lost all ability to be productive, presumably to die just a few years later. In fact, the life expectancy of US males only reached age 65 around 1950. (Females reached that longevity in the mid 1940s, and both sexes only a hundred years earlier had expected lifespans of only 40 years!)

Books targeted at today’s Late Retirees (which I define as over 60) speak quite excitedly about the new idea that people get to live for twenty or more years in retirement, and thus the financial planning is much more complicated than it was just a generation ago. So as you can imagine, those of us planning a 50+ year period of retirement need to game the system even more.

This is one of the things about which I get the most email questions. People are asking,

Should I put money into my 401(k) if I’ll be retiring much younger than the standard age? Won’t I be hit with penalties if I try to use the money before then?

Let’s review the basics:

Through most jobs, you can contribute to a 401(k) plan – currently $16,500 per year and rising. You might even get a partial or full employer match, depending on how fancy you are.

If your employer doesn’t offer this option, you can still contribute up to $5,000 on your own to an IRA account.

If you are self-employed, ( which I highly recommend! ), you can contribute up to $44,000 per year using the SEP-IRA or solo 401k options, and there’s a nice description of their differences here .

), you can contribute up to $44,000 per year using the SEP-IRA or solo 401k options, and there’s a nice description of their differences . The government lets you make any of these contributions out of your pre-tax income , so you pay no income tax on that cash, or any of its investment gains over the years. This gives you a big savings boost, which is the whole reason 401(k)s and IRAs are useful.

, so you pay no income tax on that cash, or any of its investment gains over the years. This gives you a big savings boost, which is the whole reason 401(k)s and IRAs are useful. You’ll still have to pay income tax on this money when you eventually withdraw it, but the idea is that you’ll be in a lower tax bracket then.. because you will have quit your job and your only taxable income will be your 401(k) withdrawals.

If you try to withdraw the money earlier than age 59.5, you’ll pay the income tax mentioned above, PLUS a 10% penalty on top of it.

Assuming we want to avoid the 10% penalty, we early retirees have a few options.

Strategy 1: Treat the 401(k) as your “Old Man/Old Woman Money”

The idea with this strategy is to throw enough money into the fund, such that it becomes enough to live on for a good 30 years, from age 60 through 90. As a really quick calculation, say that you can live on $30,000 per year in today’s dollars. And assume that you can safely withdraw about 5% per year from your fund from a combination of its investment returns/dividends and a bit of its principal. You would then need $600,000 of today’s dollars, scaled up for inflation to whatever year you reach age 60, to meet that goal.

Let’s say you are 30 now, and you’ve made the maximum contribution each year since graduating at age 21, and thus you have about $144,000 in the account. Let’s also assume your investments can grow at 5% after inflation. What will it be worth by the time you reach 60?

The answer is of course 144,000 x 1.05 to the power of 30 (years). This is about $622,000 inflation-adjusted dollars (i.e., in the year 2041, it will buy you just as much as $622k does today). Since this is more than the $600k we calculated above, it could be said that this person already has TOO MUCH in his 401k, and now he just needs some dough to get him between whenever he retires, and age 60.

This is a simple strategy, and it’s the one I took myself. Mrs. Money Mustache and I both let the 401k contributions run on autopilot when we were working, then promptly ignored them after we quit, where they have since continued automatically generating dividends which are reinvested in more shares every quarter. Besides the 401k contributions, we raked up some additional savings that went towards investments that provide for our current living expenses. Technically, this is sort of double-saving for retirement, but I like to think of it as a nice safety margin that allows you to loosen some of your other assumptions (like using a 5% withdrawal rate above instead of the 4% rule that serves as a general rule for sizing your retirement nest egg.

Strategy 2: Use the Roth IRA Escape Hatch Loophole

Don’t go google searching that term, because I just made it up. But here’s a trick I learned only recently from a fellow blogger named No Debt MBA:

Build up your 401k and any other savings, then quit your job to begin retirement – hooray!

You are now in a low tax bracket – you can actually roll over a chunk of your 401k into a Roth IRA account and pay income taxes on it at this point.

Then you let it sit in the Roth IRA for a minimum of 5 years

At this point, you can withdraw all of the principal (but not the gains yet, no big deal), penalty-free!

To be extra fancy, you could just roll over enough to cover your annual spending (say, $30,000) once per year into the Roth account, and pay the minimal income taxes. This would build a 5-year pipeline so that you would be able to withdraw an equal amount from the Roth account each year once you got the pipeline filled out. Of course, you also have to set aside money (or do some part-time work, or pay some 401k early withdrawal penalties) to get you through the first five years while you are waiting for the first batch to finish “fermenting”. But it is still a definite loophole that can help you spring out your 401k money penalty-free.

Strategy 3: Use the Section 72(t) Early Retirement Grocery Money Loophole

The government provides yet another complicated-but-still-useful way to draw a little penalty-free income from your 401(k). You can set up a stream of payments to yourself, called “Substantially Equal Periodic Payments (SEPP)”. The only hitch is that once you start them, you cannot stop them until you reach 59.5 years of age. To determine how much you can get, the government prescribes something called a “reasonable interest rate”, which right now happens to be 1.43%.

The 1.43% number then gets mixed and mashed with some other complicated stuff about principal withdrawals vs. life expectancy. But the bottom line is, for each hundred grand you have in your 401k, your SEPP payment will be about $2900 per year, according to this popular calculator on the subject: http://www.dinkytown.net/java/Retire72T.html. That’s some nice grocery money, but not a full lifestyle amount for most of us.

On the positive side, because you’ll be drawing the money out at such a low rate, the odds are it will grow faster than you use it, leaving you a larger amount to tap more freely once you reach 59.5.

Overall, any of these strategies will work, but the issue remains the same for early retirees – because of contribution limits, your 401k will probably not be large enough to retire on until you’ve made at least 20 years of maximum contributions and seen some investment gains as well. So while I still advise maxing out any tax-deferred savings accounts like the 401k, you’ll also need to invest elsewhere simultaneously. My own strategy was in Vanguard index funds, a paid-off house, and some rental properties, but you will surely find other places depending on your own interests.

Since I’m still over 22 years from 401k eligibility myself, I must admit that I haven’t done a huge amount of research into even more advanced strategies involving tax-deferred accounts. Some of you are masters of this subject, so if you see any errors or omissions, let me know in the comments, and I’ll continually integrate them into the article, so over time we will have a rather kickass “401k for early retirement” article.