Retirement: The Exception to The Rule
Have you thought about retiring early, but concerned about meeting expenses before your Social Security or pension kicks in? Investigate tapping into your retirement account. There are ways to avoid the early distribution penalties.
If you withdraw from your retirement account before you attain the age of 59 1/2, penalties generally apply. However, if your retirement plan has special features or if you initiate planned distributions, you may be able to avoid the penalties and bridge your income needs.
Separation From Service Exemption
If you’ve contributed to your employer’s retirement plan, you may be able to take penalty-free distributions from your account if you terminate – even if you haven’t yet reached age 59 1/2. Normally, when you take distributions from a retirement plan prior to that age you’ll be slapped with a 10 percent penalty. Fortunately, the IRS-approved "Separation from Service Exception," also known as the "Age 55 Exception," can help you avoid that penalty. Here’s how it works:
Employer Plan: You can take early penalty-free distributions only from your current employer’s plan. You must leave in the retirement account any funds you anticipate distributing before age 59 1/2. The remaining plan assets can be rolled over to an IRA. For example, if your 401(k) has a balance of $800,000, and you need $100,000 between now and your age of 59 1/2, you would leave $100,000 in the 401(k) and roll the remaining $700,000 to an IRA.
For this to work, your employer’s plan must meet ERISA (Employee Retirement Income Security Act) requirements and allow partial distributions. Check with the plan administrator. If your plan does not permit partial distributions, then this strategy will not be available to you.
Age requirements: You must be age 55 or older in the year you leave the company. If you retire in May 2018, but your 55th birthday isn’t until November 2018, you’re still eligible for the exception. And it doesn’t matter if you were laid off, fired, or taking early retirement.
Taxes: Distributions are subject to federal and state income taxes. To cover the tax, your employer will withhold 20 percent from each distribution. Be sure to include this tax withholding when considering the amount to leave in your 401(k) account. You don’t want to shortchange your spending money!
Substantially Equal Payments from IRA
You can also access funds in your IRA account without paying a 10 percent penalty, regardless of your age. What’s the catch? You must comply with multiple rules set by the IRS. This strategy is also referred to as 72(t) payments, named after the applicable section of the IRS Code. If the following provisions are not adhered to, you will owe the penalty on all your distributions.
Payments must be substantially equal over the withdrawal period. At a minimum, you must receive payments annually and continue to receive them for at least five years or until you reach age 59 1/2, whichever is longer. For example, if you begin 72(t) payments at age 50, you will be required to take distributions until age 59 1/2. If you begin payments at age 57, you’ll be required to take distributions for at least five year, which would be age 62.
The IRS has approved three methods for calculating payments – the Required Minimum Distribution Method (RMD), the Fixed Amortization Method, and the Fixed Annuity Factor Method. All three result in different amounts. Review each with both your tax and financial advisors before selecting a method. You can change it once, but only if you initially selected the Amortization or Annuity method and are switching to the RMD method.
Payments are applicable only to the IRA on which the calculation was based. Assets in other retirement accounts are not included.
Stopping payments early or modifying the amount is costly. The 10 percent penalty will apply to all distributions received prior to age 59 1/2. In addition, interest may be charged by the IRS on the penalties owed.
Once your 72(t) payments have begun, leave your IRA alone! Contributions or rollovers into the IRA are considered a modification to the account and will trigger the early withdrawal penalty.
While it may be possible to take penalty-free distributions from your retirement accounts, it may not be wise. Review your situation with your financial advisor to ensure you aren’t putting yourself at risk of outliving your assets. If you opt to take distributions early, be sure to follow all the rules!
Sarah Mahaffa, CFP is a Wealth Advisor with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Sarah.