Pre-tax retirement accounts are a wonderful way to save for your future in a tax-advantaged manner. In most instances, your contributions to these types of accounts reduce your tax liability during your working years. In order to take advantage of the tax deferral you must keep your money in these accounts until age 59 ½ and distributions are taxable at the federal and state level. Any distribution before age 59 ½ could result in a 10% penalty.
What happens if you find yourself wanting or needing to retire before age 59 ½? How do you access your money while avoiding the 10% penalty?
Like many IRS rules, there are exceptions and ways to avoid the early distribution penalty. Under the Internal Revenue Code Section 72(t), the 10% early withdrawal penalty will not apply to participants making early withdrawals from their IRAs if:
- The distribution is due to death of the IRA owner.
- The distribution is due to total and permanent disability of IRA owner.
- If the distribution is used for qualified higher education expenses of the IRA owner.
- If the owner is a qualified first-time homebuyer, distributions up to $10,000 will not be assessed the early withdrawal penalty.
- If the IRA owner has a substantial amount of medical expenses at a certain level above AGI.
- The account owner is using the distribution to pay health insurance premiums while unemployed.
- If the owner is in the military and called to active duty.
- If the distribution is made in a series of substantially equal payments.
For Qualified Plans such as 401ks, the higher education, first-time homebuyer and medical insurance premium payments while unemployed exemptions do not apply. However, some new exceptions apply to certain qualified plans. For example, if the distribution is due to a Qualified Domestic Relations Order or if the 401k owner separates from service after age 55 (age 50 for most public safety employees), participants can withdraw without incurring the early withdrawal penalty. In other words, if you separate from service from your current employer and you have a vested 401k balance, you may be able to access those funds without paying the 10% penalty prior to reaching age 59 ½.
With more and more people looking to retire from their “stressful” job before reaching age 59 ½ and much of a pre-retiree’s net worth being tied up in tax advantaged accounts, the “72(t)” distribution strategy may be worth considering.
Say, for example, you are a 55-year old Executive about to retire after working for the same company for several decades. A substantial portion of your net worth is probably tied up in your home and your retirement accounts at work. These accounts may consist of a Pension Plan and a 401K plan. In addition, you are expected to receive a Deferred Compensation payout starting at age 60. How would you bridge the gap between age 55 and 60 while keeping as much of your nest egg as possible? Under Internal Revenue Code Section 72(t) – Substantially Equal Periodic Payments, the 10% early withdrawal penalty could be avoided. The process could involve rolling the pre-tax money into one or multiple IRAs and setting up the equal, periodic withdrawals from one of the IRAs, leaving the second IRA undisturbed for future emergency needs. Determining the amount of the annual or monthly payment is calculated using one of three methods allowed (RMD, Annuitization or Amortization) and consulting with a financial or tax professional is recommended to determine which calculation method is best for your situation. The most important thing to remember is that this strategy is subject to a special recapture provision if the amount of periodic payments or the account from which the payments are drawn is modified before the later of 59 ½ or 5 years, unless certain unfavorable circumstances occur such as death or disability. In addition, there is a one-time election change allowance on the method of calculation, but that is it.
It is worth noting that the strategy of using retirement accounts prior to age 59 ½ is not for everyone and would require tax and financial planning advice to determine if it is right for you. There are many factors to consider before implementing a 72(t) distribution such as age, income, tax bracket, other sources of funds, etc. The recapture penalty is severe and one should be fully committed to following the strategy to maturity once it is initially implemented.
Keep in mind that participants in 457(b) plans may not incur the early withdrawal penalty. Additionally, early withdrawals from Simple IRAs may incur a higher penalty than the typical 10%. Your pre-tax account withdrawals will always be subject to ordinary income tax in the year of withdrawal.
An early retirement can be both exciting and challenging. It is important to have a solid plan and a well-documented strategy to access your money in the most efficient way possible. If you or someone you know has questions about these strategies, please feel free to contact our office.