Penalty-Free Income Options for Early Retirees

April 25, 2012

by Ana Maria Martinetti-Katz, MBA, CFP®, CPA – April 2012

The current state of the economy has many employers avoiding new hires and squeezing more and more from existing employees. As a result, many individuals are finding themselves in a predicament. They want and need to keep working but they can’t keep up the pace. Many want to just throw in the towel and retire but don’t know how they can afford to do so when they are still not at “normal” retirement age. Retirement plans in general do not allow an individual to distribute money penalty free before the age of 59 ½ in order to incentivize people to let that money grow tax deferred for as long as possible. However, every rule has an exception. Below we will discuss different options for individuals to withdraw retirement funds before 59 ½ and avoid the 10% penalty.

Traditional IRA Distributions

Early distributions (before the participant reaches age 59½) from a retirement plan or IRA account bring with it an additional 10% penalty. But there are some exceptions. These are listed under Section 72(t)(2) of the Internal Revenue Code and include:

  • Distributions due to death
  • Distributions due to disability
  • Distributions that are equal to or less than the amount of deductible medical expenses (medical expenses that are more than 7.5% of your adjusted gross income regardless of whether or not you actually itemize)
  • Distributions for qualifying education expenses
  • Distributions for a first time homebuyer (defined as someone who has not owned a home for at least the past two years). The lifetime exemption for this exception is $10,000.
  • Distributions made as part of a series of substantially equal periodic payments

The first five exceptions are pretty easy to understand but the last one requires some explanation and calculation.

Internal Revenue Code Section 72(t)(2) allows an individual to take a series of “Substantially Equal Periodic Payments” from an IRA before the age of 59 ½ penalty free. Specifically, one must take distributions for the longer of five years or until the age of 59 ½. The tax code provides three methods by which to calculate the amount of the distributions required:

  1. Minimum Distribution Method: With this method, you divide the value of the IRA account as of December 31st of the prior year by a life expectancy factor provided by the IRS. Because the amount must be calculated annually (and account values fluctuate with the market), it is difficult to anticipate what the annual distribution amount will be. For younger individuals with longer life expectancies, the required distribution amount should be expected to be rather small, around 4% or so.
  2. Fixed Amortization Method: With this method, you amortize the value of the account over your life expectancy (based on IRS tables) and an interest rate that cannot exceed 120% of the federal mid-term rate. (The federal mid-term rate is published monthly by the IRS). Once an annual distribution amount is calculated with this method, it remains the same for all subsequent years. This makes it easy to know what your annual distributions will be.
  3. Fixed Annuitization Method: Under this method, you divide the value of the account by a life expectancy factor to determine your annual payment amount. The life expectancy factor is based on IRS mortality tables and an interest rate that cannot exceed 120% of the federal mid-term rate. Like the Fixed Amortization Method, once the amount is determined, it cannot be changed.

You are allowed a one-time change from either the amortization method or the annuitization method to the required minimum distribution method. Any changes in the payment schedule not done correctly will trigger a 10% penalty plus interest which is applied retroactively to all previous distributions. Additionally, changes to the account balance either by additions, rollovers or transfers out of the account are disallowed.

For individuals who want to control how much is distributed from these accounts, it is possible to divide the IRAs into different accounts and take distributions on just one smaller account rather than the whole, larger pot of IRA monies. This situation is obviously more suited for individuals who either need to supplement income or who have IRAs so large that the distributions from them would far exceed what they actually need to live.

Roth IRA Distributions

Withdrawals of Roth contributions are always done tax-free because the contributions were made with after tax money (no double taxation). There are “ordering rules” in place that help determine the source of assets distributed from a Roth IRA. According to the ordering rules, assets are distributed from a Roth IRA in the following order:

  1. Regular Roth IRA contributions
  2. Taxable Traditional IRA conversions and taxable rollovers from qualified plans, 403(b) or governmental 457(b) plans
  3. Nontaxable Traditional IRA conversions and nontaxable rollovers from qualified plans and 403(b) plans
  4. Earnings on all Roth IRA assets

In other words, the first distributions from a Roth IRA are your regular contributions to the account. Once the total of those contributions has been withdrawn, they are followed by taxable and nontaxable Traditional IRA conversions or taxable rollovers from employer sponsored retirement plans (if applicable). These distributions are all taken income tax free while some may be penalty free.

However, any earnings withdrawn are subject to taxes and a 10% penalty if they do not qualify for any of the exceptions (see previous section) and it has been less than 5 years from the beginning of the year in which the IRA was initially set up and funded.

Separation from Service After 55

For individuals who were separated from service after the age of 55, an option may exist to withdraw funds from a 401(k) or other qualified employer sponsored plan penalty free. This option is on a case by case basis and determined by the employer plan document. The funds must stay in the employer plan in order for the distribution to be allowed. If the assets are rolled into an IRA, the opportunity is lost and the more restrictive rules that we discussed previously under “Traditional IRA Distributions” would apply. It is also important to mention that you must separate from service after the age of 55. You cannot separate from service before then and then begin taking distributions at 55.

Qualified Domestic Relations Order (QDRO)

The United States Department of Labor defines a Qualified Domestic Relation Order as “a domestic relations order that creates or recognizes the existence of an alternate payee’s right to receive, or assigns to an alternate payee the right to receive, all or a portion of the benefits payable with respect to a participant under a retirement plan, and that includes certain information and meets certain other requirements.” The IRS allows for a distribution from a qualified retirement plan under a QDRO pursuant to a divorce without incurring the 10% penalty, but still subject to ordinary income tax. This distribution must be done directly from the plan. If the assets are rolled into an IRA, the benefit is again lost. This may be an option for the divorced spouse that needs to refinance a mortgage or pay down debt as he/she rebuilds his/her life after such an event. However, the use of these funds under such an arrangement should be considered in conjunction with a comprehensive plan.

In closing, although it is ultimately best to distribute assets from taxable accounts, if you are under the age of 59 ½ and retired, you do have options within tax deferred accounts. The important thing to remember is that you should research all of your options before moving any monies in or out of accounts. This allows for more opportunities and greater flexibility. If you find yourself involuntarily retired, it is best to consult with competent financial counsel. He or she will help you figure out your options and come up with a tax efficient strategy that helps you meet your goals while avoiding penalties and the long term demise of your portfolio. Remember, “Knowledge is Power”.