Rubins Financial Strategies - Article, Avoid Early Retirement Penalty

Early Retirement -- How to Avoid Early Withdrawal Penalties
From IRA's Prior to Age 59-1/2

Written and edited by Harry Rubins for his clients and friends.
Not intended as legal or tax advice.
Obtain professional advice before taking action on this information.

Previously, the only way to use funds from an IRA without the 12-1/2% premature distribution penalty (10% Fed + 2-1/2% CA) was death or total disability before age 59-1/2 – choices that are not at the top of your list. You can still use the 60 day IRA rollover to avoid the 12-1/2% penalty for company pension/401(k) distributions and between IRAs. But if your financial and personal objectives prior to age 59-1/2 are longer than 60 days, then you were out of luck.

The Tax Reform Act of 1986 added another exemption to the 12-1/2% premature distribution penalty tax with Internal Revenue Code Section 72(t)(2)(A)(iv) referred to as 72(t). Generally, the exception permits individuals to take "substantially equal periodic payments". Therefore, we now have more freedom prior to age 59-1/2 to consider:

early retirement offers from company's restructuring.
career changes to start a new business or obtain more schooling.
funding college education, supporting elderly parents or other financial needs.

Originally the new exemption wasn't very useful because there were many gray areas regarding how to establish these payments. We now have guidance from the IRS (notice 89-25) so you can use your IRA to retire early, start a new business, etc. Of course, both Federal and State taxes are still due, but the 12-1/2% penalty is avoided.

The exemption is really only practical for people in their late 40's & 50's. After 59-1/2 there is no penalty. For younger individuals the IRA balances are generally small and distributions would have to continue until age 59-1/2. Once you start the distributions under the 72(t) exemption they must continue for at least 5 years or until age 59-1/2, whichever is longer. In other words, if a 30 year old begins distributions, they must continue for almost 30 years (i.e., until reaching age 59-1/2). On the other hand, if a 58 year old begins distributions, they must continue at least until age 62 (i.e., for at least five years).

Three methods are provided to set up payments to satisfy this exception to the 12-1/2% penalty which will be considered substantially equal periodic payments. Any one of the three methods may be used.

Method 1 – Required Minimum Distribution

The payment is determined according to the rules for the required minimum distributions used at age 70-1/2. Payments may be based on the joint life expectancy of the account holder and a designated beneficiary or the account holder's single life expectancy. The payment is calculated by dividing the IRA account balance by the single or joint life expectancy.

Method 2 – Amortized

The payment is determined by amortizing the IRA balance over either single or joint life expectancy. A reasonable interest rate determined on the date payments commence must be used. Note that amortizing an account balance is different than dividing the balance by a life expectancy figure. The annual payment is fixed and is the same each year.

Method 3 – Annuity

The payment is determined by dividing the IRA balance by an annuity factor. The annuity factor is the present value of an annuity of $1 per year beginning at the individual's age attained in the first distribution year. A reasonable interest rate determined on the date payments commence must be used. The account balance is divided by an annuity factor to determine your fixed annual payment. In the illustration the annuity factor for the 50 year old account holder is 11.109. The payment is the same for either single or joint life expectancy.

Method 1 is recalculated each year based on the January 1 account balance and the following year's life expectancy. Depending on the performance of the investments, next year's distribution could increase or decrease. For methods 2 & 3 the distributions are fixed so they are the same each year for at least 5 years or until age 59-1/2, whichever is longer.

Since the payments from methods 2 & 3 are fixed and not adjusted for inflation (loss of purchasing power) you need to plan your finances to take this into account for the distribution made 5 or 10 years later. Distribution must be taken at least annually. Therefore, monthly or quarterly distributions are acceptable. After 59-1/2 years old you are able to stop or change the distributions.

You need to follow the rules as the penalty is retroactive. If you change the annual payments, except as noted for Method 1; do not continue distributions until the later of five years or age 59-1/2, or if the distributions are deemed to not qualify under the 72(t) exception, the 12-1/2% premature distribution penalty tax may be applied retroactively to all distributions. Therefore use caution and the assistance of a competent tax advisor when establishing payments under the exception to the 12-1/2% premature distribution penalty tax.

The 72(t) guidelines do provide some flexibility in selecting an amount that may meet your financial needs so you can retire early. You can use any one of the 3 methods, single or joint life expectancy and a range of acceptable interest rates. This is an important decision so plan carefully, but at least you have more freedom now to consider different financial and personal objectives prior to age 59-1/2.

Find out how you can retire early and avoid the early withdrawal penalty prior to age 59-1/2. Email or call Harry Rubins at (707) 542-9449 or (800) 675-6171.