Many people believe that if you want to retire early, retirement accounts like IRAs and 401(k) plans are off-limits. But a complicated provision of the tax laws allows early retirees to use their retirement savings without paying harsh penalties.
In general, it's costly to take IRA distributions before you turn age 59 1/2. Not only do you have to pay ordinary income tax on your withdrawal, but you also have to pay a 10% penalty for early withdrawal.
However, there is a way to get money out of your IRA before age 59 1/2 without paying a penalty. By taking advantage of a somewhat complicated tax provision, you can get a portion of your retirement account balances early.
Substantially equal payments and Section 72(t)
The tax laws provide some exceptions to the 10% penalty for early withdrawals. One way to qualify is set forth in Section 72(t) of the Internal Revenue Code. The law states that if you elect to receive "a series of substantially equal periodic payments" that are based on your life expectancy, then you don't have to pay the extra 10%.
Unfortunately, what constitutes "substantially equal periodic payments" gets complicated. There are three methods you can use to calculate exactly how much money you're allowed to withdraw penalty-free. The simplest, known as the required minimum distribution method, has you go through the same calculations that older taxpayers must make after they turn age 70 1/2 and are forced to start taking withdrawals from their retirement plans, like it or not. More complicated methods -- the fixed amortization and the fixed annuitization methods -- often require professional assistance to calculate correctly.
Early withdrawal problems
But the 72(t) exception isn't perfect. The biggest problem with it is that you can't withdraw very much money. For instance, the required minimum distribution method typically allows you to take only 2% to 3% of your total IRA balance each year, depending on your exact age. It takes a healthy retirement nest egg to benefit from such a small percentage.
In addition, once you decide to start taking substantially equal periodic payments, you have to keep taking them for at least five years -- and if you're not yet 59 1/2 after those five years are up, you can't stop until you turn 59 1/2. Even if circumstances change and you don't need the money anymore, you have to keep taking withdrawals.
Setting it up right
However, there are some circumstances where taking penalty-free withdrawals does make sense. Because the rules apply separately to each particular IRA account you have, you don't necessarily have to take withdrawals based on your entire retirement nest egg.
One good strategy is to separate your IRA funds into two accounts. In one account, put high-growth stocks that don't generate dividend income, such as Cisco
Then take withdrawals only from the income-producing portfolio. For most people, the dividends from those stocks should pay enough to cover your withdrawals and prevent you from having to sell shares to come up with the cash.
For most people, though, the easiest strategy is to find other sources of money and wait until age 59 1/2 before taking money out of your retirement accounts. Although Section 72(t) is an option for early retirees and others, it's not the simplest part of the tax code -- and it will often prove more trouble than it's worth.
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Dan Caplinger updated this article, which was originally published March 10, 2008. Dan has no financial interest in the companies mentioned above. The Fool has a disclosure policy.