Retiree Portfolio Escape the Early Withdrawal Penalty

Most of us have substantial funds tied up in tax-advantaged accounts. In general, we can't tap into those funds before age 59 1/2 without paying a 10% early withdrawal penalty. However, there are two ways to avoid the penalty. Armed with this knowledge, we will be better able to make early retirement a reality.

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By David Braze (TMF Pixy)
November 26, 2001

Many of us dream of an early retirement. For me, my third retirement is at hand. In four days, I will once again leave the daily workforce. I could have retired permanently many years earlier, but I really didn't want to. With proper planning, though, that's certainly an achievable goal for you should you desire to do so. All you have to do is plan for it.

Included in your plan should be a firm understanding of how you'll pay the bills when you are no longer employed full-time. Most of us will get our retirement income from a combination of Social Security, company pensions, savings, and/or part-time work. When I retire in a few days, those will be my sole sources of income.

But if you retire before age 62, you will not receive a payment from the Social Security system unless you are disabled. And you may or may not receive a company pension, depending on the provisions of your particular pension plan (assuming one is even provided by your employer). Even if you do get Social Security, a large part of your retirement income will still come from your lifetime savings, most of which will be tied up in tax-advantaged vehicles such as Individual Retirement Arrangements (IRAs) and 401(k)/403(b) plans. In general, however, money cannot be withdrawn from traditional IRAs or 401(k)/403(b) plans prior to age 59 1/2 without incurring a 10% penalty.

But what if you want to retire early, i.e., before age 59 1/2? Well, Fool, there are ways to avoid the early withdrawal penalty. Let's look at a couple.

IRS Publication 575, "Pension and Annuity Income," tells us that an early distribution penalty will not apply when withdrawals are made "(f)rom a qualified retirement (other than an IRA) after your separation from service in or after the year in which you reached age 55." Therefore, when you leave your job in or after the year of your 55th birthday, you may take money from your employer's retirement plan(s) and only have to worry about paying ordinary income taxes.

But � ain't there always one of those? � several other factors come into play here:

  • You do not have to be age 55 at the time you leave the job. All that's required is that you will reach that age by December 31 of the year you separate from service.
  • To make a penalty-free withdrawal, the money must remain in and come from your employer's plan. If the money is transferred to a traditional IRA, the age 55 exception no longer applies.
  • The plan does not have to permit such withdrawals. The plan documents will dictate how and when distributions may be made.
  • Money left in a former employer's plan does not qualify for the age 55 penalty-free withdrawal. Only your last employer's qualified retirement plan money may qualify for this exception. Even then, you must separate from service in the year you will attain age 55 to take money penalty-free from that plan.

What happens if you retire earlier than age 55 or if most of your tax-deferred savings is in IRAs or in the plan of a previous employer? Well, all is not lost. In that case, you will almost certainly be able to use the "substantially equal periodic payments" (SEPP) rules to make penalty-free withdrawals from your IRAs or employer plans. For details on SEPP rules, see Getting the Money Early.

Interestingly, SEPP may be used at any age to avoid the early withdrawal penalty. The rules permit distributions "(m)ade as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your beneficiary (but, if from a qualified retirement plan other than an IRA, only if the payments begin after your separation from service)." The IRS allows three methods for taking SEPP, and each method results in a different amount that must be taken each year.

The SEPP exception also has some idiosyncrasies:

  • Once begun, SEPP must continue for the longer of five years or until you reach age 59 1/2. Start at age 50, and you must continue until you reach age 59 1/2. Start at age 57, and you must continue until age 62.
  • If you have multiple IRAs or qualified retirement plans, you may choose which account you wish to use for SEPP. Additionally, you may make simultaneous withdrawals from two or more IRAs, and use a different withdrawal method for each. The five-year/age-59 1/2 withdrawal period will run separately for each account based on the date the first withdrawals were made.
  • Once you select a method to use for withdrawals, that method may not be changed. Additionally, you must take the exact amount prescribed by that computation or face severe financial penalties from the IRS.
  • Qualified retirement plans do not have to allow SEPP. Plan documents will dictate how and when distributions will be made. However, if the plan does not allow SEPP, the money may almost always be moved to a traditional IRA from which SEPP may be taken.

Thus ends my regular column at The Motley Fool. However, I'll still post from time to time on the Retirement Investing and Retired Fools boards. Maybe I'll see you there. I certainly hope so. In the meantime, happy retirement planning!

Best to all...Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. In four days, he begins his third retirement. Perhaps he'll stay that way this time, but with Dave you never know. We can always hope.