Your IRA funds are intended for your retirement years. To discourage the desire to tap into retirement savings early, Internal Revenue Code Section 72(t) institutes a 10% premature distribution tax on withdrawals, if made before you reach age 59½.
Now, as with most IRS rules, there are exceptions. Distributions made after your death; distributions made because you have a qualifying disability; distributions for a first-time home purchase; qualifying higher education expenses, and unreimbursed medical expenses. All these exceptions have rules that allow for penalty-free early withdrawals.
However, what if your financial circumstances change? What if you lost your job at age 50 and had to take a job that paid significantly less? What if you wanted to retire early, but all your retirement funds are in an IRA?
One of the exceptions under Section 72(t) is for taking a series of “substantially equal periodic payments.” The payments must be for the longer of five payment years from the first distribution or until you reach age 59½. While this method bypasses the early withdrawal penalty, the withdrawals are taxed at your current income tax rate. The drawback to taking advantage of Rule 72(t) is that you may deplete your retirement accounts well before the end of your life expectancy.
For example, Bruce is 50 years old, and was laid off from his job. He has since found a new job, but for substantially less pay. Bruce rolled his 401(k) to an IRA and has depleted his non-retirement accounts to make up for the income shortcoming. With the careful help of a financial adviser or C.P.A., Bruce can take substantially equal periodic payments from his IRA. Because Bruce is only 50, he will have to take these periodic payments until he reaches age 59½.
To calculate how much Bruce can take from his IRA, he must use one of the three IRS-approved calculation methods, the Life Expectancy Method, Amortization Method or the Annuitization Method.
The Life Expectancy Method is calculated using the minimum distribution rules where the annual payment for each year is determined by dividing the account balance by the number from the chosen life expectancy table. Under this method, annual payments are re-determined each year, which may mean the amount of the payment may change year-to-year.
Payments using the Amortization Method are determined by amortizing an account balance over a specified number of years equal to life expectancy and a chosen interest rate. Once an annual distribution amount is calculated under this fixed method, the same dollar amount must be distributed under this method in subsequent years.
Under the Annuitization Method, the annual payment is determined by dividing the account balance by an annuity factor, which is the present value of an annuity of $1 per year, beginning at the taxpayer’s age and continuing for the life of the taxpayer. The annuity factor is derived using the mortality table and the chosen interest rate. Like payments calculated under the Amortization Method, the annual payment is the same for each succeeding year.
Both the life expectancy tables and mortality tables are provided by the IRS. The interest rate that may be used is any interest rate that is not more than 120% of the federal mid-term rate. According to the IRS, the account balance must be made in a reasonable manner based on facts and circumstances. Any combination of IRAs may be taken into account in determining the distribution by aggregating the account balances. Multiple IRA plans do not have to be combined for purposes of calculating payments. However, you cannot exclude a portion of an IRA. The entire balance in the account must be used.
In our example, Bruce was looking to supplement his income, not replace it. He determined the amount needed in an IRA to setup under Rule 72(t). He then opted to use the Life Expectancy method because it resulted in the smallest withdrawal. Unfortunately, even if Bruce were to find a better job in five years, he is locked into taking the scheduled withdrawals until he is 59½. He could, however, set up a new IRA and continue to save for retirement. If Bruce were to find a better job within a year, making well more than he did at his former employer, he could decide to stop taking distributions and opt to pay the 10% penalty on the one withdrawal. If Bruce’s situation were to turn worse, he could use Rule 72(t) in another IRA account. The IRS treats all accounts individually, so he would need to be sure that the appropriate payment comes from the appropriate plan.
Because these calculation methods are complex, it is important that you consult a financial adviser or C.P.A. If you make a mistake on any withdrawal, the IRS will assess a 10% penalty on each of your withdrawals.
The safe course of action is to document all plan transactions, the calculation method used, when payments are to commence and the frequency of the payments. Copies of the account statements that were used to determine the initial payment must be kept, as well as any documents or statements used for recalculation. You should also keep copies of statements reflecting the transactions as they occur.
At Henssler Financial, we adhere to our Ten Year Rule philosophy where any money needed within 10 years is invested in fixed-income investments. Any money not needed within 10 years is invested in high quality common stocks or mutual funds that invest in common stocks.
In our example, Bruce should have had 10 years of liquidity needs set aside in fixed-income investments. When his circumstances changed that resulted in an income shortfall, he could have provided for his shortfall from the 10 year liquidity funds. The Rule 72(t) should allow Bruce to weather his financial storm with little penalty. Since Bruce is tapping into his retirement funds, he will likely have to work longer to stay on track with his financial plan to maintain his current lifestyle in retirement.
At Henssler Financial we believe you should Live Ready, which includes using IRA withdrawal rules to your advantage. If you have questions on tapping into your IRA before age 59½, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
