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A: If you take a distribution from your retirement plan early, “meaning before the day you turn 59 ½ or age 55 if still in a 401(k),” you will generally have to pay a 10% early distribution penalty above and beyond any regular income taxes you may owe on the money.
Of course, it’s generally a bad idea to dip into your retirement plan early except in extraordinary circumstances. But when using your retirement funds is your only option, it’s good to know that there are several ways to avoid the extra 10% penalty on early distributions.
Important: Establish a series of Substantially Equal Periodic Payments (SEPP).
There are certain exemptions that could keep you from paying the 10% early withdrawal penalty. These are called hardship exemptions and give you an option to access your funds – provided you meet the criteria. Hardship exemptions include:
- Death of the plan participant
- Became permanently disabled
- Paid out of pocket for medical expenses
- Forced to disburse funds by a court order
- You’re over the age of 55 and retired or left your job
- Substantially Equal Periodic Payments
If you are under Age 55, and you still work for the company where your 401(k) plan is, you will have only a few limited options to tap 401(k) funds, such as taking a 401(k) loan or a hardship withdrawal – IF the company allows these options.
If you’re no longer employed by the company, you can roll the funds over to an IRA, or cash in the 401(k) plan. Be careful on cashing in – if you cash in you may void valuable creditor protection that stays in place when you keep the funds in the plan.
If you are retired, most 401(k) plans allow for penalty-free withdrawals at age 55 instead of having to wait until 59 1/2.
To use this 401(k) retirement age 55 provision your employment must have ended no earlier than the year in which you turn Age 55, and you must leave your funds in the 401(k) plan to access them penalty-free. (For many police, firefighters and EMTs, this provision makes funds accessible as early as Age 50, rather than 55.)
You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:
- 1) You become totally disabled.
- 2) You’re in debt for medical expenses that exceed 7.5% of your adjusted gross income.
- 3) You are required by court order to give the money to your divorced spouse, a child, or a dependent.
- 4) Separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
- 5) You’re separated from service and you have set-up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy.
(Once you begin taking this kind of distribution you are required to continue for five years or until you reach Age 59 1/2, whichever is longer.) This is an area that we specialize in and can offer guidance and counsel.
If you separate from service in the calendar year in which you turn 55 or later, you may be able to take distributions from your 401(k) penalty free; however, income taxes will still apply. There are additional exemptions which may allow you to avoid the early withdrawal penalty, such as: permanent disability, medical expenses that exceed 7.5% of your adjusted gross income, death of the plan participant, payments under a QDRO, certain distributions to qualified military reservists called to active duty and 72t (also known as series of substantially equal periodic payments or SEPP).
If you would like help properly structuring your Early Retirement, please contact us today.
There are (3) standard methods the IRS allows us to use in determining a 72t distribution:
- Amortization Method
- Annuitization Method
- Required Minimum Distribution Method
We have specialized software that helps us to customize a plan and select the appropriate payment method for you. Each method will provide a different monthly or annualized distribution amount. The method that will be used will depend on the amount of income that you need and your personal situation. We can help you determine which method will efficiently generate the income you need.
The life expectancy tables that can be used are:
- Uniform Life Table
- Single Life Table
- Joint Life and Last Survivor Table
The most common table used is the Uniform Life Table, and all three tables can be found on the IRS.gov website.
The maximum 72t interest rate allowed is the greater of 120% of the Federal Mid-Term annual rates of the (2) months immediately preceding the month that you start distributions. Please note this is NOT the interest rate to expect on the actual investment that the 72t distribution is coming from. It is simply the factor used to calculate the allowed amount that you can take for this valuable strategy. Current rates can also be found on the IRS.gov website.
You might be able to use your IRA assets for a short period of time using a 60 day rollover. However, you must follow the rules carefully to avoid paying a penalty. You must pay the money back and place it into the same IRA or another traditional IRA within the 60 calendar day window required by federal law. If you do not pay back the full amount within the 60 days, it will likely be considered a distribution and you’ll owe income tax on it. In addition, it may also be subject to the 10% early withdrawal penalty if you are younger than 59 ½. There are certain situations in which you may avoid the early withdrawal penalty, such as a first-time home purchase, health expenses, medical insurance, educational expenses, disability and Substantially Equal Periodic Payments.
