Cash Out Early
New rules -- and a break -- for tapping an ira ahead of schedule.
By Mary Beth Franklin, Senior Editor
From Kiplinger's Personal Finance magazine, September 2003
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Everyone knows that the magic age for withdrawing savings from an IRA is 59 1/2. But thanks to an exception that lets owners tap accounts penalty-free ahead of that schedule, Bill and Barbara Doggart of Brick Township, N.J., are enjoying an early retirement filled with boating, fishing and golf. Although Bill, 57, and Barbara, 55, pay tax on their IRA money, they ignore the 10% early-withdrawal penalty by taking regular payments based on their life expectancy.
Bill's job as an assistant manager with Verizon was eliminated when he was 54, one year shy of another loophole that allows workers who leave their job at 55 or older to tap their 401(k) funds penalty-free. When he and Barbara married last July, their new home was too far away from her job with Avon Products in New York City, so she also retired at 54. Pulling $72,000 a year out of their IRAs allows the Doggarts to live comfortably in retirement years before they thought they could afford to call it quits.
For millions of mid-career employees who have lost their jobs or choose to leave but are too young to draw traditional retirement benefits, tapping an IRA early can be the ticket for leaving the 9-to-5 grind behind. But the rules are tricky. If you start taking early withdrawals, you must continue the payments for at least five years and until you reach age 59 1/2.
Except for a new -- and, for some, lifesaving -- exception that is discussed below, once you select a payment option, you cannot change it during the payment term. If you do, you'll pay dearly: The 10% penalty will be triggered retroactively on all withdrawals, and because you didn't pay tax at the time of the withdrawals, you'll be hit with a bill for interest on the late tax payments.
How to figure the payout.
How much you can withdraw penalty-free each year depends on how much is in your account and which of three payout methods you use. The simplest -- the life-expectancy method -- divides the IRA balance by your life expectancy. If, say, you have $250,000, and IRS tables say you'll live for 29.6 years (the life expectancy for a 55-year-old), you could withdraw $8,445 ($250,000 divided by 29.6) penalty-free the first year. In year two, you'd divide the balance by 28.7, the number of years IRS tables say a 56-year-old is expected to live, and so on. The other choices -- known as the amortization and annuity methods -- are more complicated, but allow larger payouts because you build an expected rate of return into the calculation.
The IRS recently made changes to the so-called 72(t) rules (named after the section of the tax code that governs early-IRA withdrawals) to set a maximum interest rate for these calculations. Previously, taxpayers were allowed to select their own "reasonable" rate. Now you're limited to a rate published by the IRS, which was 3.06% in July. (The rate can change monthly, but all your withdrawals are based on the rate in force when you begin.) Consequently, taxpayers establishing an IRA payout schedule this year and in the future will be able to withdraw less money than they could in the past. Those who started before 2003 can stick with the rate they originally built into their withdrawal schedule.
The new IRS rules also address a problem that the original tax law did not envision: declining IRA balances caused by a bear market. Many taxpayers who had selected the amortization or annuity methods to compute their payments were stuck with disproportionately large payments compared with their shrinking balances, notes IRA expert Ed Slott of Rockville Centre, N.Y. The new rules throw taxpayers a life preserver by allowing a one-time, penalty-free switch to the minimum-distribution method. The bad news: The switch could result in drastic cuts in IRA payouts.
For example, the annual payment for a 52-year-old with a $1-million IRA who chose the annuity method with a 7% interest rate would be $85,041, says Slott. Under the old rules, if the balance dropped to $500,000, the IRA owner would still have to take the $85,041 or trigger a retroactive 10% early-withdrawal penalty. But because the new rules allow a switch to the minimum-distribution method, the IRA owner can avoid rapid depletion of the IRA. The downside: The payout would drop to $15,480 (the $500,000 balance divided by a 32.3-year life expectancy).
Once you pass the five-year-and-age-59 1/2 test, you can adjust withdrawals, or end them completely, if you wish.
--Reporter: Katy Marquardt