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Cracking Your Nest Egg Early
There are exceptions to the early-withdrawal penalty for IRAs. But be careful.
February 2007
By Susan B. Garland
You've heard it over and over again: Don't tap your IRA early. Make withdrawals before age 59 1/2, and you'll be socked with a 10% surcharge on the value of the distributions. As with most rules, this one has its exceptions. If you retire early and need to draw on your nest egg, you can avoid the surcharge, as long as you follow a number of conditions.
The early-withdrawal penalty is waived if you agree to take "substantially equal periodic payments," known as SEPP, which are based on your life expectancy. "You're acting like your own insurance company and writing yourself a fixed annuity," says William Stecker, a certified public accountant with the Marble Group in Conifer, Colo.
Unlike an annuity, the payments must last at least five years or until you turn 59 1/2, whichever is longer. The rules are complex, and you could end up paying huge penalties if you make a mistake, so go this route only if you really need the money. Once you start taking withdrawals, you're stuck. If you stop the payments or change the amounts midstream, you'll be slapped with the 10% surcharge plus interest on all prior withdrawals.
There are three ways to calculate "72(t)" payments, named after the section of the tax code that waives the surcharge. Stecker suggests that most individuals should use the "amortization" method, which usually provides the highest payment. It basically takes your IRA balance and amortizes it over your life expectancy, assuming a specified rate of return.
First, you must choose an interest rate to build into the calculation. To keep people from depleting their accounts, the IRS caps the rate at 120% of its midterm applicable federal rate (AFR). In February, 120% of the AFR was 5.65%. You then determine your life expectancy by using a life-expectancy table found in IRS Publication 590 (check the tables and the AFR at www.irs.gov). After determining your IRA's worth on December 31 of the preceding year, you can compute your yearly payments with a financial calculator or amortization software.
You can save yourself trouble if you use calculators on 72t On The Net (www.72t.net). Let's say you're 52 with a $1 million IRA. If you plug in a 5.65% rate and use the single-life table (your life expectancy is 32.3 years), the magic number is $68,026. You would have to withdraw that much each year until you pass age 59 1/2. Plan for income-tax payments because the withdrawals are taxable income.
If you don't need that much money, you can lower the interest-rate assumption, or split the IRA into separate accounts and set up the periodic-payment plan using one account. Try using the Web site's reverse calculator: You plug in the amount you'll want each year, and it will tell you the total amount of assets you need to allocate to the account.
Splitting Your IRA
For instance, if the 52-year-old with the $1 million IRA wants a payment of $30,000 a year, the calculator shows that the retiree must keep about $440,000 in the account. The person can then divide the IRA and roll over the $560,000 balance into another IRA.
Splitting an IRA allows an individual to avoid a common mistake. "Individuals plug in all of their assets and leave themselves nothing for emergencies," says Gordon Weis, who runs the Web site. If you dip into the IRA for the emergency money, Weis says, "you've busted the SEPP," and you'll be on the hook for surcharges and interest on previous distributions.
Besides the periodic-payment exception, the IRS allows you to take penalty-free money from an IRA for medical expenses, disability and a divorce settlement. But you can't take the money for medical reasons if your IRA is being used for periodic payments. Suppose you had withdrawn $100,000 a year for six years, and then withdrew $100,000 for your periodic payment and another $100,000 for a medical procedure. Stecker says you'd owe the IRS a $70,000 surcharge and at least $30,000 in interest.
However, if you had split your IRA first, you could have withdrawn the extra $100,000 from the second account surcharge-free, says Stecker, who has written a periodic-plan guide available for purchase at www.72t.net.
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