Starting at Age 59½, you can begin taking money out of your retirement accounts without penalty. Keep in mind that you will have to pay any federal or state taxes that might be due.
Distributions from Traditional IRAs prior to age 59½ are subject to a 10% penalty, in addition to applicable federal and state taxes. Under the following circumstances, you may be able to avoid the penalty on early withdrawals:
- Distributions for a first time home purchase
- Paying for higher education expenses
- Paying for medical expenses
- Separated from service
- And finally, Establishing a Series of Substantially Equal Periodic Payments
72(t) distributions are not applicable to a Roth IRA, as the dollars that were originally contributed to the Roth IRA have already been taxed. With a 401(k), contributions are traditionally deducted from your paycheck and your taxes are deferred until a later date. With an IRA, if you fall within a particular threshold of annual income, your annual IRA contributions are deducted from your Adjusted Gross Income so you haven’t paid taxes on those dollars yet either.
Roth IRA contributions have already been taxed, so 100% of your principal is tax free upon distribution (assuming it’s been open for 5 years and you are over Age 59 ½). Early withdrawal penalties will only be assessed to the extent that there are gains, and there is not a 72t exception for those penalties.
As for any other non-IRA accounts, the only exception is Non Tax-Qualified Annuities. Annuities are retirement vehicles, so even policies funded with post-tax dollars will be assessed the early withdrawal penalty if funds are taken prior to Age 59 ½. You CAN structure a 72(t)-like distribution from these annuities also. This strategy is specifically referred to as a 72(q) distribution. The payment method and options available are all the same.
Once you start your series of substantially equal periodic payments, you are not allowed to make any additional contributions to the account, including rollover contributions, direct transfers and/or annual contributions. However, right before you start the 72t income, you are allowed to move money between accounts. For example, if you have just one IRA with $200,000 in it, but you only wanted $50,000 in the account from which you are taking the series of substantially equal payments, you could transfer $150,000 to a separate IRA so it wouldn’t be affected.
Multiple IRA Accounts
If you have multiple IRAs and you are only taking 72t distributions from one of them, you can make your annual IRA contributions by contributing to a different IRA. For example, say you have one IRA at a Bank, another at a Mutual Fund company and a 3rd at an Insurance company. If you are taking 72t distributions from your IRA at the Bank, you can make your annual contributions to your IRAs at the Mutual Fund company and Insurance company without penalty, even though you are not allowed to add any money to the IRA at the Bank.
If you would like help to properly structure your early retirement plan, contact us today.
There are (2) ways we typically work with people, and there are (3) steps that we take:
- 1) Become familiar with you and your situation as well as your goals and objectives
- 2) Determine the correct payment method and amount to take as well as how to properly structure your accounts based on your unique situation
- 3) Create, implement and execute a suitable and sustainable Early Retirement game plan
Managing the early distribution accounts and payments for you, accrue no additional fee.
Some people approach us looking for the 72t calculation and investment advice, but prefer to manage the money themselves in their existing accounts. While we don’t recommend this, we are happy to run the calculations, draw up a detailed game plan and provide a proposal that lays out everything we would do if we were managing the account. We do this on a flat fee basis. The fee will depend on the complexity of your situation and the amount of time and work involved. We believe this would be a small investment compared to the thousands and even tens of thousands of dollars it would cost you if your 72t plan is NOT properly structured.
The answer is YES. Remember, retirement accounts are 100% tax deferred until you start taking withdrawals. Whether you are at, above, or under Age 59 ½, 100% of the dollars taken from your retirement account will be added to your income when filing your taxes. If you withdraw funds prior to Age 59 ½ without utilizing a known exception, a 10% early withdrawal penalty will be added to the tax liability for those dollars. So, by taking income through a 72t you are not avoiding income tax, but you are avoiding the 10% early withdrawal penalty.
Although the 72(t) rule does indeed state that you must take the equal periodic payments in such a way that the ENTIRE retirement account balance is depleted over your remaining life, there is a solution to get around this. You can open multiple retirement accounts and can choose to only apply the 72t distributions to just one of your retirement accounts (not all of them). This can most times be a complex process. We have a highly trained and experienced staff to assist and oversee that this is done in the proper manner. A mistake here could be VERY costly.