Getting the Money Early
Managing Your Retirement
Most people think that they can't touch the money in their IRAs until they reach the age of 59 1/2. While it's generally true that you're not going to want to before that age, you should know you can tap into your retirement cash before then with no penalty owed to Uncle Sam. And you don't even have to be retired to get your hands on it. What makes this possible is a little known section (ssshhhh) of the Internal Revenue Code (IRC). Section 72(t)(2)(iv), IRC -- there'll be a quiz on that later, so remember it -- stipulates that funds may be withdrawn penalty-free from an IRA or qualified retirement plan at any age prior to age 59 1/2. There is, of course, a catch. Actually, there are more catches than Jerry Rice has in the average season.
To qualify for this treatment, the withdrawal must be part of a series of "substantially equal periodic payments" determined by the participant's life expectancy or the joint life expectancy of the participant and a designated beneficiary (spouse, usually). There are three approved and accepted methods for receiving these payments, all of which result in a different sum paid to you. In each, you must pay ordinary income taxes on the withdrawal, but you will not have to pay the 10% "excise tax" due to a premature distribution.
If you have multiple IRAs, you may choose which IRA to use for withdrawals. Additionally, you may make simultaneous withdrawals from two or more IRAs, and use a different withdrawal method for each. When you get right down to it, there's almost no end to how complicated you can make these things -- but we'll try to keep them as simple as we can.
Be forewarned. There is a common belief that the various methods of determining the acceptable annual payouts were created by failed math Ph.D. candidates as some sort of bizarre revenge on society. We're not entirely going to rule out that hypothesis, but, to set the record straight, if there is any evidence to support this theory, it is marked "Top Secret." The IRS swears that it is just trying its best.
Be that as it may, let's look at the three methods through which you may take penalty-free withdrawals from your IRA.
Life Expectancy Method
The life expectancy for the participant or the joint life expectancies of the participant and a beneficiary are determined using the IRS life expectancy tables found in IRS Publication 590, Individual Retirement Arrangements. (Download this publication at www.irs.gov.)
The account balance as of the beginning of the year is divided by the life expectancy factor found in the applicable table. If your account balance is $100,000 and the table states that you are expected to live 20 years, you can take $5,000. In the second and succeeding years, the required withdrawal amount is recalculated in one of two ways. In the first, the life expectancy factor used in the first year is reduced by one (i.e., you are now expected to live 19 years), and that recalculated factor is used as the new divisor of the remaining money in the account. After 20 years, you will have withdrawn all the money.
Alternatively, you can look up the new life expectancy based on attained age. (Perhaps the IRS now thinks you will live even longer, and surprisingly, actuaries tell us that's true.) Then use that new factor as the divisor.
For every successive year, you must continue to use the recalculation method selected in year two of the withdrawal.
Should you use either of the life expectancy methods? Do you understand them? Know this much -- the life expectancy method results in the smallest withdrawal amount of the three methods permitted by the IRS to avoid the excise tax, so that may decide the issue for you.
In this method, life expectancy is again determined using the tables in IRS Publication 590. Additionally, an assumed earnings rate may be used to determine the annual withdrawal amount that will deplete the entire account over that life expectancy. The rate must be a "reasonable interest rate" decided on before the withdrawals begin, and generally it must be within 120% of the applicable federal long-term rate. There is no precise definition of this rate that has been established by the IRS, so it must be selected with care. Once determined, the withdrawal amount remains fixed from year to year; however, that amount will be larger than the one determined using the life expectancy method. Consult with a qualified tax advisor.
This method results in a fixed withdrawal amount like the amortization method, and it is computed similarly. The difference is in the fact that IRS life expectancy tables are not used. Instead, those in general use by the life insurance industry are acceptable. An annuity factor derived by using the UP-1984 Mortality Table is the general standard for this method. The resulting calculation results in the highest withdrawal amount of the three approved withdrawal methods.
72(t) Pros and Cons. Mostly Cons.
There are a number of drawbacks to using the Section 72(t) method of withdrawals. First, regardless of the method used, the process must continue for a minimum of five years or until age 59 1/2, whichever occurs later in time. Start at age 58, and you must continue until age 63. Start at age 50, and you must continue until age 59 1/2. If withdrawals are made from multiple IRAs, the five-year period runs separately for each IRA based on the date withdrawals started. This, obviously, can result in a lot of paperwork.
Second, if you make a simple math error in computing the exact amount of the withdrawal, if you stop the withdrawals too early, or if you change the calculation method, then all withdrawals up to that point are subject to the 10% premature distribution excise tax. And if that isn't enough, the IRS will also assess an additional penalty for failure to pay that amount in prior tax years.
Third, the life expectancy method too often fails to provide the needed income to the recipient anyway. To increase the amount, the person must use one of the other two methods and/or withdrawals from multiple IRAs. The "reasonable interest rate" that must be used in these methods, while resulting in a higher withdrawal amount, can be challenged by the IRS. Thus, it's a rate that must be selected with extreme care. Additionally, the calculations involved in the amortization and annuity methods may be beyond the capability of most folks. In short, the potential for error and subsequent IRS penalties with these two methods is large.
To be safe, those who wish to use Section 72(t) withdrawals should engage a professional skilled in the computations of all three methods. In addition, that professional should provide the account owner a letter specifying in detail the calculation method used. The letter should also specifically express an opinion that the calculations comply fully with the requirements specified in the IRC and by the IRS. That way, there's someone for you to point your finger at if everything blows up and the IRS comes a-callin'. Things are just much safer that way.
If you don't really need to think about taking the money early, learn what happens when you must take the money.