Retirement Planning – Penalty Free Early Retirement Options

So you have made all the right moves and all the efforts you have put into planning your retirement have paid off. In fact, they have paid off so well you can actually retire much earlier than you planned. You have checked and double checked your calculations and indeed have reached all the financial goals you wanted to before you set off for the next phase of your life, retirement. So you have decided that you can kiss the daily rat race goodbye and begin to live a life of fun, happiness and no stress at the ripe old age of 48. But, as it works out the bulk of the assets you will be living off of are currently in your company retirement plan (soon to be rolled over to an IRA). How are you going to enjoy the fruits of your labor without getting dinged by the 10% early withdrawal penalty imposed by the IRS?

I have gotten many inquiries from clients about ways to tap into retirement funds, pre-retirement. Some of these are from people who are actually retiring early but others who have run into short term financial problems and are looking for a solution. The fact is Uncle Sam has a provision in the tax code, a 72(t) distribution, which allows people access to their retirement funds before they are retired and without the imposition of the senseless 10% early withdrawal penalty. The 72(t) distribution is an exception available to anyone under age 59 ½ (if you’re over 59 ½, you can tap your retirement accounts without penalty). In a 72(t) withdrawal, the distributions must be “substantially equal” payments based upon your life expectancy. The catch is that once the distributions begin, they must continue for a period of five years or until you reach age 59½, which ever is longest. Once that period is met, changes in the withdrawal amount and frequency can be made or even stopped. The full rules and life expectancy tables can be found in IRS Publication 590.

There are currently three (3) approved methods for calculating 72(t) distribution totals:

o Life Expectancy

o Amortization

o Annuitization

Without going into the pros, cons and the nuances of each of the above methods, to determine which provides the best results for your specific situation the withdrawal amount should be calculated for each method. The result of each method is then compared to the amount you have determined is needed. Select the method that best matches the desired withdrawal amount, As a general rule of thumb you can expect to get more from the Annuitization or Amortization methods than from the life Life Expectancy method.

While this sounds like an attractive solution to a near term financial problem, it can have disastrous effects if not well thought out and planned for. If you are seriously considering taking a 72(t) distribution it is important to be aware of the potential downsides of doing so.

o If you use too high a rate of withdrawal, you could run out of money. This could occur before your retirement ends and worse yet even before the 72(t) distribution ends. This possibility increases substantially if your investments decline in value over the distribution period. This is not as a remote of a possibility as one might think.

o Even if you could afford to spend your retirement money without impacting your retirement, 72(t) withdrawal calculations are complicated. Moreover, if you make a mistake the IRS can levy a 10% penalty on the withdrawals … retroactively.

o Quite frequently the IRA custodian will have problems with the proper coding of the withdrawal when reporting the distributions on Form 1099R to the IRS. This can cause a major time, resource and financial headache when you have to clear up their reporting error. In addition and as important it can raise an unnecessary investigative flag with the IRS. Having the IRS auditing your returns regularly is something we would all like to avoid if at all possible.

o Once you start an annuitization or amortization method withdrawal, you are stuck with that amount until your 72(t) term ends (i.e. no recalculation allowed for these methods) even if your investments decline in value. Only way to reduce amount taken out is if you make a one-time only election to switch to the life expectancy method (which doesn’t guarantee a certain amount of income like amortization or annuitizing) or waiting until your 72(t) term ends.

Keep in mind that if you only need a portion of your IRA to make the desired withdrawal amounts it would be worth your time to split the money in two separate IRA’s. That way, if you require more money than anticipated, you can start 72(t) payments on the second IRA. Additionally, if only a portion of your money is needed to meet your desired distribution levels there is no need to expose the other assets to the potential risks inherent in the 72(t) option.

The 72(t) is a great tool for early retirees to access their retirement savings without losing a portion of their money to IRS early withdrawal penalties. For short term emergency financial relief, I recommend using the 72(t) as a last resort. That being said, regardless of your reason for using the 72(t) option, mistakes are costly so it would pay to get expert help to determine the best solution.

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